Stock-based executive compenation

April 26, 2011 12:06 PM

Why we should do away with stock-based executive compensation. Three excerpts from a new book on executive pay by Roger Martin, dean of the University of Toronto's business school: The next financial crisis could be right around the corner. How an economic theory changed the way CEOs get paid. What the NFL can teach us about executive compensation.
posted by russilwvong (34 comments total)

I'm curious as to what alternative benchmark he'd like to use. DCF? You'd better get a neutral 3rd party to make that estimate. The game-playing a good CFO or accountant can do with internally generated numbers is breathtaking.
posted by leotrotsky at 12:18 PM on April 26, 2011 [1 favorite]

I can see this argument applying to short vesting periods and outright stock grants, but I don't understand why Martin thinks stock-based compensation in and of itself is bad.
posted by BrotherCaine at 12:21 PM on April 26, 2011

)Outrageous Compensation is the result of a different principle-agent issue. The board gets captured by the chairman and ceo - usually because those two or some combination thereof ends up controlling the nominating committee that determines the makeup and sometimes the compensation of the board The other culprit is the compensation consultants - who care more about staying employed then they do about determining fair compensation - so they come up with insane rationales for approving the comp deals but forth by management, that the board can then rubber stamp "Because our neutral third party said this was fair, and to the industry standard"

)His point about using stock in comp is sorta fair. What you've gotta do is come up with a regime that accepts there can be differences in the medium term between what a company is worth and what the market things it is worth, while at the same time not giving mgmt targets that are easy to manipulate. Its really a tight rope and very few companies get it right. I think without question options should be abolished and replaced with restricted stock. Perhaps even restricted stock grants indexed to an array of financial metrics that are broad enough to limit the game playing CFO's can pull off. Leotrotsky is 100% correct - if you let them these guys will come with anything.

I think eliminating all stock though is overkill.
posted by JPD at 12:40 PM on April 26, 2011 [1 favorite]

@ Brother Caine: The final two (full) paragraphs of the last link lay out pretty well why he thinks stock based compensation is a bad idea. I'd be interested to see what his alternative is, though. Guess I'll have to read the book.
posted by KingEdRa at 12:41 PM on April 26, 2011

This is pretty stupid. His conclusion is that we should do away with stock based compensation because it creates incentive to maximize short term stock gains over long term stock gains is throwing the baby out with the bathwater.

The problem is not with aligning executives to shareholder value, its giving them a time horizon that is far too close. Any good CEO knows that building a bigger, stronger more profitable company is the way to long term stock appreciation. They also know that short term strategies to boost stock price are almost never good for the longer term. So just make the stock vest over 10 years, make it vest more in the out years. Stop the CEO from selling for the first 5 years. There are a whole bunch of ways a Board can set the right time horizon. But of course you probably couldn't write a whole book about it.
posted by Long Way To Go at 12:45 PM on April 26, 2011 [5 favorites]

I couldn't agree more whole-heartedly with the author's description of the wrong-headedness of the move away from stocks as long-term investments and generators of reasonable dividends. It's all about share price now, nobody even talks about dividends. Executives will hollow out companies in order to drive the share price in the short term, at the expense of the long-term viability of the company, and it's disgraceful.
posted by Mister_A at 12:47 PM on April 26, 2011 [2 favorites]

Here's the thing - a well run company grows productive book value (or cash flow, or what ever defendable metric floats your boat) at a faster rate than a poorly run company, and in the long-run the market rewards that. If you reject that idea, and you think the share price is purely about beating expectations, then yes, you would arrive at his conclusion. Really what he's saying is we need to eliminate compensation that rewards short-termism at the expense of neglecting the long-term. I don't think anyone with a clue disagrees with that.

I think the issue is more pernicious - management realizes they can't goose numbers forever, so they favor regimes that have short payoffs, and they get their lackeys on the board to go along with them. In other words - its not just that its flawed, its that they know its flawed, and seek to benefit from that flaw.
posted by JPD at 12:47 PM on April 26, 2011

Warren Buffet pays himself exclusively with stock in Berkshire and he has never failed to take the long-view.

I think Martin has correctly identified the problem and his solution is wrong it just isn't the best solution.
posted by VTX at 12:52 PM on April 26, 2011 [1 favorite]

The paragraphs that hippybear quotes are lucid and make a clear case for why stock compensation is bad, but it leaves me wondering something. If stock compensation puts the CEO at odds with the shareholder, why doesn't the market absorb this information and lower expectations of long term value of stocks where CEO pay is tied to short term stock performance?
posted by dgran at 12:59 PM on April 26, 2011

Because in this country the market is a religion and CEOs are prophets and the Deacons screaming from the pulpits on CNBC all day long sing the infallibility of the prophets.
posted by spicynuts at 1:03 PM on April 26, 2011 [1 favorite]

I am very interested in reading all of this because it is directly connected to the work I do, but unfortunately I am currently busy at that work and do not have time to read it. I will say generally that no matter what metric is used to tie an executive's compensation to the success of his or her company, it seems somebody will find a way to game it or massage it or manipulate it. I don't know if these articles mention it, but Treasury was bandying about requiring or encouraging some form of "hold past retirement" when it comes to certain incentive equity awards, but I haven't heard much about it lately. I will say that the use of golden parachute payments, golden coffins, post-retirement medical, etc. for executives has decreased substantially over the last decade, although many, many deeper problems remain unaffected.
posted by Falconetti at 1:10 PM on April 26, 2011

Because in this country the market is a religion and CEOs are prophets and the Deacons screaming from the pulpits on CNBC all day long sing the infallibility of the prophets.


this made me laugh thanks. Generally CEO's are frat boys made good. anyone who thinks they know what the hell they are talking about generally gets what they deserve.
posted by JPD at 1:10 PM on April 26, 2011

Exactly. The only exceptions I've ever met are those that actually started in the mailroom or at a entry position where they actually did the work of production or sales and worked their way to CEO after 30 years.
posted by spicynuts at 1:20 PM on April 26, 2011 [1 favorite]

Exactly. The only exceptions I've ever met are those that actually started in the mailroom or at a entry position where they actually did the work of production or sales and worked their way to CEO after 30 years.

Did you ride a mammoth to school when you were little?
posted by Trochanter at 1:24 PM on April 26, 2011 [1 favorite]

The board gets captured by the chairman and ceo - usually because those two or some combination thereof ends up controlling the nominating committee that determines the makeup and sometimes the compensation of the board

This is the real problem, of course. Ultimately I blame the investor community, which is the group that has the means to make a difference. There are a ton of institutional investors that cry about CEO comp and short-termism, but those voices are overwhelmed by the huge flows of money that are invested with little attention paid to these issues. Fast-moving hedge funds are an easy target for blame, but I also blame the rise of passive index investing, which allows investors to abrogate their corporate governance duties.
posted by mullacc at 1:25 PM on April 26, 2011

Fast-moving hedge funds are an easy target for blame, but I also blame the rise of passive index investing, which allows investors to abrogate their corporate governance duties.


I'd add a third guilty party - the popularity of the RiskMetrics' Corporate Governance products that allow many active managers to outsource their research into governance issues. Essentially when you wage a proxy fight in the US, it is these guys you plead your case to - far more than the larger shareholders on the register.
posted by JPD at 1:31 PM on April 26, 2011

[W]e should do away with stock-based executive[s] compensation.

Problem solved.
posted by Faint of Butt at 1:34 PM on April 26, 2011

There is a fascinating section in The Master Switch which dwells on the relatively new phenomenon of the corporate conglomerate, which we are now all-too-familiar with in the form of General Electric and other megacorps. The book addresses the consequences of the media conglomerate in American culture but goes quite a bit further in terms of political theory, which I was delightfully surprised by. These are two great tastes which I suspect taste great together.
posted by mek at 1:46 PM on April 26, 2011

I think that executive compensation should be (mostly) embargoed for a predetermined number of years, with explicit conditions on its release only if the corporation continues to meet certain requirements. This will definitely encourage long-term thinking.
posted by chimaera at 1:47 PM on April 26, 2011 [1 favorite]

We need executives or some form of leadership in companies, especially large ones. Someone has to steer the ship. What form that takes is not written in stone. I'm assuming the suggestion to do without was hyperbolic, but felt a counterpoint was needed.
posted by Antidisestablishmentarianist at 1:48 PM on April 26, 2011

I have a suggestion.

I suggest that we stop talking about "compensation", whatever the heck that means, and talk about "salary", same as everyone else gets. I think putting executive pay into a special category with a special word is a serious mistake.

I also suggest that we look really, really, hard at the claim that somehow businesses can't get quality executives without offering outrageous salaries. I note that back in the 1950's, during the peak of American economic growth, the average CEO earned only around 12 times what the lowest paid worker in the company made. These days the average is around 300 times what the lowest paid worker makes.

I find it difficult to believe that modern CEO's are really worth 288 times what CEO's back in the 1950's were worth or that they bring 288 times more expertise or quality or benefit to the company.

I find the argument that superstar CEO's are needed to be especially questionable given the way the superstar CEO's cratered the nation's economy, and historically the way they have failed to make companies succeed even when they did not fail so miserably as to ruin the entire economy.

I am, therefore, quite inclined to agree with the linked article. Paying CEO's in weird ways has demonstrably failed. A direct exchange of labor for cash seems like a much better way.

I'd also suggest cutting how much cash we give them in exchange for their labor. How about we try paying them only around 12 or 20 times what everyone else gets, and see what happens? I'm betting the quality of talent attracted by that level of salary can't possibly do any worse than the superstar CEO's have.

Or, really, why pay them even that much? Why should a job requiring an MBA pay more than a job requiring any other sort of master's degree?
posted by sotonohito at 2:21 PM on April 26, 2011 [8 favorites]

GREED.
posted by carsonb at 2:47 PM on April 26, 2011 [1 favorite]

Generally CEO's are frat boys made good.

Depends on the industry. This is generally not the case in tech. But in finance, manufacturing, etc; sure.
posted by wildcrdj at 3:11 PM on April 26, 2011

This is actually one of the areas where I do some research. I agree that the excerpts so far give us some indication of why he views stock compensation as problematic, but not what he suggests as a solution.

One of the problems with options is that they may over-encourage risk taking. The problem is that they do not provide the CEO with any downside risk, and so he/she may feel an incentive to make overly risky bets about the firm's future. Here is a good article about that.

I actually have a paper coming out in the next few months where we actually find that some CEOs who feel like their identities are closely linked to the firm are actually likely to seek after lower pay when firm performance is low.

My dissertation advisor has done research that shows how the explanations for CEO compensation have changed over the years from explanations that stressed that we have to compensate CEOs so highly in order to retain their valuable skills, to explanations based on agency theory (like the author mentions in the linked articles). He has also done a bunch of research on boards and why they often fail to function as we think they should.
posted by bove at 4:03 PM on April 26, 2011 [1 favorite]

)Outrageous Compensation is the result of a different principle-agent issue. The board gets captured by the chairman and ceo

the other problem is that the board is usually stuffed with executives from other companies as well.

Warren Buffet pays himself exclusively with stock in Berkshire and he has never failed to take the long-view.

He's also giving all his money away and hardly spent any of it. Not really a typical CEO. He's also more of a "Financier" then a "CEO". I mean, Berkshire Hathaway is a finance company that invests in other companies with their own operational CEOs.
posted by delmoi at 4:25 PM on April 26, 2011 [1 favorite]

I'd also suggest cutting how much cash we give them in exchange for their labor. How about we try paying them only around 12 or 20 times what everyone else gets, and see what happens? I'm betting the quality of talent attracted by that level of salary can't possibly do any worse than the superstar CEO's have.

Raise the tax rate then. Astronomically, like it was in the 1950s (70%+ for salary over 1M).

It'll go one of two ways - the executives will pay themselves 4x what they make now in order to maintain their lifestyle (taking money out of the pockets of the middle class), or they'll decide that instead of funneling all that money into the government's pocket, it might just be a good idea to take a lower salary, lower standard of living and reduce the multiplier from 40x to 20x.
posted by SirOmega at 5:03 PM on April 26, 2011

bove: --not what he suggests as a solution.

A 2009 Harvard Business Review blog post:

Fortunately, there is a simple solution. Scrap stock-based compensation entirely and compensate executives on the basis of improving real measures such as EPS [earnings per share], ROIC [return on invested capital], and market share. Those are things over which executives exert significant control and if they improve those real results, stock price will follow. It isn't hard or complicated. It just takes going back to principles.

An alternate proposal: Saving Stock-Based Compensation from Itself. (If I understand correctly, the executive would be required to make a loan to the company in exchange for shares. To a prospective CEO, that would be even less appealing than compensation based on business metrics.)

List of Martin's recent publications.

His articles on the battle between capital and talent--CEOs being a particular example of individual, hard-to-replace "talent"--are particularly interesting.

From giant pension funds to small retail investors, capital has increasingly lost its patience with talent, whether it be CEOs, fund managers, lawyers, investment bankers, athletes or actors.

Although "talent" is technically labor, more easily replaced workers are likely to sympathize with capital rather than talent.
posted by russilwvong at 5:35 PM on April 26, 2011 [1 favorite]

Some counter points.
1-This guy seriously suggests we should learn from the NFL in managing CEO pay? This is the worst timed book ever given the masssive labor dispute.
2-The investors who bought shares in the company are primarily interested in performance of the stock price.
posted by humanfont at 5:37 PM on April 26, 2011

"Is greed good? "Quoting Gordon Gecco in "Wallstreet: Money never sleeps" I believe greed is good as long as you are honest. The problem is not to be paid by performance. The problem is ruling a company knowing that you are not going to be held accountable for your mistakes.
posted by juanillogg at 6:17 PM on April 26, 2011

I don't get his point at all. If we're trying to talk about theory, let us get back to basics - stock price determination - at the first order level, stock prices are a function of the income stream it provides - company profits / dividends.

Changes in stock prices then reflect changes in market sentiment / expection of those future income streams (dividends), ie, a stock yielding $1 of dividends per year in infinity would be worth $10 now, if the expectations shifted such that the stock is perceived to yield $0.50 of dividends per year, then stock valuation would fall to $5m.

(assuming company profit being split into dividends and retained earnings which are identical for purposes of company valualation)

There are many second order and frictional effects but the effect is largely similar: stock valuation always comes back down to real profits generated by the company. Even if you were buying stock in order to resell (not receive dividends) it would eventually be sold to someone who would be interested in the dividends, and that would have determined the sell price anyway. No company earning $2 per stock per year and paying a dividend of $1 per year, say, would spend very long being undervalued at $5 or overvalued at $100.

And so I don't see any fundamental reason why using stock prices to motivate CEOs would be flawed: if the CEO allowed expectation of future profits to fall by 20% while on his watch, it should be reflected in a drop of 20% in the company's valuation, and thus a 20% drop in CEO compensation. That's exactly in line with how things should be: if "expectations" are high when he takes the job, that's because the company is already in a good position, built and placed there by his precedessor - if he can't beat those expectations, that means he's not adding any value to the company by being there, and thus should not be paid. And the reverse too.

I agree for the most part that CEO compensation is too high, but I have seen lousy CEOs destroy value in companies, to the point where I sometimes think the company would have been better off spending a couple million more dollars to steal a better CEO from another company.
posted by xdvesper at 8:05 PM on April 26, 2011

Did you ride a mammoth to school when you were little?

We didn't have school when I was little. They hadn't invented it yet. If you're thinking this is a ludicrously outdated idea, the current CEO of my company worked his way up in the industry from entry level.
posted by spicynuts at 5:23 AM on April 27, 2011

Fortunately, there is a simple solution. Scrap stock-based compensation entirely and compensate executives on the basis of improving real measures such as EPS [earnings per share], ROIC [return on invested capital], and market share. Those are things over which executives exert significant control and if they improve those real results, stock price will follow. It isn't hard or complicated. It just takes going back to principles.


EPS and ROIC? Hah hah hah hah. Gaming EPS is like CFO level 001. Gaming ROIC = convincing the board that goodwill doesn't matter and buying lots of business at a return greater than your cost of debt. That's like spring semester of CFO 001.
posted by JPD at 5:56 AM on April 27, 2011

spicynuts: I'm just kidding around, but you must agree your guy was a rarity. I've said elsewhere that my mom worked for a big oil company starting in the 60's and she watched all the head people there go from being geologists and engineers to MBAs and financial people during her time.
posted by Trochanter at 7:41 AM on April 27, 2011

More from the Globe and Mail's series of excerpts:

What capitalism can learn from the NFL

Why are CEOs compensated differently than quarterbacks?

Flawed economic theories are destroying American capitalism
posted by russilwvong at 11:42 AM on April 29, 2011