Don’t Get Tripped Up: Hurdles and Limits to Bonus Contract Payouts

This study introduces a contracting feature common in practice to the academic literature. Hurdles, sometimes referred to as funding gates, are a common contract feature which alters the path to annual bonus contract payout. Missing the performance hurdle results in a different outcome than would have been otherwise achieved often resulting in zero payout to the entire bonus contract. We investigate characteristics of firm-years with hurdle contracts relative to firm-years without and how these contracts differ from traditional contracts. We employ a multivariate hurdle determinants model to show that it is largely other characteristics of the compensation contract and the use of a compensation consultant that determine hurdle use. We next determine that these hurdles represent binding incentive constraints by documenting that they positively influence the likelihood of a zero bonus payout and the negatively impact dollar value of the payout itself and the payout as a percentage of target. Finally, we document that hurdles, particularly when the hurdle performance metric is earnings, positively influence the pay-performance sensitivity of bonus contracts. Overall, understanding this common contracting practice enhances our understanding of how performance metrics are combined in practice to produce annual bonus contracts.