Incentive contract: performance rises when employees have an equity stake, says U of T study

A new study in organizational economics from the University of Toronto argues that companies do better when they have an incentive contract that incorporates equity shares.

The study found that in particular it’s businesses of the “new economy” that are most likely to benefit from an equity-heavy approach.

Take a look at Google Inc.’s various products and services – from the well known search engine, to Google+, Android, Google Glass and Chrome OS – and you’ll see a company that takes diversification seriously. But one issue that companies like Google face is facilitating cross business collaboration.

How do you develop the effective communication, cross-pollination and synergy – what’s known as economies of scope – across units with diverse goals and interests?

Researcher Joanne Oxley from U of Toronto’s Rotman School of Management argues that equity incentives delivered down the managerial ladder can help.

“Our results suggest that you should use equity incentives more for managers who need to collaborate across divisions than for those who are focused on their own tasks,” says Profesoor Oxley. “All in all, it’s just a really useful thing to have in the toolkit.”

Professor Oxley began with the commonly held assumption in her discipline and in the wider business community that fostering collaboration within a multi-business company is supported by offering managerial compensation based on “global” (firm-wide) profits. But this incentive contract approach can harm more “local” efforts, she argues, as managers can lose focus on innovation and growth within their own units.

Professor Oxley insists that interdependence and cooperation require middle management to be motivated to create cross-unit synergies. The strategy is particularly relevant in the case of “new economy” companies within the tech industry, as these businesses often have to bank on future growth and profitability in lieu of current success.

Professor Oxley developed a theoretical model to explore the effects of adding equity to the mix of incentives (along with profit compensation) for managers and she found that some firms do better with the addition of equity-based incentives. The difference comes from the change in focus – from the short-term gain of profit to the long-term investment of stock options. “The forward-looking nature of stock prices makes equity value a more appropriate benchmark for managerial performance than accounting profits,” says Professor Oxley.

And valuable not just for executives and so-called C-suite employees. Professor Oxley insists that interdependence and cooperation require middle management to be motivated to create cross-unit synergies. The strategy is particularly relevant in the case of “new economy” companies within the tech industry, as these businesses often have to bank on future growth and profitability in lieu of current success.

Business Insider’s Henry Blodget points to Amazon as a prime example of this approach. He writes, “Why does Amazon’s stock keep hitting new highs while the company (as critics love to point out) continues to generate almost no profit? Because Amazon’s management has stated very clearly that the company is going to invest aggressively in the long-term future instead of worrying about near-term profits. And Amazon’s management has demonstrated, again and again, that it can make smart-enough investments that, over the long haul, the investments can produce even greater returns.”

Professor Oxley’s paper appears in the recent issue of Strategic Management Journal.

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