Stocks or Options? Moral Hazard, Firm Viability and the Design of Compensation Contracts

We consider the choice between stocks and options to provide effort incentives to a risk-averse manager. We show that stocks can dominate options as a means of motivation only if nonviability risk is substantial, as in financially distressed firms or start-ups. Options dominate stocks for other firms. These results hold regardless of the existing portfolio of the manager. We provide empirical evidence that higher bankruptcy risk is indeed correlated with more use of stock.