CEOs, Shareholders, and Preferences for Risk

Cite this Article
Thomas A. Lambert, CEOs, Shareholders, and Preferences for Risk, Truth on the Market (March 17, 2006),

Mark Cuban, owner of the Dallas Mavericks and co-owner of Landmark Theatres, has been blogging about equity-based CEO compensation and the problems it purportedly creates. Cuban’s theory is that paying CEOs in company stock does not tend to align their interests with those of shareholders; instead, it leads CEOs to pursue excessively risky business ventures.

As a post at today’s Dealbook explains, Cuban’s primary argument is that shareholders and CEOs “have completely different agendas: Most chief executives want to hit a ‘home run’ — taking big risks for potentially big payoffs — while most mom-and-pop shareholders simply hope not to ‘strike out’ and lose their nest egg.” Equity-based compensation, Cuban says, exacerbates this problem.

Putting aside whether equity-based compensation is good or bad, Cuban’s claim concerning the risk preferences of CEOs and shareholders strikes me as exactly backward. Stockholders would normally prefer corporate managers to take more, not less, business risk.

When it comes to managerial decision-making, rational stockholders prefer greater risk-taking (which is associated with higher potential rewards) for a number of reasons. First, stockholders have limited liability, which means that if a business venture totally tanks and creates liabilities in excess of the corporation’s assets, the stockholders are off the hook for the excess. Since stockholders are able to externalize some of the downside of business risks, they’ll tend to be risk-preferring. Moreover, stockholders are the “residual claimants” of a corporation — they don’t get paid until obligations to all other corporate constituents (creditors, employees, preferred stockholders, etc.) have been satisfied. In other words, they get nothing if the corporation breaks even, and they therefore would prefer that managers pursue business ventures likely to do more than break even. Finally, stockholders are able to eliminate firm-specific, “unsystematic” risk from their investment portfolios by owning a diversified collection of stocks. They therefore do not care about such risk (although they do demand compensation for bearing non-diversifiable, “systematic” risk). Professor Bainbridge‘s terrific treatise, Corporation Law and Economics, provides more detail on why stockholders tend to prefer riskier business ventures. (See pp. 259-63.)

Compared to equity investors, corporate managers (including CEOs) tend to be relatively risk-averse. Unlike shareholders, they get paid even if the corporation breaks even, so high-risk/high-reward ventures are less attractive to them. In addition, they cannot diversify their labor “investment” so as to eliminate firm-specific risk (one can generally work only one job, after all). Managers therefore tend to prefer “safer” business ventures.

Cuban is thus wrong when he writes that “CEO[s] want[] to hit the homerun of their career when they take the job, the shareholder just doesn’t want to strike out with their life savings.” When it comes to business risks, it’s the CEOs who tend to be the wimps.