influences of top management team incentives on firm risk taking

Strategic Management JournalStrat. Mgmt. J., 28: 81–89 (2007)

Published online in Wiley InterScience (www.interscience.wiley.com) DOI: 10.1002/smj.548

Received 14 April 2003; Final revision received 14 February 2006

RESEARCH NOTES AND COMMENTARIES

INFLUENCES OF TOP MANAGEMENT TEAMINCENTIVES ON FIRM RISK TAKING

PETER WRIGHT,1* MARK KROLL,2 JEFFREY A. KRUG3 andMICHAEL PETTUS4

1 Fogelman College of Business and Economics, The University of Memphis,Memphis, Tennessee, U.S.A.2 College of Administration and Business, Louisiana Tech University, Ruston,Louisiana, U.S.A.3 School of Business, Virginia Common wealth University, Richmond, Virginia, U.S.A.4 Tabor School of Business, Millikin University, Decatur, Illinois, U.S.A.

In our work, the influences on subsequent firm risk taking of fixed incentives relative to variableincentives as well as the separate effects on subsequent corporate risk taking of variableincentives are examined. Focusing on the top management team members, we find a higherproportion of incentives that are devoted to fixed incentives relative to variable incentivestend to be inversely associated with subsequent firm risk taking. Managerial stock options aredirectly and uniformly associated with subsequent corporate risk taking. Executive shareholdings,however, display a curvilinear relationship with subsequent enterprise risk taking. Copyright 2007 John Wiley & Sons, Ltd.

Researchers have often found weak or inconsistentassociations between top managerial incentivesand corporate outcomes (Barkema andGomez-Mejia, 1998; Kroll et al., 1997). The rea-son for the inability of prior works to discerndistinct associations between incentives and out-comes may be due to a lack of accounting forhow managerial incentives are structured ex ante(Tuschke and Sanders, 2003; Wright et al., 1996).In this study, we examine the relationships of topmanagerial incentives with subsequent corporateoutcomes. More specifically, we explore the effects

Keywords: top management; team variable incentives;corporate risk taking; concentration of executive wealthportfolios*Correspondence to: Peter Wright, Fogelman College of Busi-ness and Economics, The University of Memphis, 300 FogelmanCollege Administration Building, Memphis, TN 38152, U.S.A.E-mail: [email protected]

on subsequent firm risk taking of the ex ante ratioof salary to ownership incentives, as well as theseparate effects on firm risk of option ownershipor shareholdings. The motivation of our work is toshed further light on the associations of managerialincentives with corporate risk taking.

The remainder of the paper is organized asfollows. In the forthcoming section, we presentour conceptual development and hypotheses. Wethen describe our sample construction and researchmethodology. Next, the findings and indications ofthe empirical examination are presented. Finally,we offer our concluding discussion.

CONCEPTUAL DEVELOPMENT

Our premise is that executive incentives influ-ence subsequent corporate decisions that entail risk

Copyright 2007 John Wiley & Sons, Ltd.

82 P. Wright et al.

taking. We consider risk taking as the distributionof possible outcomes from a choice. As managersapproach risk-taking activities, it is assumed theyrecognize both the upside and the downside poten-tial of outcome variance. Where executives believethey can benefit from the upside potential ofoutcome variance, we expect risk-increasing orvariance-enhancing corporate decisions on theirpart. In contrast, we anticipate managers maychoose lower outcome variance corporate alter-natives where they perceive that risk-reducingstrategies may protect their well-being, becausethese strategies limit the downside potential ofoutcome variance. Our concern is with the influ-ences on subsequent firm risk taking of managerialsalary relative to ownership incentives or owner-ship incentives by themselves, as elaborated uponin the following sections.

Salary stream to ownership incentive values

Higher salaries may attract more top managerialcandidates to the firm. Furthermore, by offeringbetter salaries, enterprises may gain an improveddistribution of senior executives from whom tochoose. Consequently, enterprises that pay highersalaries can be selective and hire the superior can-didates, or those with more accomplished recordsand greater reputations. While higher salaries willtend to attract better candidates for employment asexecutives, we suggest what might be more rele-vant to the determination of subsequent firm risktaking is the impact of the proportion of managerialsalaries to ownership incentives that are granted(rather than the impact on subsequent firm risk tak-ing of salary by itself). The reason is companiesthat put a relatively higher proportion of executiverewards at risk will tend to attract less risk averseagents.

Note that managers’ worry for the loss of theirsalary, due to risk-taking activities, may lessentheir propensity to take risks. In effect, man-agers may lose their jobs and personal incomestreams in the event of corporate underperfor-mance or bankruptcy due to risk-taking activ-ities. Hence, salary streams may focus execu-tive attention on the downside potential of out-come variance. Contrarily, ownership incentives(options and shareholdings) may ordinarily elicitvariance-increasing strategies by focusing manage-rial attention on the upside potential of outcomevariance. Variance-increasing strategies may boost

firm appraisal, enhancing the value of manage-rial ownership incentives. Presumably, managerswho are more (less) risk averse would preferrewards that devote less (more) to variable com-pensation (ownership incentives) and more (less)to fixed compensation (salary streams). Indeed,agents who are less risk averse could be recruitedand retained by firms that provide greater amountsof rewards in the form of variable compensationand lesser amounts in the form of fixed compen-sation. Perhaps, more risk-averse executives willavoid employment with firms that structure a lesserproportion of their rewards based on salary and agreater proportion based on ownership incentives.

Our discussion indicates that managers may beconcerned with the downside potential of outcomevariance with respect to their salary earnings orfixed incentives. In this context, downside poten-tial refers to disemployment and loss of personalincome stream, if the enterprise underperforms orgoes out of business with risk-taking activities.Such a concern may elicit risk-decreasing strate-gies. Alternatively, executives may focus on theupside potential of outcome variance regardingtheir ownership incentives or variable rewards,eliciting risk-increasing strategies. With risk-in-creasing strategies, firm value may increase, en-hancing the worth of executive ownership incen-tives. If fixed incentives intensify the propensity toformulate variance-decreasing strategies, but vari-able incentives heighten the predisposition to adoptvariance-increasing strategies, we hypothesize thatthe top managers’ salary stream values to owner-ship incentive values may be negatively related tosubsequent firm risk taking:

Hypothesis 1: Ratios of the top managers’ salarystream values to ownership incentive values willbe inversely associated with subsequent corpo-rate risk taking.

Option values

Options ordinarily offer the possibility of gain withno possibility of loss. That is, executives withoptions benefit as the company’s stock price rises.If the stock price goes down, however, executivesare not confronted with wealth loss since they willnot exercise their options. Thus, options may focusmanagerial attention on the upside potential of out-come variance. If so, managers might be expectedto consider variance-increasing or risk-bolstering

Copyright 2007 John Wiley & Sons, Ltd. Strat. Mgmt. J., 28: 81–89 (2007)DOI: 10.1002/smj

Research Notes and Commentaries 83

corporate strategies. With higher firm risk taking,the value of the top executives’ option ownershipcould rise; consequently, their pecuniary interestsmay be promoted with variance-increasing strate-gies.

Emphasis should be made that we are interestedin the influences on corporate outcomes of at-the-money options. Out-of-the-money options maynot provide any influence on firm outcomes. In-the-money options may be influential but mightbe subject to exercise and their exercise couldbe idiosyncratic (to individual preferences regard-ing at what price to exercise and when to exer-cise after the options are vested and before theexpiration date). Idiosyncratic contingencies maydistort the effects on firm outcomes of top man-agerial option holdings. Moreover, with additionalrisk-taking activities, in-the-money options may besubject to the downside potential of outcome vari-ance. At-the-money options are not subject to thedownside potential of outcome variance. They cap-ture incentive effects on the day they are grantedand they are not subject to exercise on the date ofthe grant. Also, at-the-money options granted to afirm’s top managers are typically issued simulta-neously, with the same expiration dates, and thesame exercise prices. By examining only at-the-money options, not only can we relax the concernfor the effects of idiosyncratic contingencies butalso the concern for the effects of the downsidepotential of outcome variance. Given this discus-sion, we submit our second hypothesis:

Hypothesis 2: Top managers’ option holdingvalues will be directly associated with subse-quent corporate risk taking.

Common stock values

Whereas at-the-money options only expose execu-tives to the upside potential of outcome variance,shareholdings expose managers to both the upsideas well as the downside potentials of outcomevariance. A firm’s external shareholders are alsoexposed to both upside and downside share pricemovements. Evidently, managerial shareholdingsmay bring forth a congruency of interests betweenmanagers and equity holders as agents and princi-pals share a common fate in this setting. Empir-ical research has often demonstrated that withhigher managerial equity stakes risk-enhancing orvaluable firm strategies more frequently prevail

(Chang, 2003; Kroll et al., 1997). The implicationof the findings of the related empirical researchis that there is a monotonically positive associ-ation between shareholdings and growth-orientedfirm risk taking.

We similarly suggest that, as the top manage-ment team’s shareholdings in the firm rise fromnegligible to moderate values, firm risk takingmay be enhanced. With growth-oriented corpo-rate risk taking, firm value might increase, boost-ing the worth of managerial shareholdings. Thus,owner-managers may be enticed with the upsidepotential of outcome variance. Some top execu-tives, however, may be required or pressured topossess more company stock than prudent froman optimal-personal portfolio perspective. There-fore, in conformance with the arguments of Wright,Kroll, Lado, and Van Ness (2002), our contentionalternatively is that as the top management team’sshareholdings further rise from moderate to sub-stantial values, firm risk taking may be low-ered because managerial personal wealth portfolioscould become undiversified. Note that senior man-agers are subject to bearing too much firm-specificrisk because all of their human capital is investedin the firm. Bearing too much risk increases riskaversion (Wiseman and Gomez-Mejia, 1998). Assuggested above, at substantial values of share-holdings in the firms they manage, top executivesmay also become confronted with too much riskin their personal wealth portfolios, focusing theirattention on downside outcome potentials. In thissituation, senior managers may become loss aversebecause they bear excessive risk. Consequently, wepropose when a substantial component of an exec-utive’s wealth becomes concentrated in a singleinvestment (i.e., in the firm), she may find it pru-dent to decrease risk taking with respect to thatinvestment.

Evidently, our expectation is that as executiveshareholdings increase from negligible to moder-ate values, firm risk taking will rise. As managerialshareholdings are further increased to substantialvalues, however, our expectation is that the influ-ence on firm risk taking of executive ownershipstakes will be negative. In effect, we are expectingan inverted, U-shaped association between valuesof executive shareholdings and subsequent corpo-rate risk taking.

We emphasize that Morck, Shleifer, and Vishny(1988) have demonstrated that firm value is asso-


84 P. Wright et al.

ciated with managerial shareholdings in a curvi-linear fashion. Their findings indicate that, asthe percentage of insider shareholdings increasefrom 0 to 5 percent, firm value is enhanced. Asshareholdings increase from 5 percent to 25 per-cent, firm value declines. Moreover, as sharehold-ings increase beyond 25 percent, firm value againincreases. It should be stressed that only a verysmall minority of firms have insider ownershipbeyond 25 percent. Even insiders of initial publicofferings retain only about 13 percent of corporateequity, whereas managers of publicly traded enter-prises average less than 1 percent (Carpenter andSanders, 2002; Certo et al., 2001). Also, Morckand colleagues (1988) measured ownership by thepercentage of shareholdings. We alternatively sug-gest where executive decisions affect firm strategy,entailing risk taking, the appropriate measure is thedollar value of ownership incentives, not percent-age of equity stakes. The contentions provided arecaptured in the final hypothesis of this study:

Hypothesis 3: The relationship of the values ofthe top managers’ shareholdings with subse-quent corporate risk taking will be positive asshareholdings are increased from negligible tomoderate values, but negative as shareholdingsare further increased to substantial values.

SAMPLE CONSTRUCTION ANDMETHODOLOGY

Sample

To secure a sample of established firms from abroad array of industries, we randomly selected2500 firms from the Compustat database. Thisdatabase contains approximately 10,000 firms. Toremain in the sample, firms’ executives must havebeen in place no later than the beginning of 1996in order to establish their incentive bases in theircorporations. Only those firms were retained forwhich the needed data could be obtained from theCompustat, Disclosures, Hoover’s Online, Institu-tional Brokers Estimate System (IBES ) databases,or SEC filings for the years of the study. Weexcluded from our sample enterprises that wereacquired during the study period. Given our selec-tion criteria, a total of 397 firms comprised ourfinal sample. The average size, profitability, orrisk of our sample firms (proxied by net sales,

ROA, and the standard deviation of ROA) are notmaterially different from those of the average firmin the Compustat database.

We have required that the top management teammembers remain in place for a 6-year period(1996–2001). Our deletion of firms due to man-agerial turnover, consequently, may have intro-duced sample bias. Therefore, we have tested forsuch a possibility. Following Gilley and Leone(1991) and Heckman (1979), we estimated a logis-tic regression model intended to predict exclusion(vs. inclusion) in our sample, given the influ-ences of select variables that theoretically mayhave induced executive turnover. In our model, weincluded five predictor variables: prior as well ascurrent period performance of each firm’s stock,outside board membership, institutional invest-ments, and blockholder ownership (Wright, Kroll,and Elenkov, 2002). We estimated our logit modelusing a sample of 397 randomly selected firmsfrom the Compustat database as well as the 397firms included in the sample. The results of thelogistic regression model did not suggest that theselection criteria have biased our sample. That is,none of the predictor variables were significant. Asa consequence, no corrections were included in themodels.

Dependent variables

To assess the risk-taking propensities of our sam-ple firms’ management teams we employed bothaccounting and market-based risk measures so asto enhance the robustness of our findings. Specif-ically, we employed the lagged (1997 through2001) standard deviation of the sample firms’ quar-terly returns on assets (ROA) and the lagged stan-dard deviation of monthly total returns to share-holders.

Independent variables

Our independent variables include the average val-ues of salary streams, options, and common stockholdings of the top management team members.The Securities and Exchange Commission requiresthat publicly traded enterprises provide incentivedata not only for their CEOs but also for theirnext four highest paid executives. To value thesalary streams of the top management team mem-bers, we initially identified each executive’s salaryfor 1996. Next, we estimated the number of years



left in each top management team member’s careerby subtracting his/her age (as of 1996) from 65(with an average of 12.39 years left in executivecareers). Managerial careers ordinarily are con-fronted with a mandatory retirement age of 65.We then calculated the present value of the annu-ity of each top management team member’s salaryas of 1996, discounted at 3 percent for the yearsremaining in her career. A 3 percent discount rateis appropriate because it represents the true eco-nomic return on capital, absent inflation. Addition-ally, since this rate does not include an inflationpremium, it implicitly allows for annual growth inexecutives’ salaries over the duration of the annu-ity. The values of the top five executives’ annuitieswere subsequently averaged.

To value shareholdings, we estimated the worthof our sample firms’ executive stock ownership bymultiplying the number of shares CEOs and thenumber of shares the four senior managers ownedin 1996 by the average monthly closing stockprices of their enterprises for the same year. Next,we divided this value by five to derive the valueof the average top management team members’shareholdings.

To value options in our study, we have employedKerr and Kren’s (1992) modified version of theBlack–Scholes model (Black and Scholes, 1973).Such an approach reflects the underlying volatilityin the sample firms’ share prices and we stressthat volatility is a key issue in our study. Theoption variable that we have used represents theaverage of the values of the top management teammembers’ at-the-money option holdings in 1996.We shall remember that in the first hypothesisan inverse association between the ratio of thetop management team salary streams to owner-ship incentives and firm risk taking was expected.Therefore, we divided average salary stream val-ues by the combined values of stock and optionholdings as of 1996.

Control variables

A number of control variables (collected for theyear 1996) were included in our models. As bonusawards may influence levels of firm risk taking, weestimated the average bonus values received by thetop management team members and included thesevalues in the regression models. Firm size, proxiedby the natural log form of the total number of eachfirm’s employees, was included because risk taking

may be influenced by corporate size. Additionally,higher proportions of outsiders as board membersmay mean further scrutiny of managerial behavioron behalf of shareholders, implying greater pres-sures for firm risk taking and innovations. Hence,the percentage of outside directors on boards wasincluded as a control variable. Since blockhold-ers (those owning 5 percent or more of outstand-ing shares) tend to press managers for innovativeleadership, the percentage of outstanding sharesof blockholders was included. Moreover, we con-trolled for prior risk because firm risk, represent-ing greater uncertainty over corporate outcomes,may accentuate managerial risk bearing, making itunlikely that their subsequent decisions would bemade in a risk-neutral manner and consistent withshareholders’ interests.

A strategy variable served as a control vari-able for total firm diversification: Jacquemin andBerry’s (1979) entropy measure. We recognize thatthe level of firm diversification may impact firmrisk. Because risk measures may vary across indus-tries, we included industry risk measures as con-trol variables. Specifically, for each 2-digit SICcode represented in our sample, we estimated aver-age 5-year (1997 through 2001) standard devia-tions of ROA and total returns to shareholders.These data were also taken from the Compustatdatabase. Given that we have included the ratio ofthe average top management team salary streamto ownership incentives as an independent vari-able in the models, we also included the value ofaverage salary stream as a control variable (own-ership incentives are included as independent vari-ables).

Regression models

The hypotheses are tested using two sets of hier-archical regression models: one set for each of therisk measures employed. In each set of modelswe initially entered our control variables. In thesecond step we tested our first hypothesis by enter-ing the ratio of the average top managers’ salarystream values, divided by the average ownershipincentive values. The second step also includes atest of Hypothesis 2, as the average top manage-ment team’s option holding values were entered.Additionally, as part of our test for the presence ofan inverted ‘U’-shaped or curvilinear relationshipbetween the average top management team stockownership values and firm risk taking (tests of


86 P. Wright et al.

Hypothesis 3), we entered the average top manage-ment team stock ownership variable. In the thirdstep we entered the squared value of top manage-ment team stock ownership (Cohen and Cohen,1983: 224–227). If our third hypothesis is sup-portable, the stock ownership variable should besignificantly and positively associated with firmrisk taking, whereas its squared term should be sig-nificantly and negatively related to corporate risktaking. We employed F -tests to determine whetheradding the quadratic term enhanced the explana-tory power of our models in a material way (Cohenand Cohen, 1983).

Because we used quadratic terms in the models,the independent variables were centered, in orderto enhance interpretation of the results. Given thatsome of our managerial incentive variables wereskewed, we eliminated firms that unduly influ-enced the regression results, using the followingprocedure. Initially, each model was estimated.Next, observations that had residual values morethan four standard deviations from the mean resid-ual were deleted. This procedure eliminates distor-tions resulting from extreme outliers. In responseto this process, 13 firms were eliminated from ouranalysis where the standard deviation of ROA wasemployed as the dependent variable. Moreover, 19firms were deleted where the standard deviation oftotal returns to shareholders served as the depen-dent variable.

RESULTS

In Table 1, the means and the standard deviationsfor our measures of the dependent and independentvariables are provided. A correlation matrix is alsopresented.

In Table 2, the results of the relationshipsbetween the values of the top management teammembers’ salary stream to ownership incentiveratios as well as option holdings and the twomeasures of risk are shown. The results are sup-portive of Hypotheses 1 and 2. The ratios oftop management team salary stream to ownershipincentives are significantly and negatively asso-ciated with both risk measures. In contrast, theresults demonstrate a significantly positive rela-tionship between top management team mem-bers’ option holdings and firm risk taking. Themodels presented in Table 2 also examine therelationship between stock ownership and risk.

These findings are consistent with Hypothesis 3.We found significant nonlinear relationships (i.e.,inverted U-shaped relationships) between top man-agement team shareholdings and both risk mea-sures.

CONCLUDING DISCUSSION

The motivation of our study has been to exam-ine the effects on corporate outcomes of manage-rial incentives. Apparently, a higher proportion ofincentives that is devoted to fixed rewards rela-tive to variable rewards tends to be negativelyassociated with subsequent corporate risk tak-ing. We have expected and found that managerialoption incentives are directly and uniformly relatedto subsequent firm risk taking. Granting moreoptions, however, might not always be desirable.While option holdings will increase risk taking byfocusing executive attention on the upside poten-tial of outcome variance, to the extent that optionholdings enhance upside potential without increas-ing downside risk, they may provide a disincen-tive for high-quality decision making. Also, somesenior managers may selfishly abuse the privilegeof option ownership by inappropriately announc-ing stock buy-backs. These announcements maypositively impact share prices, increasing the val-ues of managerial options. Share buy-backs, how-ever, are not always indications of the best useof company funds. Funds utilized for repurchaseprograms may instead be used to capitalize on rent-producing opportunities, such as the acquisition ofnew plant and equipment or the initiation of addi-tional research and development projects (Sandersand Carpenter, 2003).

Our expectation has been that common stockincentives may focus managerial attention on theupside potential of outcome variance, elicitingrisk-increasing decisions. With growth-orientedfirm risk taking, firm value may increase, enhanc-ing the worth of executive shareholdings. Ourexpectation, however, only holds where manage-rial shareholdings in the enterprise are expandedfrom negligible to moderate values. Because sometop executives are required or pressured to pos-sess more company stock than prudent from anoptimal-personal portfolio perspective, our alter-native anticipation has been that, at substantialvalues of shareholdings, executives may focus onthe downside potential of outcome variance. As



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88 P. Wright et al.

Table 2. Regression analyses: associations of managerial incentives with firm risk taking

Variable S.D. of ROA S.D. of TRS

Model 1 Model 2 Model 3 Model 4 Model 5 Model 6

Prior standard deviation of ROA 0.428∗∗∗ 0.627∗∗∗ 0.609∗∗∗

Prior standard deviation of totalreturns to shareholders

0.728∗∗∗ 0.827∗∗∗ 0.802∗∗∗

Average top management team bonus 2.646 2.478 2.391 1.370 1.339 1.280Log of total employees −2.111∗ −2.185∗ −2.097∗ −3.114∗∗ −1.978∗ −1.610∗

Outside board membership 0.512∗ 0.626∗∗ 0.627∗∗ 1.412∗ 1.421∗∗ 1.428∗∗

Total blockholder ownership 0.410∗ 0.416∗∗ 0.516∗∗ 1.311∗ 1.316∗ 1.218∗∗

Entropy −3.179∗ −3.402∗ −3.529∗ −8.179∗∗ −6.402∗ −6.806∗

Industry average standard deviationof ROA

0.157∗ 0.180∗ 0.183∗

Industry average standard deviationof total returns to shareholders

0.356∗ 0.380∗ 0.383∗

Average top management team salarystream

−0.645∗∗ −0.629∗∗ −2.239∗∗ −2.341∗∗

Average top management team optionholdings

0.061∗∗ 0.067∗∗ 0.331∗ 0.390∗

Ratio of managerial salary stream toownership incentives

−0.507∗∗∗ −0.531∗∗∗ −2.227∗∗∗ −2.500∗∗∗

Average top management team stockownership

0.284∗ 0.286∗∗ 1.607∗ 1.713∗

Average top management team stockownership squared

−0.004∗ −0.019∗

Model F -statistic 17.28∗∗∗ 22.08∗∗∗ 27.84∗∗ 16.41∗∗∗ 23.93∗∗∗ 24.71∗∗∗

Model R2 0.312 0.438 0.483 0.277 0.518 0.553Change in R2 0.126∗∗∗ 0.045∗∗ 0.241∗∗∗ 0.035∗∗

N = 384 N = 384 N = 384 N = 378 N = 378 N = 378

∗ p < 0.05; ∗∗ p < 0.01; ∗∗∗ p < 0.001

noted, senior managers are subject to bearing toomuch firm-specific risk since their human cap-ital is invested in the enterprise. At substantialvalues of equity ownership, managers may alsobecome confronted with too much risk in theirpersonal wealth portfolios (Wright et al., 1996).Senior executives may become loss averse in thissituation because they bear excessive risk (Wise-man and Gomez-Mejia, 1998). In effect, we haveexpected and found an inverted, U-shaped relation-ship between values of managerial shareholdingsand subsequent corporate risk taking. Given ourcontentions and findings, the practice of contin-uously increasing common stock incentives maybe questioned, because at substantial values ofthese incentives managerial decisions may becomeunduly influenced by a risk aversion predisposi-tion, harming the interests of external shareholders.In this study, we have attempted to provide addi-tional insights on the effects of values of top man-agers’ incentives on firm risk taking. Our resultsindicate that managerial incentives do matter as

they significantly impact subsequent corporate risktaking.

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