The groundbreaking work of Oliver Hart of Harvard University and Bengt Holmstrom of the Massachusetts Institute of Technology, which includes providing invaluable insight into how employment contracts should be structured, recently earned the two professors the 2016 Nobel Memorial Prize in Economic Science. Hart and Holmstrom’s research offers a variety of theoretical models and frameworks through which they analyze the competing interests of employees, managers, CEOs, shareholders, and others, and attempt to reconcile them via contracts.
Over the past few decades, Homstrom and Hart’s findings have been used to evaluate whether particular contracts accurately measure the performance and value of employees and other agents to companies while offering the right amount of incentive. Specific factors that the research contemplates in its assessment of employment contracts include ownership, control, the measurability of an agent’s performance, risk sharing, and the motivations of the parties involved.
Rather than simply pay an individual a fixed salary or reward a manager for the performance of a company in a vacuum, the professors suggest considering alternative compensation structures and contracting terms, including:
In order to ensure that a company’s interests are aligned with those of an employee, it may make sense to tie an individual’s compensation to performance rather than pay her a set amount. By withholding a portion of an employee’s compensation, the company can provide incentives for the individual to earn the full amount by meeting certain goals. Whether or not this type of arrangement makes sense will depend in great part on the measurability of an employee’s performance and the stability of the business environment.
Another metric for evaluating an employee’s value, particularly one who is in a decision-making position, is the overall performance of the company. One common mistake businesses make is setting goals or targets based solely on the absolute performance of the company, rather than taking into account the performance of the company as compared to other similarly situated businesses. If a company does well in a thriving market or suffers during a market collapse, the employee should not be rewarded for good luck or punished for misfortune. A company performing well relative to others is a far superior measurement of employee value.
Most contracts cannot contemplate the exact outcome of every situation that may arise in a given relationship. Companies recognize that it is impossible to list specific instructions for every job responsibility, and this in turn may actually be counterproductive. In such cases, the parties should determine who has the power to decide what to do in situations where they cannot reach an agreement. In this manner, the parties are able to avoid having to anticipate every possible future event while entering into a relationship that allows them to move forward with their main, general purpose, i.e. employment.
While Hart and Holmstrom’s work is highly theoretical and informative, it is essential to use their tools in conjunction with a business’s specific needs. Depending on the business type, number of employees, and variety of other factors, businesses may have widely different terms and compensation structures that work best for them. Notwithstanding this, business owners are advised to consider the research finds of Professor Hart and Holstrom’s when making decisions about their own employees and businesses.
This article was prepared with the assistance of Julie Lee, 3L (CUNY School of Law).
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