Performance-vested Stock Options and Pay-Performance Sensitivity

The paper investigates the incentive effects of performance-vested stock options (PVSOs) in aligning management interests with shareholder wealth. Performance targets attached to option vesting would prevent executives from receiving rewards from outcomes that are unaffected by their effort.Such targets align executive pay more closely with shareholder wealth.The degree of interest alignment is measured by pay-performance sensitivity (PPS).Using data on 4,238 executive-level observations for 1,383 executive directors in the largest 244 UK non-financial firms from 1999 to 2004, we find that the presence of PVSO schemes in executive-compensation contracts is associated with higher PPS, consistent with the idea that stronger incentives are provided by PVSOs.The empirical evidence also shows that PVSOs outperform unconditional stock options (TSOs) in providing incentives, since higher PPS is associated with the presence of PVSOs. Moreover, the results testify the role of vesting-target difficulty of PVSOs in the pay-performance relation.Specifically, difficult targets are associated with lower PPS levels, implying that too difficult targets negatively affect managers' choice of effort, that relatively lower effort is to be expected, and that the interests of managers will diverge from the interests of shareholders.