CEOs, Shareholders, and Preferences for Risk

Thom Lambert —  17 March 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.

Thom Lambert


I am a law professor at the University of Missouri Law School. I teach antitrust law, business organizations, and contracts. My scholarship focuses on regulatory theory, with a particular emphasis on antitrust.

4 responses to CEOs, Shareholders, and Preferences for Risk


    I realize I’m totally unqualified to comment on this, but to me, Cuban’s analysis doesn’t seem that far off. Corporate CEOs often have golden parachutes that will pay them a large sum of money when they leave the company regardless of how their efforts pay off. Beyond that, many of them are already extremely wealthy from previous stints as corporate CEOs or from family money. While, they receive a sometimes enormous sum of money in the form of equity compensation, the loss of that net worth is likely not valued as highly as it would be to a “mom and pop” shareholder. This seems to make sense given diminishing marginal utility of money. A CEO with a guaranteed pay out (in effect insurance) of several million dollars seems likely to be more willing to take a large risk for a potentially huge payoff than would someone who may have a substantial portion of their retirement savings and net worth tied up in their investment with no insurance policy on the backend to guarantee them a sizeable return if the risk materializes and results in a substantial depreciation of the holding’s value.

    I’d agree that “mom and pop” shareholders being once removed from the buying decision through mutual funds may make a difference. However, most studies show that individuals do not properly diversify their 401(k) and IRA holdings. I’d tend to agree with Prof. Manne that they are passive, but that may be because of other factors and not some inherent risk-seeking behavior. Cum hoc ergo propter hoc. (Aren’t individuals generally presumed to be risk averse?) I’d think a lack of knowledge, concern over making a mistake, and inertia are more likely explanations than risk-seeking.

    Again, I acknowledge that you gentleman have more knowledge and education in this area than I do. I just thought I’d toss my 1 cent in to the discussion.


    Exactly right!

    Cuban’s point of view is exceedingly naive (or intentionally misleading). Everyone wants a homerun — the question is how much risk is it worth bearing to get one, given that swinging for the bleachers also means more strikeouts. Sure, ambitious CEOs like homeruns. They also don’t want to lose their shirts. What’s amazing is that Cuban makes this very point — although he draws precisely the opposite conclusion from it:

    Then there are those hired to be CEOs. What are the goals of hired CEOs ?. Plain and simple, its to get paid. To make as big a chunk of money as they possibly can in the shortest amount of time. No one in their right mind is going to take on a job with the amount of pressure, stress and away from family time that comes with being the CEO of a public company without getting paid incredible sums of money.

    Unless CEOs are exceptionally thick (and they aren’t), that “getting paid incredible sums of money” translates into “receiving compensation with an extremely large expected net present value.” I would think that by Cuban’s own standard “failing to get paid at all because the company failed utterly” would be undesirable and factored into any rational analysis.

    Moreover, to echo Bill — here’s Cuban on shareholder interests:

    There is a survey published by the Securities Industry Association that provides some fascinating data about who owns stock in the US, how much and how they hold it.

    Here is the link to the survey, entitled Equity Ownership in America 2005.

    For the sake of this argument, the highlights of the survey are that nearly 90 pct of equity owners hold some or all of their equity assets in tax deferred accounts, 90 pct of all equity holders dont have any sell transations in any given year and 96 pct of investors agree with the statement, “I view my equity investments as savings for the long term�

    My “analysis� of this data is that if corporate management wants to be in alignment with shareholders, they better understand the shareholder credo, which is:

    �Ive invested in your company for my future and the future of my family. Dont screw it up !�

    My “analysis” of this data is that shareholders are well-diversified and utterly passive. They want risk, risk, risk! If CEOs tend to take big risks, then that’s just great for the vast majority of shareholders.

    Bill Sjostrom 17 March 2006 at 4:05 pm

    Cuban also overlooks the fact that most mom-and-pop shareholders don’t own shares directly anymore (and they shouldn’t). Instead, they own them through mutual funds where they’re getting diversification whether they realize it or not.

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