Through the Grapevine: Network Effects on the Design of Executive Compensation Contracts

by Susanna Gallani

Overview — Designing the compensation package for a CEO is a complex task with many variables and uncertainties. While in principle the structure of executive compensation should be directed to aligning the goals of the executive with the strategic goals of the firm, the adoption of common models of compensation may tilt the compensation structure away from this alignment. It is thus important to identify the drivers of compensation similarity across firms. In this paper the author identifies such drivers – above and beyond known economic and governance characteristics of the firm – by providing evidence that firms connected through board networks or hiring common compensation consultants exhibit greater similarity in the structure of CEO compensation. At the same time, however, different networks influence different aspects of the compensation design.

Author Abstract

Effective design of executive compensation contracts involves choosing and weighting performance measures, as well as defining the mix between fixed and incentive-based pay components, with a view to fostering talent retention and goal congruence. Despite large variability in firms' characteristics and goals, compensation design is subject to isomorphic pressures, which cannot be completely explained by industry affiliation or peer group membership. Inter-firm professional network connections, such as board interlocks and compensation consultants, provide means and opportunities to observe and imitate organizational behavior across firms. Using information disclosed in proxy statements of publicly traded companies, I predict and find that firms connected through board interlocks or common compensation consultants display a higher degree of isomorphism in the design of executive compensation contracts. However, consultants with larger customer base and greater expertise mitigate these isomorphic tendencies. Additionally, interlocks and compensation consultants exert different influences on different aspects of the compensation design.