How Should Performance Signals Affect Contracts

This paper studies the value of additional performance signals in compensation and financing contracts under contracting constraints, such as limited liability, monotonicity, or upper bounds to pay or incentives. We show that informative signals may have no value for contracting, because the payment cannot be adjusted to reflect the signal realization -- contrary to the informativeness principle, which was derived assuming no contracting constraints. We derive necessary and sufficient conditions for a signal to have value under such constraints. Our results have implications for pay-for-luck, option repricing, performance-based vesting, performance-sensitive debt, and the conditions under which a principal should invest in costly monitoring.