The role of long term incentives, particularly equity holdings, in the decision making of CEOs has long been an area of interest for researchers and practitioners alike, given the potential significance of this relationship in company performance. A recent study of CEOs of US companies examined how a CEOs stock option holdings can affect their preference for short- or long-term strategic projects. The study found that when CEOs have accumulated stock option wealth, their likelihood of investing in the long-term increases, however when they have a large amount of recently granted options CEOs are more likely to prefer short-term projects.
Key Topics: Executive compensation; Stock options; Long term incentives; CEO decision making; Temporal orientation
Title of Reviewed Article: Going Short-Term Or Long-Term? Ceo Stock Options And Temporal Orientation In The Presence Of Slack
Researchers: Geoffrey P. Martin (University of Melbourne), Robert M. Wiseman (Michigan State University), and Luis R. Gomez-Mejia (University of Notre Dame).
Publication: Strategic Management Journal, 2016, Vol. 37 No. 12, pp. 2463–2480.
Setting the Scene
Both empirical and anecdotal evidence indicates that CEOs have significant influence over their company’s temporal strategy, that is, on the company’s focus on short- or long-term strategic projects. Managerial short term thinking has been widely described as destructive (Drucker, 1986; Marginson & McAulay, 2008), as it can be detrimental to a company’s long term performance and sustainability (Jensen, 2008).
While a large volume of prior research has examined CEO decision making and company performance (e.g. Chrisman & Patel, 2012), there is limited research specifically on the role of CEO equity based compensation in companies’ temporal orientation. Prior research, such as that by Souder and Bromiley (2012), for example, was inconclusive in determining the role of stock options on the temporal orientation of CEOs.
Behavioral agency research has indicated that CEOs, in response to equity incentives, will take account of personal wealth implications when making choices relating to company strategy, considering the impact on company performance and share price (e.g. Devers et al., 2008; Martin, et al., 2013). With stock options, the cash value of options (or current wealth) reflects potential losses to a CEO if risk taking is not successful and the company stock price falls (Martin et al., 2013), and as such CEOs may have incentive to taking a longer term strategic view as it poses less risk to their current wealth. Similarly, when prospective wealth captures future increases in stock option wealth, CEOs may take a shorter term strategic view in order to realize personal gains sooner.
This study extends behavioral agency research by examining the role of CEO incentives in a company’s temporal orientation when slack is available, i.e. when accumulated company resources, which are in excess of those required by the company in order to operate efficiently, are available to fund adaptation or strategic initiatives (Greenley & Oktemgil, 1998). Slack has been established as another factor that can impact on a CEO’s strategic decision making, as slack gives the flexibility to allocate resources to fund strategic initiatives across different time horizons.
This study put forward a number of research hypotheses for examination:
Hypothesis 1 – “Available slack will be positively related to long-term orientation in investment choices.”
Hypothesis 2 – “CEOs’ current wealth will be positively related to their long-term orientation
in investment choices.”
Hypothesis 3 – “CEOs’ prospective wealth will be negatively related to their long-term orientation in investment choices.”
Hypothesis 4 – “CEO current wealth substitutes for rather than enhances the positive effect of available slack upon long-term orientation in investment choices.”
Hypothesis 5 – “CEO prospective wealth enhances rather than neutralizes the positive effect of available slack upon long-term orientation in investment choices.”
How the research was conducted
Data was collected from Execucomp and COMPUSTAT for the period 1996 – 2011. COMPUSTAT provided 10-K reports for U.S. public companies, while Execucomp provided proxy statement data for U.S. public companies.
Companies from the manufacturing sector only were assessed for this study and 6012 CEO-year observations were included in the analysis.
As it was not possible to directly measure CEO’s’ temporal orientation when making investment choices, the researchers used asset durability as a proxy. Asset durability was measured by dividing the annual investment in property, plant, and equipment (PP&E) by depreciation expense.
Current wealth was measured using data from Execucomp. Prospective wealth was calculated using the average Dow increase over the period of analysis, which was 7%. Available slack was measured using companies’ cash and short-term securities.
A number of control factors were also taken into account in the analysis, such as company size, R&D expenditure, company performance, and CEO compensation.
Key Research Findings
The results supported Hypothesis 1, as available slack was positively related to long-term investment orientation.
A relationship was found between CEOs’ current wealth and their long-term orientation in investment choices, and as such Hypothesis 2 was also supported, albeit weakly.
Hypothesis 3 predicted that a CEOs’ prospective wealth will be negatively related to their long-term investment orientation, and the results supported this hypothesis, finding that when a CEO prospective wealth was greatest, the company’s asset durability, and therefore the CEO’s investment horizon, tended to be shortest.
Hypothesis 4 predicted that CEO current wealth substitutes for, rather than enhances, the positive effect of available slack on long-term investment orientation. The results indicated that there was a substitution effect, a thus Hypothesis 4 was supported.
Hypothesis 5 was also supported, with the results that CEO prospective wealth did indeed enhance the positive effect of available slack on long-term investment orientation.
The results indicate that stock options can affect the temporal orientation of CEOs, but that their affect may be more nuanced than previously thought. The results indicate that when a CEO has accumulated option wealth, there is an increased likelihood that they will invest in the long term. However, when a CEO has a significant number of recently granted options, they are more likely to invest in the short term, achieving personal wealth gains more quickly. This is interesting as it indicates that stock options, intended to align CEO and shareholders’ orientation, can lead to CEOs, in certain circumstances, to subordinate company level factors (e.g. slack) that could provide opportunity to invest in value enhancing longer term opportunities, in preference of their own wealth prospects.
The results further suggest that in order to understand the relationship between CEO temporal orientation and current wealth, contextual factors of the relationship must be considered, such as the available slack of the company.
Organizational and Reward Implications
This study highlights some of the complexities of CEO compensation, and how important contextual factors and the personal wealth profile of the CEO are in understanding whether stock options, and indeed other compensation vehicles, will meet their intended purpose.
The results of this study warn against a one size fits all approach to CEO compensation. One implication for boards is that they should anticipate CEO taking a short-term outlook where they have been granted new stock options. Furthermore, this study highlights the importance of boards monitoring the CEO’s portfolio of stock options to ensure they have sufficient risk bearing that will encourage a longer-term focus. Boards might consider issuing stock in addition to stock options, as a means of counterbalancing the prospective wealth and related incentives of new stock options.
This study examines the important role that compensation design can plan in a CEO’s orientation towards short- or long-term strategic projects, and in doing so provides a deeper understanding of the influence of CEO equity based compensation on a company’s temporal horizon. While stock options are often a central element of CEO compensation, future research would benefit from a fuller review of typical CEO compensation, to include other compensation elements, and how they may interact with stock options in shaping a CEO’s temporal perspective.
Source Article: Martin, G. P., Wiseman, R. M. & Gomez-Mejia, L. R. (2016). Going short-term or long-term? CEO stock options and temporal orientation in the presence of slack. Strategic Management Journal, 37(12), 2463–2480.
Published by: John Wiley & Sons, Ltd.
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