Damodaran on Valuation

11.1. EQUITY-BASED COMPENSATION

There are three forms of equity compensation. The oldest and most established one is to give stock or equity in the firm to management, employees, or other parties as compensation. This second is a variant, with common stock and equity granted to employees with the restriction that these shares cannot be claimed and/or traded for a period after the grants. The third is equity options, allowing employees to buy stock in the firm at a specified price over a period; these usually come with restrictions as well.

In recent decades, equity-based compensation has become a bigger part of overall employee compensation, initially at U.S. firms and more recently in other markets as well. There are four major factors behind this trend:

1. Stockholder-manager alignment. As publicly traded firms have matured and become larger, the interests of stockholders (who own these firms) and managers (who run these firms) have diverged. The resulting agency costs have been explored widely in the literature. In a seminal work, Jensen and Meckling (1976) argue that managers, acting in their best interests, often take actions that destroy stockholder value.^[] Researchers have shown that managers, left to their own devices, accumulate too much cash, borrow too little, and make poor investments and acquisitions. Offering equity in the firm to managers may reduce the agency problem by making managers behave more like stockholders.

   ^[] M. C. Jensen and W. H. Meckling, "Theory of the ...