What’s wrong with giving CEOs lots of equity-based pay?
Roger Martin illustrates his concerns using the example of two CEOs hired on Jan. 1, 2007, whose companies’ shares both trade at $100 (U.S.). The CEOs stay for five years before leaving and each receives $5-million worth of new stock options or share unit grants every year as part of their total $10-million annual pay packages.
Steady Eddie
Steady Eddie’s company survives the market crash of 2008 and 2009 unscathed but the share price does not rise either, sitting at $100 until he departs. His stock options, issued every year at an exercise price of $100 (that is, the market price of the shares), are worthless because the share price has not risen. He makes no money on his options after five years of oversight. He does better if he is paid with $5-million of restricted share units each year, instead of stock options.
At the end of five years, his share units are worth $25-million because he receives $5-million worth each year and they don’t change in value.
Thrill Bill
Thrill Bill’s share price tracks the average of the S&P 500 index, crashing by almost 40 per cent in 2009 then bouncing around to end 2011 at just $89. After five years as CEO, his company’s share price is down 11 per cent, but with some far deeper lows at points along the way.
When Bill leaves, he cashes out his options for a gain of $7.2-million because he was reloaded each year with new grants at lower exercise prices as his company’s share price languished. When the share price rose again, his low-cost options became far more valuable. If he is paid in share units instead of options, Mr. Martin calculates Bill’s share units are worth $26-million by the time he departs.
Why are they worth more than Eddie’s units? Even though Bill’s share price is lower at the end of 2011, he got a larger number of share units each year when the share price was depressed to ensure his compensation grant still equalled $5-million in annual value. When the share price rose again, he benefited from holding more share units than Eddie.
The lessons?
Mr. Martin says many directors believe share units are better than options for ensuring CEO pay is aligned with company performance. But “dreadfully performing” Bill still made $26-million from his share units when he would have made $7.2-million if he had options in the same scenario, he says.
The bigger moral of the story, he says, is that equity compensation rewards share price volatility more than steady performance, with Thrill Bill earning more than Steady Eddie if he is paid in either options or share units. And Bill’s windfall gains could have been even higher if he had done anything deliberate to spur more share price volatility, Mr. Martin adds.
“If in fact he wanted to act manipulatively, Bill could have made a lot more money – a lot, lot more money.”