CEO Compensation and Private Information: An Optimal Contracting Perspective

Abstract

We consider the joint optimal design of CEOs’ severance pay and on-the-job pay in a model in which the CEO has interim private information about the likely success of his strategy. The board faces a tradeoff between reducing the likelihood that the firm forgoes an efficient strategy change and limiting the CEO’s informational rents. The optimal truthtelling mech-anism takes a simple form: it consists of fixed severance pay and high-powered, non-linear on-the-job pay, such as a bonus scheme or option grant. Our model makes testable predic-tions linking CEOs’ severance pay and on-the-job pay to each other as well as to the firm’s external business environment, firm size, and corporate governance.