Performance Contingencies in CEO Equity Awards and Debt Contracting

Abstract

We find that firms that grant performance-contingent (p-c) equity awards with accounting-based vesting conditions to their CEOs have lower cost of debt, less restrictive loan terms, and higher credit ratings. The benefits of p-c accounting awards on debt financing are greater when the moral hazard problem faced by debtholders is potentially more significant, for example, for firms with poorer credit ratings and lower asset tangibility. We find some evidence that p-c equity awards with stock price-based conditions have higher cost of debt and lower ratings, primarily for absolute performance awards. Event studies of the stock and bond price reactions to the adoption of p-c accounting-based awards indicate that there is a net benefit created for the firm. Overall, our findings suggest that the incentive-compatibility of accounting-based p-c awards mitigates the potential agency conflict between shareholders and debtholders.