The Absolute Best Takeover Defense

Using leveraged options and “offset carry” plans as a basis for CEO pay, companies have the means to pay for performance, and to become unattractive takeover prospects.

May 1 1989 by David R. Meredith


The American CEO has gained the reputation of being the greediest SOB on the block, probably in the world. Compared with CEOs in Japan or Europe, the compensation levels of American CEOs seem unconscionable. Our government has responded with restrictive taxes on golden parachutes, limits on pensions and taxes on perquisites. And it’s likely to get worse.

Compensation “experts” and the financial press have attacked CEO pay as being linked to virtually anything other than the shareholders’ best interests. Instead of a solution, we have developed some catchy jargon: “paying for performance” is the name of the game, and becoming a “corporatreneur” is the goal.

Typically, there are three stages in the development of a business, and three corresponding roles the CEO will play: As the founder, he develops a vision, then fights to create a market; as the manager, he devel, ops and guides, establishing structure and organization to take the vision national or worldwide; and as the raider, he fulfills the role of scavenger, tearing the company apart, capitalizing on inefficiencies.

This does not have to be the natural progression, however. Although most CEOs attempt to preclude the move from manager to broker, all too often the manager/CEO is shackled with pay plans which fail to reward risk-taking. And taking risks is exactly what motivates the founder/CEO to create the organization, and the raider/CEO to take it over and apart.

 

BIG BUCKS FOR FOUNDERS IS OKAY

Would the public and business press have reacted to Michael Eisner’s (Disney) pay package with the same level of indignation had it been “Uncle Walt’s” name in the proxy? Why are Charles Lazarus (Toys R Us), Fred Smith (Federal Express), or Steve Jobs (Apple), viewed differently from Ford’s Don Peterson or Coca-Cola’s Roberto Goizueta? Because founders of successful businesses are viewed as folk heroes, the epitome of the American dream. Founder’s pay is their just reward for taking calculated risks while creating jobs, tangible products or services, and is a tribute to their vision.

If they had failed, few would have heard of them, other than the banks who foreclosed on their homes, and friends and family who believed in them.

In start-up operations, it is not unusual for the founders to put up much of their own money, in addition to time and talent. For this, they receive a low (or no) salary, and few benefits. But they also receive a pot full of stock. In a study of successful “threshold” companies, our firm found that the typical founder/CEO owns 14.3 percent of the stock This ownership, then, seems to be the principal reward for risk-taking.

 

RAIDERS HAVE DONE WELL, TOO

Few will deny that raiders are attracted by the lure of making big dollars in takeovers of undervalued/ undermanaged, established companies. Far from being viewed as folk heroes, the takeover/turnaround specialists have been accused of creating value with mirrors: maximizing shareholder value where inefficiencies exist-they claim to keep corporate America honest. Assuming this premise is accurate, should we not adopt the raiders’ perspective, methodology and, to an appropriate extent, even their compensation potential for the current manager/CEO?

One common criticism of raiders is that they add more debt than value to a transaction. Although this can happen, the creation of new debt should not be the primary focus of the manager/CEO. Debt forces the raider to squeeze out maximum operating efficiencies in order to make interest payments. By focusing on operating efficiencies, and then viewing the capital structure of the organization in relation to the resulting cash flows, the manager/CEO should be able to avoid an unwanted takeover. The key is not to be on the list of candidate organizations at the outset. By maximizing operating efficiencies, managing the stock price, and keeping assets fully utilized, CEOs can make their companies unattractive takeover prospects.

The danger in adopting the raider’s strategy is that it mortgages the future in hopes of maximizing current profits. For example, if a major consumer goods company were to be acquired by an investment bank, the resulting debt load could drive management to cut overhead, and eliminate marginal or losing components. Short-term profits, however, could also be enhanced by cutting such “non-essential” expenditures as R&D, new product development, advertising and/or training and development. This, however, could endanger “off-balance sheet” assets, such as brand recognition, shelf space, or relationships with suppliers and distributors. “Trimming fat” by cutting marketing positions, curtailing advertising or squeezing available margins for others up and down the market chain is dangerous. This costly shortcut is one aspect of a raider’s mentality to avoid, not emulate.

In the world of venture capital, the management team receives compensation in two forms: A “management fee”-typically 1 to 2 percent of the funds managed-similar to the base salary and benefits paid to CEO/ managers; a “carried interest” portion of around 20 percent of net additional value, after providing a reasonable return on capital, such as prime plus 200 basis points.

Of the 20 percent “carry,” half usually is paid to the CEO. Depending on the structure of the deal, half of the remainder-or 5 percent-often is paid to the second executive, with the remaining 5 percent paid to the rest of top management. On top of cash compensation-which seldom exceeds $250,000-this arrangement represents pay for performance to a degree unheard of in the corporate setting.

With the typical founder/CEO owning a 14-15 percent stake, and venture capitalists delivering 10 percent of the upside potential to the broker/CEO, how does the manager/CEO fare? After all, most CEOs are in this category.

 

DESTROYING THE ENTREPRENEURIAL PERSPECTIVE

Managing profits, providing stability, building a lasting organization, convincing the banks that the risks are minimal-what more can be asked of the professional manager? It is a natural reaction to the volatile days of the start-up. After scrambling for existence and fighting to get an appointment with every banker, supplier and distributor, even the most performance-driven creator/entrepreneur can be excused for wanting to re-establish a degree of sanity.

Consider the founder’s rationale:

`All this talk-supporting the vision by developing the appropriate infrastructure, and establishing market dominance within a time frame that precludes serious competitive intervention-it all sounds so professional, so lasting so legitimate. And so different from the day-to-day survival we followed until now. What the hell, it is better to own 5 percent of a billion-dollar business than 50 percent of a hundred-million dollar enterprise. Leverage, that’s the key. One can only do so much, there are only so many hours in the day.”

The trap is set, the bait is irresistible. The first notion that all is not well comes when the founder/principal initiates the search for the manager/savior. The lesson in executive compensation begins when the founder sits down with the executive search consultant who explains, “I know these dollar figures for salary, guaranteed first-year bonus and long-term incentive grants are a lot more than you’re used to seeing, but those are the realities of The Market.”

“Who can argue with The Market? Besides, if I’m going to pay that much for him, I guess a raise is in order for me. After all, as chairman, I make all the really big decisions”

The lesson continues after the hiring decision is made.

`A contract? Why? I trust him. Yes, I know there are tax advantages to pensions, but these SERPs* seem a bit costly. I didn’t realize that our new CEO would be able to retire after eight years of service. I thought the reason we decided to use stock options was to avoid any hits to earnings. I understand that SARs” will help us with the insider trading limitations, but now it seems like he’s better off than the shareholders. How many others do it? You mean to say, if we finally sell to the Koreans, I have to fund the excise taxes on the amount exceeding three times all this added together because he made the determination that their style wasn’t congruent with his own? Don’t tell me…it’s The Market’s fault!”

This apocryphal conversation is based more on fact than fancy. In fact, the situation may even be worse than portrayed. While the SERPs and SARs, golden parachutes and handcuffs, MBOs and ROEs are each based on “sound compensation theory and practice,” they collectively create an environment better suited to tenured professors or career government workers than to the leaders of American industry.

 

PROFESSIONAL MANAGERS ARE PAID AS BUREAUCRATS

The manager/CEO is different from the founder and the raider. They are organization builders and professional administrators. Once a founder’s vision is created, the vast scale of today’s capital and consumer markets often requires an experienced administrator at the helm.

Their skills are different. So are the personality-based factors for success. The time frames are different. Why has it been argued that professional managers be paid as entrepreneurs? They are not entrepreneurs, and therein lies the problem.

Professional managers are paid a relatively high, fixed base salary, generous benefits, rich cash incentives and long-term, stock-based incentives that often pay off generously, even if the company’s rate of return is less than that paid on T-bills.

Where do the high salaries come from? In theory, base salaries are determined by reconciling the outside market conditions with the relative value of the positions within an organization. As currently practiced, both sides of this pay equation have elements which give the wrong message to CEOs who are supposed to be making decisions that result in the efficient allocation of resources.

First, the market’s base salary levels for CEOs are often derived from the size of revenues or assets managed. Compensation “professionals” will tell you that the rule of thumb within most industries is that as revenues double for a given company, the pay for the CEO increases by about 25 percent. What effect does this have on the CEO who determines that a high-volume, low-margin division should be sold off, and the proceeds plowed back into the core business? He would be begging for a pay cut.

This problem could be compounded by the company’s current means for determining internal relative worth-such as the widely-recognized Hay plan. In such a position evaluation plan, CEO pay is based on the number of points accumulated. What does one get points for? Dollar value of assets managed, number of subordinates, in some instances the average or highest pay of those managed. In other words, CEO/ managers are paid to build, maintain and make the organization grow-not necessarily for results.

Unfortunately, critics of this approach have developed their own “solutions,” touting multiple regression models which consider such factors as incumbents’ age and the number of layers of management below them. Following this logic, the highest-paid executive will be the oldest empire builder left. The message: the bigger, the better.

The facts are difficult to refute. Larger companies do pay more than smaller companies, and there is a certain logic which dictates that as responsibilities increase, so do the rewards. However, it us arguably more difficult to build a billion-dollar company than it is to manage one. Further, it is important to focus on efficiency rather than merely on size, despite the problems inherent in measuring efficiencies.

 

BONUSES TIED TO “ACCOUNTING” PROFITS

At the top of the organization, efficiency is measured by return on equity, growth in earnings per share, or even by total return to shareholders. Further down in the organization, responsibilities and performance are more often defined by return on assets or return on capital employed. The problem is that such measures are based on a theoretical base-an accounting value including depreciated assets-and, perhaps, as much the subject of transfer pricing or cost allocation games as true economic “value added” measurements.

A better approach may be to link compensation to production volumes, or net cash flow, as a percentage of a division’s market value-real, appraised, or even perceived by formula. Why this digression into division bonuses? Because the raider/CEO is more likely to take this hard-line, financially rigorous approach to asset allocation. Rather than viewing an asset’s performance from a historical perspective, or against budget attainment, the question will be, “If I liquidate this asset, can I get a better return on the proceeds?”

Most corporations reserve six to seven percent of the shares outstanding for longterm incentives to management. Since most companies only grant one or two percent a year, it would take the typical manager/ CEO (who only receives a portion of these grants) a long time to accumulate the 10 to 15 percent stake received by the founder or raider.

Stock options represent the most widely-used stock-based pay vehicle. Their simplicity and relative efficiency from an accounting standpoint make them very attractive. But their grants come in such an irregular fashion that the “cost” basis or exercise price is also erratic. Shares reserved but unissued essentially represent a currency which is devaluating at the same rate as the company’s growth. There are two other shortcomings. First, while CEOs have been led to believe that options represent a “pure” incentive (i.e., they do not produce any value unless the value of shares increases), this is not accurate. Options typically represent a first-dollar incentive.

In other words, if the value of shares increases by five percent a year, the value of options increases by the same amount. An incentive (albeit a small one) is being paid for a level of performance which the shareholder could have bettered by putting money in a NOW account.

The second shortcoming is that options do not pay dividends. Therefore, if a CEO holding options declares a special dividend, perhaps as a defensive measure, the longterm portion of his pay may actually decrease in value.

Thus, the manager/CEO is paid more like a tenured professor or a government bureaucrat than a founder or a raider. He receives a high fixed salary seldom tied tightly to performance, as well as a relatively fixed bonus that does not seem to vary with the wealth he helps create for the shareholder. In addition, the manager/CEO receives long-term incentives which pay off even if the shareholder gets a return that is less attractive than a savings account. The manager/CEO is handed generous benefits to care for him and his family from cradle to grave. Compensation pros have now fixed the only remaining risk and, to cover that danger, he receives almost three times his pay if he loses his job, and is guaranteed help in finding a new job to boot!

While few argue that the founder’s rewards are undeserved, many believe that the raider’s rewards are grotesque inasmuch as the raider “creates little or no value.” The truth is, many raiders do create value by freeing up underproductive assets. And it is here that the manager/CEO can and should take a chapter out of the raider’s book.

THE “OFFSET CARRY” PLAN

If the professional manager/CEO were to view his company as a raider would, he would see to it that underproductive assets are fixed or unloaded. But, from a pay perspective, this is asking the CEO to cut his own throat-or at least his own pay. Therefore, American industry must seriously consider abandoning the bureaucratic pay model it currently uses, and develop other, more appropriate means of motivating manager/CEOs. The “Offset Carry” model described below is one way this can be accomplished, if the CEO, the compensation committee, and board have the will to truly pay for performance.

Under the Offset Carry plan, the CEO gives up a significant portion of the traditional pay package, replaced with a venture capitalist-type carried interest. For example, assume the existing total pay package for the CEO was $1 million, while a venture capitalist “carry” equaled 10 percent of profits under a risk-adjusted return; a 50/ 50 offset carry would cause the CEO’s bureaucratic package to be cut in half (to $500,000) while a 5 percent carried interest was added.

Another alternative, called Leveraged Options On Performance (LOOP), does essentially the same thing. Under LOOP, the CEO (and his management team, if they so choose) would be offered an opportunity to take up to a 50 percent cut in base salary, annual incentives, benefits and perks. For this sacrifice, their old options would be replaced with new “leveraged” options whose strike price (i.e., the price at which they could exercise their options) increase at the rate paid on long-term T-bills (say 9 percent). Thus, the options would be worthless if company performance was not better than that of a risk-free investment.

Why would a CEO do such a thing? The key to LOOP is to grant substantially more options-as much as four times as many as traditional practice would dictate.

With this increase in number of shares under option, the average CEO would be “made whole” on his pay cut if the company stock beat the T-bill rate by 300 basis points (say 12 percent versus 9 percent). At 600 basis points, the solid-performing CEO would be substantially ahead (and so would the shareholder).

If such a plan were adopted by management-and it worked as advertised-why not extend it to additional employees? Fixed costs would go down, variable costs would be linked to value created for the shareholders. And when the “fat cats” won, everyone could share in the gains-but not without first contributing to the opportunity.

Whether one uses an Offset Carry or a leveraged option approach, the value of these alternative approaches lies in the CEO being required to give up some (or much) of the security of a bureaucratic plan, in order to get the rewards that have historically been reserved, first for the founder and later for the raider. Any CEO who is willing to make this type of bold move is like Babe Ruth pointing to the bleachers with his bat. You know that he can and will deliver.


David R. Meredith is chairman and co-founder of Personnel Corporation of America (PCA), a New York-based human resource management consulting firm. A former principal of McKinsey and chairman of Meredith Associates, Inc., he holds a Ph.D. from M.I.T.’s Sloan School of Management and a B.A. from Colgate University.