Firm Strategy and CEO−VP Pay Differentials in Equity Compensation

Abstract

We examine whether pay differentials between the chief executive officer (CEO) and vice presidents (VPs) can be explained by firms’ strategic priorities. We find that firms that pursue prospector-type strategies have a larger CEO−VP difference in equity compensation. We argue that such a pay differential relates to the relative authority that CEOs have in strategic decision-making, and we find that authority allocation based on a firm’s strategic priorities is consistent with the relative ability of the CEO vis-à-vis the VPs. Our results remain consistent after considering alternative explanations including CEO power, risk-taking incentives, and tournament incentives among VPs. Further analyses reveal that a large CEO−VP equity pay differential enhances firm value for prospector-type firms, and that shareholders and proxy advisors tend to incorporate firm strategy in their say-on-pay votes and proxy recommendations.

Keywords:

• Firm strategy
• Pay differential
• Strategic decision
• Decision-making authority structure

JEL classifications:

• J30
• M41
• L20

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplemental Data and Research Materials

Supplemental data for this article can be accessed on the Taylor & Francis website, https://doi.org/10.1080/09638180.2022.2119153.

Acknowledgments:

We appreciate the helpful comments of Mary Barth, Brian Cadman, Eddy Cardinaels, Alper Darendeli, Henri Dekker, Neil Fargher, Ian Gow, Paul Healy, Robert Holthausen, Chung-Yu Hung, Xue Jia, Anne Lillis, Don Moser, Vic Naiker, Valeri Nikolaev, Matt Pinnuck, Katherine Schipper, Naomi Soderstrom, Jeroen Suijs, Laurence van Lent, Mark Wilson, Huaxiang Yin, Wei Zeng, Yachang Zeng, Huai Zhang, and the seminar participants at University of Melbourne, Nanyang Technological University, Australian National University, Deakin University, and 2021 EAA Annual Congress. Our deepest acknowledgment goes to Alex Abernethy. All remaining errors are our own.

Correction Statement

This article has been republished with minor changes. These changes do not impact the academic content of the article.

Notes

1 Higgins et al. (2015, p. 674) provide a useful illustration to delineate the differences in decision-making between prospector and defender firms, arguing that prospectors ‘often make decisions before formalizing plans’ while defenders ‘carefully plan before making decisions.’

2 In its report on U.S. compensation policies, Institutional Shareholder Services (ISS) comments that CEO−VP pay difference is a red flag for problematic pay practices (https://www.issgovernance.com/file/policy/2015-us-comp-faqs.pdf). Moody’s makes a similar point: ‘A notably sharp differential between CEO pay and disclosed compensation of other top executives may indicate key person risk around the CEO, potential succession challenges, and the possibility of inordinate power and responsibility lodged in the CEO position’ (Moody’s, 2006).

3 Anthony (1965) long ago described decision-making within a firm as a three-tiered hierarchy that includes strategic, managerial, and operational levels of decision-making.

4 However, we do not discount the importance of collaboration between a CEO and VPs in firms competing in a fast-changing market. What we emphasize is the value of timely strategic decision-making in those firms.

5 We follow Bentley et al. (2013) and compute the standard deviation of the total number of employees over a rolling five-year window (i.e., from year t − 4 until year t).

6 We perform a range of validity tests, including CEO−VP equity pay differentials under specific strategic decision-making (i.e., mergers and acquisitions) and pay differentials on individual VPs (i.e., CEO−COO versus CEO−CFO equity pay differentials) to ensure that our measurements of pay differentials and firm strategy capture what we intend to measure. Please refer to the Online Appendix for further detail.

7 In a test tabulated in the Online Appendix, we show that firms in pursuit of prospector-type strategies are associated with higher CEO equity pay ratio (i.e., the percentage of equity grants in total annual compensation), suggesting that prospectors’ CEOs tend to have higher variability of outcomes, which is consistent with prior evidence that prospectors operate under great business uncertainties and therefore may deliver volatile performance (Bentley et al., 2013; Higgins et al., 2015). Combined with greater performance-induced CEO turnover rates for prospector firms, our results suggest that high pay differentials reflect CEOs taking on a greater share of firm decision rights.

8 The within-firm standard deviation is 1.68 for STRATEGY and 1.73 for DIFF, compared to the overall standard deviation of 3.34 for STRATEGY and 3.22 for DIFF.

9 They are defined by industry-level R&D intensity. Specifically, we remove firms with a SIC of 2833, 2836, 7372, 2835, 3661, 2834, 8731, 3845, 3576 3826, 2834, 3661, 2836, 3674, or 7372.

10 We further investigate the joint effect of firm strategy and CEO−VP equity pay differentials on the operational performance of a firm. Specifically, firm operational performance is measured by industry-adjusted ROA in years t and t + 2, respectively. We replicate Eq. (1) using adjusted ROA as the dependent variable. We find that the interaction between firm strategy and CEO−VP equity pay differentials is significantly positive, suggesting that operational performance increases with pay differentials in firms that implement prospector-type strategies.

11 Since the values of DISSENT are truncated between 0 and 1, our model is subject to the limited dependent variable problem (Tobin, 1958). To adjust for possible bias, we log transform DISSENT into log (DISSENT / 1 – DISSENT) and re-estimate the model. We find consistent results (not tabulated).

12 However, the coefficient on DIFF_{STRATEGY-PREDICTED} is not statistically significant in column 4 when ISSFOR is the dependent variable.