Week 1 Managerial Compensation & Control of the Firm

Managerial Compensation & Control of the Firm

As we discussed previously, whether managers will, in fact, act in the best interests of stockholders depends on two factors.

Managerial Compensation
Management will have a significant economic incentive to act in the interest of the firm’s owners (that is to seek to increase share value) when two conditions related to compensation exist.

• Tie managerial compensation, particularly at the top, to financial performance in general and to share value in particular.
• Promote better performers within the firm. Those managers who are successful in pursuing stockholder goals will be in greater demand in the labor market and thus command higher salaries.

Control of the Firm
Control of the firm ultimately rests with stockholders. They elect the board of directors, who, in turn, hires and fires management. The mechanism by which unhappy stockholders can act to replace existing management is called a proxy fight. A proxy is the authority to vote someone else's stock. A proxy fight develops when a group solicits proxies in order to replace the existing board, and thereby replace existing management.

Another way that management can be replaced is by takeover. Those firms that are poorly managed are more attractive as acquisitions than well-managed firms because a greater profit potential exists. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders' interests.