Firm Performance Pay as Insurance against Promotion Risk

Abstract

The prevalence of pay based on risky firm outcomes for non-executive workers presents a puzzling departure from conventional contract theory, which predicts insurance provision by the firm. I revisit this puzzle in a framework with workers who prefer early resolution of uncertainty. When workers at the same firm compete against each other for promotions, the optimal contract features pay based on firm outcomes as insurance against unfavorable promotion prospects. The model’s predictions are consistent with observed phenomena such as option-like payoffs, performance-based vesting, and over-valuation of equity pay by non-executive workers. It also generates novel predictions linking organizational structure to firm performance pay.