Performance-based Compensation

Introduction

Intuitively, it is natural to expect that the performance of an employee and the company affect managerial compensation. However, it is essential to understand that choosing the correct composition of the compensation package should be made while taking into account the existing risk associated with holding the company's shares, the current composition of the employee's equity holdings, and the degree of the employee's risk-aversion, which could be affected by his domestic situation, wealth, and lifestyle.

Compensation in the form of options assumes that the employee has a direct impact on the company's performance and on its market price. Compensation in the form of bonuses, however, is based on the actual performance of the employee, the officer, the division, or any other business unit influenced by the employee. The targets which the employee or officer have to meet are usually either set at the beginning of the period or result from a periodic performance assessment made by the employee's managers.