2. Alternative hypotheses
This section develops three testable hypotheses about compensation and control of top management by a board of directors. The hypotheses concern the relation between stock price performance and management compensation; sales growth rates and management compensation; and stock price performance and management turnover. The section also includes a discussion of other empirical work. Tests of the hypotheses developed in this section are reported in the following two sections.
2.1. Stock price performance and compensation
Monitoring and review of managers by the board of directors is a major internal managerial control mechanism. The board approves the structure of incentives to which managers respond, including decisions about the compensation of top management. Smith and Watts (1984) present evidence indicating that the compensation plans approved by boards of directors generally link pay to performance measures which are themselves directly related to shareholder wealth. For instance, the value of stock options held by a manager at the beginning of a year gives him an incentive to act in ways which maximize stockholder wealth throughout that year. Phantom stock or stock appreciation rights, if awarded prior to or at the beginning of the year, have the same incentive effect