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CEO Compensation: How Much is Enough?

These days, CEO pay is more closely aligned with shareholder interests than ever before. But too many compensation committees blindly follow competitive practice and ignore the potential unintended consequences of highly leveraged compensation. The result? Squandered company resources-and some very cranky shareholders.

Let’s face it. Today’s compensation committee members may have the most difficult job in Corporate America. CEOs pepper them with data suggesting that they are paid less than their peers. Institutional investors demand pay-for-performance programs that don’t create dilution. Pay critics stand ready to pounce under almost any circumstance, from a top-performing CEO who makes hundreds of millions of dollars to a failing CEO who receives contractual severance payments. Can the compensation committee job possibly be worth its $1,000-per-meeting fee?

Consultants at Unifi Network (a unit of PricewaterhouseCoopers LLP) have worked with compensation committees at hundreds of public corporations. Almost all those directors have been hard-working, independent-minded, and concerned about shareholder interests. They want to spend limited shareholder resources on compensation programs that maximize shareholder returns.

But too often they fail to foresee the consequences of their decisions on CEO pay-at least one reason why it remains such a controversial issue.

According to research conducted by Unifi Network for Chief Executive’s 13th annual survey of CEO compensation, CEO pay is aligned with company performance more closely today than ever before. Yet the survey, which covers 288 companies in 17 industries, identifies many dysfunctional pay packages that either unintentionally weaken the link between pay and performance or over-spend shareholder resources. Fortunately, we have also identified many CEO pay packages that meet the pressures of a super-competitive labor market and still advance the interests of shareholders.


With all the rhetoric about CEO pay excesses, it is surprising how few critics conduct rigorous analyses. Perhaps this is because any thorough review demonstrates the close alignment between CEO pay and company performance. In our study, for the 250 companies with the same CEO in 1998 and 1999, the median increase in CEO base salary was 6.3 percent. Median total cash increase rates were 10.4 percent, and median total performance pay increase rates were 13.7 percent. None of this is very surprising, given most companies’ strong performance in 1999.

CEO pay critics compare these increase rates to the general labor market’s 4 percent to 5 percent range and conclude that CEO pay is out of control. This simplistic conclusion disguises the emphasis on risk in CEO pay. Sixty-nine CEOs, or about 28 percent, experienced declines in total cash compensation from 1998 to 1999. Ninety-one CEOs, or 36 percent, earned less in total performance pay than they did the year before. Not all CEOs are enjoying substantial income growth.

Our Leverage Index and Capitalization Index charts demonstrate the emphasis compensation committees place on linking CEO wealth potential to shareholder value creation. The Leverage Index measures the sensitivity of the CEO’s one-year pay package to growth in the company’s stock price, while the Capitalization Index also takes into consideration all the shares and options the CEO holds.

An Index of 1.00 indicates no sensitivity; 2.00 means the one-year pay package (or, in the case of the Capitalization Index, total cash compensation plus all stock-derived wealth) is worth twice as much if the stock price doubles. In our judgement, compensation committees should aim for a minimum CEO Leverage Index of 2.00 and a minimum Capitalization Index of 10.00.

In 1999, 209 (72 percent) of the 288 CEOs in our study had a Leverage Index of 2.00 or more, which is actually a small decline from 219 (76 percent) in 1998. This appears to reverse past practice, but we attribute it to the custom at many companies of making a large option grant one year and then skipping the next. Two hundred-thirteen CEOs in the study (or 74 percent) exceeded the Capitalization Index standard of 10.00, indicating the success of most compensation committees in linking CEOs’ personal fortunes to company stock price performance.


Based on our research, we have identified five CEO pay strategies that can lead to negative unintended consequences. While these mistakes are by no means exhaustive, they demonstrate how challenging it is to apply pay-for-performance principles successfully. But there is hope, because there are also many examples of thoughtful compensation committees that accomplish shareholder objectives without triggering undesired outcomes. The five dangerous strategies are:

  •   Mega-grants of stock options in a volatile market.
  • Option-only, long-term incentive programs in a disfavored industry.
  •  Anti-dilution programs linked to option exercise.
  •  Excessively generous severance agreements.
  •  Option terms longer than 10 years.

Option Mega-Grants

CEO pay critics love to attack option mega-grants, frequently defined as an award with a grant value (exercise price times number of shares) of at least 300 percent of the CEO’s base salary. “It transfers too much wealth from shareholders to the CEO,” institutional investors claim. “It creates too much disparity in pay between the CEO and the company’s average worker,” labor leaders shout. “With that many options, even mediocre performance creates huge option value,” gadfly critics assert.

Option mega-grants can be a useful tool-especially when accompanied by a longerthan-usual vesting schedule-but some compensation committees use them when they shouldn’t. Their best use occurs when a company hires a new CEO from the outside, because the mega-grant jump-starts the CEO’s alignment with shareholders (and frequently makes up for value left on the table at the previous employer). For example, when Hewlett-Packard granted new CEO Carly Fiorina restricted stock worth about $65 million and 600,000 stock options, the company specified that the awards compensated her for stock and options she forfeited when she left Lucent Technologies.

For a company with a volatile stock price, however, large option grants don’t work very well. If the price declines significantly below the exercise price, then the compensation committee faces a quandary (especially now that the accounting rules make repricing impractical). Should the committee tell the CEO to tough it out and risk departure, or should it grant additional options at the lower price?

Dole Food Co. chose the latter in December of 1999, when the compensation committee repeated the grants it had made earlier in the year, except with a lower exercise price. The committee explained that the duplicate grant was “necessary to ensure that the company’s compensation package remains competitive.” But this may not have been necessary if the committee had recognized the volatility in the stock price and spread the option grants out during the year.

Disfavored Industries

Never have so many industries been out of favor with investors during a stock market boom. In one of the most bullish years ever, 10 of the 17 industries we studied suffered negative shareholder returns. The five lowest-performing industries-automotive, banking, retail, utilities, and healthcare-had median shareholder returns of -18.0 percent, compared to +18.8 percent for the five highest performers-technology, entertainment and media, telecommunications, petroleum and natural gas, and capital markets. Even within the technology industry, with median shareholder returns of 34.2 percent, six of 18 companies had negative shareholder returns for the year.

When an industry falls out of favor with investors, most compensation committees want to encourage the CEO to take the right steps that will position the company for investor success when the tide turns. But too many compensation committees continue to rely exclusively on stock options in their CEO pay packages, even though their value may fail to recognize the superior performance of the CEO in a down market. These companies risk senior management defections to more favored industries; witness the departure of Joseph Galli from Black & Decker to become president and COO of (Galli recently left Amazon for the top post at B2B company VerticalNet.)

Given the inherent cyclicality of the automotive industry, the compensation committee of Ford Motor has learned how to solve this problem. In addition to an option grant, CEO Jacques Nasser also received performance shares (i.e., restricted stock with performance-based vesting) and a multi-year cash bonus. By using a variety of longterm incentive vehicles, the compensation committee encouraged Nasser and his management team to position Ford for superior shareholder returns in the future. For the long-term cash plan, objectives included such metrics as strong global brands, superior customer satisfaction and loyalty, and best total value to the customer.

Anti-Dilution Programs

According to a recent survey sponsored by the National Association of Stock Plan Professionals and conducted by Unifi Network, the median non-technology company grants options at an annual rate of about 1.5 percent of shares outstanding per year. Technology companies have a much higher run rate-4.5 percent according to the same survey, with Internet companies topping the chart at 8.4 percent per year (based on a Unifi survey of 118 public Internet companies). As a result, shareholder dilution heads the list of today’s compensation committee concerns.

Many high-technology companies believe that their stock price growth will erase any dilution concerns. They may be right, but it’s a risky strategy. Other companies control dilution by repurchasing shares when employees exercise options. To come up with the necessary cash, the company has two alternatives -either fund it internally and reduce the value of the company, or borrow it and leverage up the balance sheet. Either way, shareholders interests are weakened.

Campbell Soup and other shareholder-oriented companies utilize a smarter approach. They repurchase shares when the options are granted, instead of waiting until they are exercised. When the employee pays the exercise price, it replenishes the company’s cash account 100 percent. Shareholders “pay” the cost of capital until the options are exercised, which is usually far less than the options’ in the-money value. This strategy enables companies to compete effectively for executive talent without diluting shareholder interests.

Severance Agreements

Each year brings a fresh example of an excessive severance agreement for a failed CEO or other senior executive. This year’s leading candidate is Jill Barad of Mattel, who resigned as CEO earlier this year following a series of performance disappointments and received severance payments valued at almost $50 million.

Some elements of her severance package, such as $12.8 million in supplemental retirement benefits, were contractually based and were earned during her 20 years as a Mattel employee. But other components appear excessive: forgiveness of a $3 million company loan used to purchase her home; $3.3 million to cover taxes on the loan forgiveness; and forgiveness of another $4.2 million loan used to pay taxes on vested restricted stock.

Nothing angers shareholders (and employees) more than a large severance payment to a failed CEO. We understand that the cost of the severance package may be trivial compared to a continuing decline in shareholder value. However, too often, compensation committees ignore the long-term effects on employee and shareholder morale when they reward departing CEOs for failure.

Despite their dislike of CEO severance agreements, shareholders should understand that there is one situation where such deals work to their advantage. Compensation committees should provide severance protection to the CEO and other key executives in the event of termination following a change in control, whether friendly or unfriendly. Academic studies have verified that CEOs encourage value-creating mergers and takeovers when they are protected, and fight them when they are not. Given today’s vigorous M&A market, change-of-control severance protection is a shareholder-friendly program.

The typical program covers the CEO in the event of termination within two years following a change in control. The benefit normally includes two to three times salary plus bonus, benefits continuation for the same period, vesting of any stock options or restricted stock, vesting in any deferred compensation arrangements or supplemental retirement programs, and a gross-up if the benefits trigger payment of an excise tax. These features advance shareholder interests because they counterbalances any inherent resistance a CEO might have to a value-enhancing change in control.

Quaker Oats goes one step further with a program that makes the company more valuable to a potential acquirer. In his severance agreement, CEO Robert Morrison has the right to exercise the severance trigger himself in the thirteenth month following a change of control. At first glance, this clause seems like another CEO give-away, because Morrison can voluntarily terminate and force the acquiring company to pay his severance benefit. But on closer inspection, it encourages him to stay with the new company through the first year, thus ensuring the acquirer of management continuity even while the organization remains fragile. As a result, the severance agreement actually strengthens Quaker Oats as an acquisition candidate-and potentially enables its shareholders to receive a larger takeover premium than might otherwise be the case.

Extra-Long Option Terms

Most CEO options are granted with 10-year terms, even though on average they are usually exercised four or five years after grant. In order to emphasize the role of options as a long-term incentive, some companies have begun granting options with longer terms. For example, last year Procter & Gamble granted then-CEO Durk Jager options with 15-year terms. Chiquita Brands grants its executives twenty-year options, as does

Unfortunately, this approach has the unintended potential consequence of increasing stock option overhang. (We define overhang -a key measure of dilution-as options outstanding plus authorized for grant, as a percentage of shares outstanding.) Compensation committees at most non-technology companies aim for total overhang in the 8 percent to 12 percent range (although 15 percent rates are not unusual in general industry, as are 20 percent rates at high-tech companies). By keeping these options around longer-especially if the stock price has declined significantly (which happened at Procter & Gamble)-companies risk high overhang rates that potentially create excessive and costly shareholder dilution.

We encourage some companies to reduce their option term from 10 years to five or seven years. First, this acknowledges that most executives exercise in-the-money options early anyway. Second, it encourages executives to convert their options into real

shares and thus completely align their interests with shareholders. Third and most important, if the stock price declines, these high-priced options expire more quickly and stop inflating the company’s overhang rate and potential future dilution.

Shareholders, journalists, and CEO pay critics continue to scour proxy statements, looking for examples of CEO pay excess. Compensation committees need to continue carrying out their responsibility to spend shareholder -30%-resources wisely, in a way that maximizes shareholder returns.

But in doing so thoughtfully, they can avoid many of the unintended consequences of today’s popular CEO pay programs.


What About Those Internet CEO’s?

We’ve all seen the headlines. “Timothy Koogle of Yahoo Earns $1.7 billion in 1999! AOL’s Steve Case Makes $1.1 billion!” According to USA Today, four of 1999’s 10 most highly paid CEOs ran Internet companies. And let’s face it-these are not the biggest organizations in existence today, and certainly not the most profitable. So what’s going on? Have compensation committees gone crazy?

In the words of a well-known television advertising campaign: “Not exactly.” In fact, these compensation packages represent a new model of CEO pay, one that is highly leveraged, provides little security, and sends the message to grow the stock price rapidly or else. Cash compensation is held to a minimum, while option grants exceed anything seen previously. Critics may decry the fortunes some Internet CEOs are earning, but it’s the right type of pay package for an industry where growth by acquisition is critical to success, and the principal currency for acquisition is company stock. If this is a company’s growth strategy, then it makes sense to provide super-sized option grants that motivate the CEO to achieve aggressive stock price growth.

As the industry begins to mature (somewhat) and stock appreciation potential begins to cool, we expect Internet CEOs’ pay packages to start resembling those of more traditional high-tech companies. Compensation may still be more option-heavy than general industry, but salary and bonus will become more significant parts of the total pay mix. In fact, a recent study by Unifi Network of 118 public Internet companies indicates that this is already beginning to take place.

In any case, we would encourage readers not to overreact to the reports of astronomical pay packages for Internet CEOs. These analyses typically include paper gains on options, many of which are unvested or remain subject to lock-up periods. As we witnessed following the NASDAQ meltdown last spring, many Internet CEOs saw their options fall out of the money-proving that highly leveraged pay packages and extreme stock price volatility can be an explosive combination.


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