Research that has been conducted on business leaders suggests that financial incentives can work for executives and quite often do, according to Alex Edmans writing in a recent edition of Harvard Business Review. Edmans, who is a Professor of Finance at London Business School, writes that poorly designed incentives – take, for example, those with short vesting periods, or paying according to quarterly earnings – can ‘backfire’. But he reckons that ‘to completely scrap equity will throw the baby out with the bathwater’.
For Edmans the solution is simple – to extend the vesting period to the long-term.
‘Financial incentives only work in jobs where there’s some kind of comprehensive performance measure that weights all the different dimensions appropriately. Clearly, for lots of jobs, no such measure exists.
But, for executives, you do have such a measure – the long-run stock price. In the long run, every executive decision will eventually show up in the stock price. The stock price captures not just current profits, but expected future profits, growth opportunities, balance sheet strength, corporate culture, customer satisfaction, relations with stakeholders, and so on, and weights them by their relative importance for firm value.’