Abstract
This study investigates how stock liquidity affects the compensation incentives faced by the directors on the board. The results show that the proportion of cash‐based compensation in the directors' compensation package increases when the firm's shares are less liquid: a one standard deviation increase in the bid‐ask spread from the mean is associated with a 3% larger fraction of cash in the directors' compensation package. The effect is more pronounced for firms whose management does not issue Earnings Per Share (EPS) guidance and for firms whose Chief Executive Officers (CEOs) themselves have higher pay in cash and lower pay in the form of equity. These results suggest the compensation incentives offered to directors in firms with illiquid shares result in the interests of shareholders being less aligned with those of the directors compared with firms with liquid shares.