Compensation structures incentivize performance and facilitate hiring and retention of skilled employees and managers. But how to optimally design incentive packages?
Compensation may include a combination of direct salary, starting bonuses, end-of-year performance bonuses, equity grants or stock options, and non-pecuniary benefits. Among others, equity compensation is often used for incentivizing skilled employees, particularly in innovation-oriented technology businesses. Traditional theories explaining why firms offer equity suggest that workers with a higher rank or a more important function should receive compensation packages more heavily weighted in equity.
Yet, economists Jiayi Bao from the University of Pennsylvania and Andy Wu from Harvard Business School analyzed data from 1,034 startups in the technology sector and found that, contrary to the theoretical predictions, many firms adopt an equality-in-equity strategy: i.e. they offer their employees the same levels of equity compensation but different cash salaries across different job ranks and functions. Within a firm that adopts the equality-in-equity strategy, when a higher ranking employee receives higher salary but the same equity as a lower ranking employee, the compensation package for the higher ranking job is more heavily weighted in salary. This results in an asymmetric compression in equity and salary within the firm. In their work, the authors try to explain the puzzle by investigating whether workers have distinct preferences for equality in equity versus equality in salary. If so, what are the mechanisms driving the different equality preferences?
They first present a theoretical group production model with domain-contingent inequality aversion. In other words, the model assumes that workers do not like inequality within the firm and that this preference depends on the domain: aversion to inequality in equity is stronger than that in salary. One possible explanation for differences in inequality aversion is that many firms have a limited amount of equity to distribute. Hence, equity, unlike salaries, is perceived as scarce by employees, and inequality in this domain matters more to them. The model shows that inequality in equity has a negative asymmetric effect on effort (effort responds more to equity cuts than to equity raises) while inequality in salary, under some circumstances, may have a positive asymmetric effect on effort. As the result, for firms with a fixed equity compensation budget, it might be optimal to adopt an equality-in-equity compensation strategy.
The authors further conducted an experiment to test the predictions of their theoretical model and to find evidence for a possible mechanism. They recruited 960 workers from Amazon MTurk to participate in a 15-minute study. The experiment had a within-subject design with each participant experiencing seven scenarios (in a random order) of group production with different compensation schemes. In each scenario, a participant was paired with a random partner, and each received a flat payment to mimic salary and a share of group output to mimic equity. It was further complemented with a between-subject design: to one group of participants (treatment) the authors presented output share as a percentage, while to another group (control) – in experimental points. While the real value of the output share did not differ between the groups, the formulation in percentage points facilitated the relative comparison of share size between participants and drove the salience of the finiteness of the 100% output. The experimental findings corroborated the existence of domain-contingent inequality aversion, and further demonstrated that such domain-contingency was largely driven by a perception of equity scarcity among workers.
Reference: Bao, J., & Wu, A. (2017). Equality and Equity in Compensation. Harvard Business School Working Paper Series # 17-093.