Moonshot Pay Kind of Works

The point of executive pay is to create incentives. Public companies should structure their chief executive officers’ pay packages to encourage the CEOs to act the way the companies want. What do the companies want? I dunno, it depends. Plausibly, for most companies, the answer is something along the lines of “steadily increasing profits.” Those companies should give their CEOs pay packages that encourage them to steadily increase the profits. What does this look like? Maybe a nice base salary so the CEO doesn’t have to worry about paying rent, a big bonus if profits go up, a chunk of stock options so that the CEO shares in any gains she creates for shareholders. Normal stuff.

One important notion in executive pay theory is that the shareholders of a public company tend to be less risk-averse than the CEO, so they have to structure the CEO’s pay to encourage her to take risks. The idea is that the shareholders can diversify away the idiosyncratic risk of the company (they can own lots of stocks), while the CEO mostly can’t (her paycheck, human capital and reputation are tied to the one company, plus she probably has a lot of stock she can’t sell). If the company goes bankrupt, or the stock falls a lot, that’s okay for the shareholders — they’re diversified — but existentially bad for the CEO. If the company has the opportunity to do a project with an 80% chance of doubling its stock price and a 20% chance of leading to bankruptcy, arguably — arguably — the shareholders will want that and the CEO won’t.