Managerial Compensation Schemes with Informed Principals

We study managerial compensation schemes for situations, where the current management knows more about the company's expected profitability than the new employee. When a manager is offered a contract with only a low fixed salary but a high profit participation, he is afraid that the company's profit outlook may be quite bad. Employers are aware of this. In equilibrium high profit employers offer their new managers high fixed salaries and low profit participations. They thereby credibly signal to their new managers, that they are high profit types. Low profit firms on the other hand will offer contracts with high profit participations and low fixed wages. One can thus easily explain the prevalence of contracts with high fixed salaries, without having to appeal to employee risk aversion.