The use of stock-based compensation as a solution to agency problems between shareholders and managers has increased dramatically since the early 1990s. We show that in a dynamic rational expectations model with asymmetric information, stock-based compensation not only induces managers to exert costly effort, but also induces them to conceal bad news about future growth options and to choose suboptimal investment policies to support the pretense. This leads to a severe overvaluation and a subsequent crash in the stock price. Our model produces many predictions that are consistent with the empirical evidence and are relevant to understanding the current crisis.
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∗We would like to thank Mary Barth, Joseph Beilin, Dan Bernhardt, Jennifer Carpenter, Alex Edmans, Xavier Gabaix, Dirk Hackbarth, Zhiguo He, Elhanan Helpman (the editor), Ilan Guttman, Alex Joffe, Ohad Kadan, Simi Kedia, Ilan Kremer, Holger Muller, Thomas Philippon, Andrei Shleifer, Lucian Taylor, and three anonymous referees, as well as seminar participants at the 2009 NBER Summer Institute Asset Pricing meetings, the 2008 Western Finance Association meetings in Waikoloa, the 2006 ESSFM Conference in Gerzensee, the 2006 Finance and Accounting Conference in Atlanta, Hebrew University, IDC, Michigan State, NYU Stern, Oxford, Stanford, Tel Aviv, the University of Chicago, the Chicago Fed, the University of Illinois at Urbana–Champaign, and Washington University for helpful comments and suggestions. Kandel thanks the Krueger Center for Finance Research at the Hebrew University for financial support.