May 2007 Vol. 105 No. 7 THE REVIEW

Reverse Monitoring: On the Hidden Role of Employee Stock-Based Compensation

Sharon Hannes

This Article develops a new understanding of equity-based compensation schemes, such as employee stock option plans. Current literature views such schemes as a measure aimed at motivating the recipient employees to work harder for the firm. Under that view, this method of remuneration either complements or substitutes for other measures used to monitor the performance of the recipient employees. In contrast, this Article proposes that recipient employees be viewed as potential monitors of other employees and that stock options (or similar types of compensation) motivate them to fulfill this task. This view has many applications and can shed light on persistent puzzles, including why there is sweeping use of stock ownership plans by many “new economy” firms. No junior employee at Microsoft or Intel can improve the value of her heavyweight employer to such a degree that it will make it worthwhile for her to work harder once stock options are offered. Nevertheless, given the sensitivity of the “knowledge industry” to leakage of its intellectual property, all employees can add much to the company’s value by standing on guard against such loss. If technology is both a vulnerable and critical asset for the organization, option recipients will be alert in protecting against infringement. Since not much effort needs to be exerted to monitor their peers and supervisors to prevent this significant harm, incentive compensations can easily motivate employees to perform their monitoring task. Many other applications of this new view that cannot be explained by the current literature are discussed in the Article.

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