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Bold Thinking In CEO Pay

Boards of directors are discovering that CEOs must think and act like owners if they intend to win. Here are five ways to build partnerships with shareholders.

It hardly matters who is talking or listening: The issue of CEO compensation seems to be an inexhaustible topic. How much is too much? It’s not how much, but how! How high is too high?

In our fifth annual survey of CEO pay, published in September, we suggested that the issue to be addressed is this: “Do the CEO and the stockholders share a common economic destiny-one where the CEO’s rewards reflect those received by the company’s investors?”

Certainly many shareholders would say no, having watched the earnings on their investment drop significantly. Our survey showed that return to shareholders dropped 70 percent from a median of a 10 percent annual return to shareholders in the 1986-1989 performance period to about 3 percent in 1987-1990. At the same time, CEO pay dropped by only 14.1 percent.

That, of course, is history, and while others busy themselves as Monday morning quarterbacks of the comp game, we choose to leave the old debate over the worth of a CEO to free market forces, and concentrate instead on designing pay packages that support the execution of today’s strategies.

We are seeing the beginning of a new wave of bold and creative thinking in the CEO pay arena. This should bode well for both the shareholder and the CEO.

MEGA-GRANTS TO CEOs

A newly hired CEO shouldn’t have to wait and slowly build equity through annual stock option grants. In our opinion, a new CEO should get a “jump start” through a mega-grant to get him thinking like an owner from day one.

When the board of directors of M/ACOM hired Tom Vanderslice as CEO, they must have recognized the need to control fixed costs and provide him with an opportunity for wealth creation. He was granted one million stock options and 250,000 shares of restricted stock. If M/ACOM stock grows at 15 percent over the next five years, shareholders will add $144 million to their net worth. Similarly Vanderslice will add $6.8 million to his. While this potential gain seems high for the CEO of a $375 million company, his cash package of $652,300 is less than 10 percent of it. Thus, Vanderslice wins big only when the shareholders win big. Isn’t 4.7 percent of the shareholder gain a small price to pay for an M/A-COM turnaround, considering the magnitude of the task of reversing the 15 percent annualized price decline over the last four years?

Martin Emmett is another classic example of a CEO who puts his money where his mouth is. When he was hired in 1989 as CEO of Tambrands, an underperforming consumer products company, he and the board agreed that the bulk of his pay should be tied to his ability to get the company going again. He took 12 percent less in salary than his predecessor (thus reducing fixed costs), but was granted 300,000 stock options. The result? In the two years he’s been CEO, the stock price has nearly doubled. Emmett has gained about $7,000,000 on his options, compared to his annual cash compensation of $735,000 last year. The stockholders meanwhile have gained $950 million. Emmett’s share of the stockholders’ gain was less than one percent. We think that’s a good deal for the stockholders.

MEGA-GRANTS TO CEO/OWNERS

Mega-grants can also be helpful with CEOs who are major stockholders in their companies. Charles Lazarus of Toys R Us is a good example. Although he already owned 1,881,000 shares, last year he was granted 750,000 stock options.

While some would argue that this is another example of blatant excess, we think not. When the CEO is a major stockholder, his interest may lie just as much in preserving the value of his holdings as in growing it. Equity investors, on the other hand, want growth; otherwise, they would put their money in risk-free T-bills. Thus, there can be a gap between the capital-preserving interest of the CEO/owner and the investment-growth interest of his fellow investors. Lazarus’s mega-grant of options helped bridge the gap, because these options will only pay off if he performs for the shareholders.

OPTIONS IN EXCHANGE FOR CASH

Swapping salary and/or bonus for stock option grants is another way of changing the compensation mix in favor of the long-term stock-based component. Ronald Skates, CEO of Data General, is a perfect case in point. His total cash compensation in 1989 was $1,550,000. In 1990 he received only $464,000-a 70 percent reduction in cash costs. In lieu of cash, Skates got a stock option grant of 157,000 shares. Although their below-market exercise price provides some underlying value (and security), the options still helped produce a respectable leverage index of 0.84 percent. (See our September 1991 CE article for a definition of leverage index.) The company has been a performance laggard, with annualized returns to shareholders of -37.6 percent. If Skates can turn performance around, he can be a big winner. Isn’t that the kind of pay package shareholders want?

At Torchmark, the Birmingham-based insurance company, key executives can “swap” up to 100 percent of their annual incentives and up to 20 percent of salary for stock options. The options are valued as if they are publicly traded, with the value discounted to adjust for their illiquidity and employment risk.

General Mills, on the other hand, introduced a broad-based program to provide about 80 executives the opportunity to receive stock options in exchange for future merit increases. General Mills’ proxy statement indicates that its objectives are to increase employee ownership and reduce fixed expenses. Over 90 percent of eligible employees have chosen to participate.

LEVERAGED OPTIONS

Another pathfinder is Paul Fireman at Reebok. In signing a new deal in 1990, he gave up an annual cash bonus equal to 5 percent of the company’s annual pre-tax earnings in excess of $20 million, which was worth $14 million to him last time around. In exchange, he got stock options on 2.5 million shares. The shareholders got a CEO who can’t begin to exercise those options until the shareholders have first gotten a reasonable return on their investment, because Fireman’s average exercise price is 18 percent higher than the market price was when the options were granted. If Fireman wins, he will win big. If he loses, he has sacrificed $14 million. Isn’t that the kind of entrepreneurial approach to CEO pay that should be applauded?

SAFETY NET OPTIONS

Yet another stock-based arrangement is that of safety-net options. This type of program is particularly effective when there is reason to believe that the stock market won’t appropriately recognize superior operating performance. Suspecting this to be the case, Gannett introduced a stock option plan with a guaranteed payout floor if operating performance objectives are achieved. In tandem with options, performance units were issued. If the options are underwater at the end of the performance period (four years), yet the operating performance target is hit (15 percent EPS growth per year), then 75 percent of the option exercise price is paid out. This approach frees management from the oppression of quarterly earnings pressure, so they can feel confident about making the right long-term decisions for the business.

PERFORMANCE OPTIONS

Performance options are a new technique showing up on the compensation horizon. Performance options have a fixed exercise price but a variable award. The number of options that become exercisable is a function of operating performance. For example, if EPS growth is 10 percent per year over a five-year performance period, 50 percent of the options are exercisable and 50 percent are canceled. If EPS grows at a 15 percent clip, 100 percent are exercisable. Like safety net options, performance options encourage CEOs to do the right thing with the understanding that eventually the investment community will recognize them.

A SPIRIT OF COMMON ENTERPRISE

Clearly, there are many exciting new concepts in CEO pay today. Boards are becoming highly creative in tailoring performance-driven pay packages by linking CEOs and their shareholders in a spirit of common enterprise. And this is as it should be in a capitalist system based on the principle of rewarding those who create economic value in the broadest sense.

One further note: It is no secret that investors-particularly institutional investors-are constantly searching for signs of how the CEO regards the company’s future prospects. Companies that utilize innovative, entrepreneurial designs in their CEO pay packages are sending an important positive message to the investment community. Through the medium of pay design, these companies are showing that their CEOs are betting their future personal wealth on company performance. Can the message be any clearer or stronger?


David R. Meredith is chairman and cofounder of Personnel Corporation of America (PCA), a Norwalk, CT-based firm specializing in human resource management. A former principal of McKinsey, he holds a Ph.D. from MIT’s Sloan School of Management.

About david r. meredith