We explore the impact of Knightian uncertainty on contracting within a multi-layered firm. We study a setting where, absent uncertainty, division managers should be paid based on their division performance, but not other divisions’ performance. As uncertainty increases, division managers are more pessimistic about the prospects of their division, diminishing effort. When uncertainty gets large enough, headquarters grants a share of the other division to hedge uncertainty, and thus instill confidence. When headquarters is also uncertainty averse, the optimal contract when there is sufficient uncertainty is to grant equity in the entire firm. Our model can explain the prevalence of equity-based incentive contracts in young firms with uncertain cash-flow prospects, and the preference for performance-based contracts in more mature and well established firms.
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