When firm value is non-linear in manager effort, pay-for-performance, measured as the sensitivity of manager compensation to firm value, is not a sufficient statistic for the strength of managerial incentives. To show this, we characterize the optimal contract between an investor and a risk-averse manager in the presence of a lumpy investment option. In our model, increasing the size of the growth option can decrease pay-performance sensitivity despite always increasing managerial effort and incentives. Low pay-performance sensitivity is consistent with higher effort and incentives because increasing the size of the growth opportunity increases the convexity of the value function with respect to firm productivity and makes firm value increasingly sensitive to managerial effort. Empirically, we show that a one standard deviation increase in Market-to-Book, a proxy for the presence of growth options, leads to roughly 6.5% decrease in Jensen’s (1990) pay performance sensitivity, as measured by dollar changes in manager wealth to dollar changes in firm value. This effect is consistent with our theoretical finding that pay-performance sensitivity is decreasing in the size of growth options.

(Joint work with Barney Hartman-Glaser (UCLA) and Geoffery Zheng (UCLA).)