Organizational Governance and Employee Pay

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Strategic Management Journal

Strat. Mgmt. J.

,

26

: 377–384 (2005)Published online in Wiley InterScience (www.interscience.wiley.com). DOI: 10.1002/smj.452

RESEARCH NOTES AND COMMENTARIESORGANIZATIONAL GOVERNANCE AND EMPLOYEEPAY: HOW OWNERSHIP STRUCTURE AFFECTS THEFIRM’S COMPENSATION STRATEGY

STEVE WERNER,

1

HENRY L. TOSI

2

and LUIS GOMEZ-MEJIA

3

*

1

University of Houston, Houston, Texas, U.S.A.

2

SDA—Bocconi, Milan, Italy and College of Business Administration, University of Florida, Gainesville, Florida, U.S.A.

3

College of Business, Arizona State University, Tempe, Arizona, U.S.A.

This research investigated how the ownership structure is related to the

ﬁ

rm’s overall compensa-tion strategy. The

ﬁ

ndings extend previous research that focused primarily on CEO compensationstrategy. We show that there are signi

ﬁ

cant differences in the compensation practices that applyto all employees as a function of the ownership structure. The results show that for owner-controlled

ﬁ

rms and owner-managed

ﬁ

rms there is signi

ﬁ

cant pay/performance sensitivity for all employees. In management-controlled

ﬁ

rms, changes in pay are related to changes in sizeof the

ﬁ

rm. These

ﬁ

ndings lead us to conclude that ownership structure not only affects upper management’s pay, but also the pay of all employees through substantial differences in the

ﬁ

rm’scompensation practices.

Copyright



2005 John Wiley & Sons, Ltd.

The strategic management literature has devotedmuch effort on trying to understand the myriad of factors that underlie top management compensa-tion, particularly how it is related to

ﬁ

rm perfor-mance. The focus on upper management pay, par-ticularly the CEO, is not surprising—in most orga-nizations decision making and absolute authoritylie at the top. Much of this work is based on agencytheory and the theory of managerial capitalism, thecentral theme of which is how to design top man-agement compensation schemes in ways that moti-vate this group to work in the interests of equityholders and not engage in self-serving behaviors.

Keywords: executive compensation; employee pay; own-ership structure

∗

Correspondence to: Luis Gomez-Mejia, College of Business,Arizona State University, Tempe, AZ 85287-4006, U.S.A.E-mail: luis.gomez-mejia@asu.edu

According to these theoretical perspectives, linkingpay to performance results in increased risk shar-ing between principal and agent, which purport-edly engenders ‘common fate’ between the parties(and hence greater ‘incentive alignment’). Empir-ical studies generally

ﬁ

nd that incentive align-ment at the top is lowest where it is needed themost: when ownership dispersion is high (e.g.,Hambrick and Finkelstein, 1995; Gomez-Mejia,Tosi, and Hinkin, 1987; McEachern, 1975; Kroll

et al

., 1997; Tosi and Gomez-Mejia, 1989). Inother words, it appears that when upper manage-ment pay-setting discretion is not constrained bymajor shareholders, executives reduce their risk bydecoupling pay from performance and instead linktheir pay to criteria they can easily control (primar-ily

ﬁ

rm growth; see Kroll, Simmons, and Wright,1990; Wright, Kroll, and Elenkov, 2002).

Copyright

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2005 John Wiley & Sons, Ltd.

Received 26 December 2002Final revision received 14 September 2004

378

S. Werner, H. L. Tosi and L. Gomez-Mejia

What remains to be studied, however, is theanswer to the question: ‘What is the role of own-ership structure as a determinant of the

ﬁ

rm’soverall pay–performance relations?’ In this paperwe address this issue by examining how owner-ship structure affects the criteria used to deter-mine pay adjustments for the entire organization.We found that ownership dispersion is associ-ated with a decoupling of pay increases from

ﬁ

rmperformance, and a closer linkage between payincreases and

ﬁ

rm growth for all employees. Theseresults mirror previous

ﬁ

ndings on CEO pay, sug-gesting that the impact of ownership structureon pay–performance relations cascades to lowerrungs of the organizational ladder.This study is important for several reasons. First,it improves our understanding of the ‘internal mon-itoring’ process discussed by early agency writers(e.g., Fama, 1980). Dispersed ownership not onlyreduces risk sharing at the top but it also reducesrisk sharing for the entire organization, suggestingthat if CEO monitoring is weak then internal con-trols (as re

ﬂ

ected in pay–performance relations)are also weak. Second, we extend the literatureon agency and managerialism to consider inter-

ﬁ

rm pay allocation criteria. Relatedly, we add tothe labor economics and industrial relations liter-ature by showing that the pay determination cri-teria across

ﬁ

rms vary as a function of owner-ship structure. Lastly, this study has major appliedimplications given that aggregate compensationcosts often exceed 80 percent of total operatingexpenses (cf. Gomez-Mejia and Balkin, 1992) andare many times greater than those associated withupper management’s compensation expenses, theprimary concern of most prior research. Our

ﬁ

nd-ings suggest that pay-related agency costs underatomistic ownership are much greater than initiallythought by those who just focused on upper man-agement pay (since pay–performance relations areinsigni

ﬁ

cant for the entire organization, not onlyat the top).

THEORETICAL FRAMEWORK ANDHYPOTHESES

Pay–performance relations below the top exec-utive ranks have been analyzed in the strategicmanagement literature primarily in terms of howrisk sharing varies as a function of

ﬁ

t with contex-tual factors. For instance, Rajagopalan and Finkel-stein (1992) argued that environmental complex-ity is associated with the use of riskier outcome-based performance criteria to make pay decisionsin order to minimize monitoring costs. In a follow-up study, Rajagopalan (1996) reports that highlyperforming prospector

ﬁ

rms tend to rely on incen-tive compensation, which poses greater risk (sinceit is uncertain) but also greater upside potential (asemployees stand to gain if prospects turn out tobe successful). Similarly, several papers by Balkinand Gomez-Mejia (1987, 1990) and Gomez-Mejia(1992) report that risk sharing in the pay systemis greater under conditions of high technologicalintensity and high environmental volatility as the

ﬁ

rm retains greater

ﬂ

exibility by tying compensa-tion costs to gyrations in

ﬁ

rm performance.All of the above studies appearing in the

Strate-gic Management Journal

have

ﬁ

lled importantempirical and theoretical gaps by showing how theorganization’s risk-sharing emphasis with the com-pensation system interact with contextual factors.By adopting a contingency theory perspective, thisstream of research largely assumes that organiza-tions choose pay criteria based on what is best forthe

ﬁ

rm given the context it faces (for instance, lowor high environmental volatility; cf. Balkin andGomez-Mejia, 1987, 1990; Gomez-Mejia, Makri,and Larraza, 2003; Miller, Wiseman, and Gomez-Mejia, 2002). This rational, instrumental approachto compensation strategy is very different fromthe parallel research on how ownership structureaffects top management pay (where self-servingbehaviors prejudicial to the organization often playthe key role). Next, we argue that one importantfactor to consider in explaining inter-

ﬁ

rm differ-ences in pay allocation criteria is ownership struc-ture, with those

ﬁ

rms where executives enjoy muchdiscretion (i.e., under high ownership dispersion)preferring to adopt low-risk compensation strate-gies for the entire organization and vice versa whenexecutives are closely monitored (i.e., under highownership concentration).

1

1

There is a large literature in labor economics and industrialrelations that focuses on inter-

ﬁ

rm pay differentials. Since ourobjective is to analyze inter-

ﬁ

rm differences in criteria used tomake pay adjustments (which are re

ﬂ

ective of compensationrisk sharing between employees and the

ﬁ

rm) rather than oninter-

ﬁ

rm pay level differentials we do not delve into the laboreconomics and industrial relations literature here (for an excel-lent review see Gerhart and Rynes, 2003).

Copyright



2005 John Wiley & Sons, Ltd.

Strat. Mgmt. J.

,

26

: 377–384 (2005)

Research Notes and Commentaries

379

The ownership structure and employeepay/performance sensitivity

Research supports the agency theory logic thatowners (principals) prefer to tie agents’ pay to per-formance, since it aligns agent and principal goals,thereby reducing the threat of moral hazard (Fama,1980; Fama and Jensen, 1983; Tosi

et al

., 1999).This appears to be the case in owner-controlled(OC)

ﬁ

rms, but not in management-controlled(MC)

ﬁ

rms. In the OC

ﬁ

rms, CEO compensationis more sensitive to changes in performance thanin MC

ﬁ

rms (McEachern, 1975; Dyl, 1988; Kroll

et al

., 1990; Tosi and Gomez-Mejia, 1989; Ham-brick and Finkelstein, 1995; Wright

et al

., 2002).Managers subject to higher-risk bearing and enjoy-ing lower discretion than those in OC

ﬁ

rms arelikely to forge tighter linkages between employeepay and performance for several related reasons.First, such a compensation strategy is likely toreduce the employment and compensation risk of managers whose actions are under close scrutiny.Assuming that principals prefer to share perfor-mance uncertainty with employees in exchange forpotential upside earning gains, then top executivesare likely to implement these compensation strate-gies in order to be in good standing in the eyes of their monitors.Relatedly, there is both theory and evidencethat the incentive system at the top is likely tocascade throughout lower levels in the organi-zation as a form of ‘internal monitoring’ (Famaand Jensen, 1983; Williamson, 1964; Werner andTosi, 1995). Therefore, if powerful equity holdersimpose performance-based incentives at the top,these upper echelons are likely to develop simi-lar pay policies and practices at lower levels tomimic the risk they incur. This means that in theaggregate, employee compensation will be moresensitive to

ﬁ

rm performance in owner-controlled

ﬁ

rms than in manager-controlled

ﬁ

rms.Finally, incentive-based compensation schemesfor employees may increase performance, yetthey may reduce employee satisfaction (Schwab,1974), disrupt the social fabric in organizations(Whyte, 1949), and create more tension insupervisory/employee relations and high turnover(Kohn, 1993). Such outcomes are not uncommonin ESOPs, pro

ﬁ

t sharing, gainsharing, and othersimilar aggregate incentive plans widely used inindustry (Welbourne, Balkin, and Gomez-Mejia,1995). Managers become a stronger target of employee displeasure when workers are asked toforfeit base compensation in lieu of potentiallyhigher incentive payments, and these rewards arenot forthcoming when

ﬁ

rm performance targetscannot be met (see Gomez-Mejia, Welbourne,and Wiseman, 2000, for a review of theseplans and related literature). Thus, given highdiscretion, managers may prefer less performance-based pay throughout the organization because of problems that these sorts of compensation systemsmight induce and avoid them to create a moreharmonious work environment, even if this maynot be in the best interest of owners.

The ownership structure and employeepay/size sensitivity

A key prediction of managerialism is that whenownership is widely dispersed so that managerialdiscretion is high, top executives seek to increaseorganization size, which augments their power,salary, status, and security (Baumol, 1959; Mar-ris, 1964). Unlike

ﬁ

rm performance,

ﬁ

rm size canbe easily and deliberately manipulated to meetrevenue targets through mergers and acquisitions,diversi

ﬁ

cation, internal growth strategies, and thelike. Empirical evidence supports the propositionthat MC executives tend to pursue

ﬁ

rm growthmore often than OC executives, and that executivepay tends to be more closely linked to changesin size among the former than among the lat-ter (McEachern, 1975; Gomez-Mejia

et al

., 1987;Hambrick and Finkelstein, 1995).One would expect that the observed

ﬁ

rmsize–pay relation would not stop in the executivesuite but that it would cascade across the entireMC organization. There are three reasons for thisexpectation. First, linking compensation increasesto

ﬁ

rm growth involves lower risk sharing foremployees (as

ﬁ

rm size is more controllableand less variable than

ﬁ

rm performance), whichdecreases the possibility of workers’ dissatisfaction(which as we discussed earlier may be presentwhen pay–performance relations are strong) andhence management can avoid potential employeebacklash. Second, if unencumbered MC executiveswish to pursue an aggressive growth strategy, itseems logical that average employee pay shouldgo up in tandem in order to secure suf

ﬁ

cientemployees to sustain such an expansion. As thenumber of vacancies increase such a compensationstrategy (1) will attract better applicants, and

Copyright



2005 John Wiley & Sons, Ltd.

Strat. Mgmt. J.

,

26

: 377–384 (2005)

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