An Analysis of Net-Outcome Contracting with Applications to Equity-Based Compensation

Given a standard moral hazard problem, the agent’s optimal compensation can be cast as a function of either (i) the gross outcome, or (ii) the net outcome, which is the gross outcome net of the agent’s compensation. Contracts based on the net outcome are important in practice because (i) equity-based compensation (e.g., stock and options grants, and bonuses contingent on shareholder return) is pervasive and (ii) stock price is firm value net of compensation. We characterize the optimal net-outcome contract in terms of its slope, curvature, complexity, and pay-for-performance sensitivities. We further describe limitations of net-outcome contracting. We trace implications for research that has examined equity-based compensation through the lens of gross-outcome contracting.