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Home > Corporate Governance Best Practice > Balancing Senior Management Compensation Arrangements with Shareholders’ Interests

Corporate Governance Best Practice

Balancing Senior Management Compensation Arrangements with Shareholders’ Interests

by Henrik Cronqvist

Executive Summary

  • Appropriately designed executive compensation schemes can add substantial value for the firm’s shareholders.

  • Base salaries should be competitive with those awarded by similar-sized firms in the industry in order to attract and retain superior top-executive talent.

  • Most perquisite-type compensation is now outdated, fails to align manager–shareholder interests in any obvious way, and should be avoided.

  • Annual cash bonuses should be based on measures that can’t be easily manipulated through accounting practices adopted by management.

  • Long-term, equity-based compensation in the form of stock options or grants is the most effective way to harmonize the interests of senior management and shareholders.

  • It is important to anticipate increased disclosure and scrutiny of executive compensation structures by the media when a particular compensation structure is being designed.

Introduction

The board of directors, and specifically the compensation committee (or remuneration committee), has the challenging task of designing a compensation structure for the chief executive officer (CEO) and other senior managers that balances their interests with those of the shareholders. The general idea is to make an executive’s pay sensitive to the value created for the firm’s shareholders. In this way, everyone shares the common goal of maximizing shareholder value.

Corporate executives can in principle be compensated in three different ways:

  • base salary and perquisites, or “perks”;

  • annual cash bonus;

  • shares.

No one form will perfectly align the interests of senior management and shareholders. The task of designing a value-adding compensation structure is therefore about identifying the mix between these different forms of compensation that best incentivizes senior management to create value for the shareholders.

Designing a Value-Adding Compensation Structure

The base salary is the starting point for the compensation package and is commonly set through benchmarking based on a survey of similar-sized firms in the company’s industry. Because of risk aversion, most executives will not accept a purely performance-based pay package. Though not sensitive to company performance, the base salary can still play a key role in attracting and retaining superior managerial talent.

Perks such as country club membership and private use of a corporate aircraft used to be common. There is, however, a trend towards the use of fewer perks, mainly because of increased disclosure and scrutiny by media and “watch-dog” groups.1 For example, in an article with the headline “Only the little people pay for lawn care,” columnist Gretchen Morgenson of the New York Times wrote that Donald J. Tyson, the former CEO of Tyson Foods, received $84,000 in compensation for “lawn maintenance costs” during 1997–2001.2 Though the perk was an insignificant portion of his pay during this period, the public’s perception of its size can be much more significant than its monetary value. Perks perceived as excessive can cause customer resentment and, as a result, adversely affect both brand and shareholder value.

In contrast to base salary and perks, annual cash bonuses are conditional on short-term financial or nonfinancial goals being met by the firm or individual senior managers. Executives’ bonuses, other than for the CEO should be based on their particular business unit’s performance, though a part may be based on overall firm performance or cooperation among executives managing different business units.3 Nonfinancial targets can include successfully launching a new product line, meeting a certain customer satisfaction level, or appointing a new chief financial officer (CFO). These objectives should be specific, attainable, and measurable in the short run. Examples of financial performance targets are earnings per share (EPS), earnings before interest, taxes, depreciation, and amortization (EBITDA), and economic value added (EVA). Regardless of which measure is chosen, a particular threshold has to be attained before a minimum bonus is paid. If the performance is above that threshold, the bonus should increase in increments up to a prespecified maximum. One advantage of annual cash bonuses is that they are one-time compensation for past, realized performance—unlike base salary raises, which are permanent.

Using accounting-based performance targets, such as EBITDA, carries two potential risks. First, short-term performance measures can result in myopic behavior by management: For example, managers trading off short-term earnings growth at the expense of creating shareholder value through valuable R&D projects. Second, accounting-based measures can lead to earnings management, and in the extreme case even manipulation, in order to boost current earnings.

Equity-based compensation, in the form of options or stock, can be used to circumvent some of the problems with short-term, accounting-based cash bonuses. Stock options are the most common form of long-term incentive pay. These allow the executive to purchase a certain number of shares at a prespecified exercise price, commonly the stock price on the day of the option grant, and with a specific period length, often 10 years.

To see how stock options can consolidate manager and shareholder interests, suppose that the stock price at the time of a grant of 250,000 options to a CEO is $50. If the stock price doubles over a couple of years, the CEO will make a profit of $12.5 million (250,000 shares × ($100 – $50)). In contrast, suppose that the stock price declines to $25. Then the options are said to be “underwater” and worth nothing, but the CEO does not lose any money. If the CEO creates value for the shareholder by taking actions that result in the stock price going up, he or she will be rewarded with a slice of that value added. Granted stock options commonly vest (reach a point where they cannot be taken away) over time according to a schedule, or after the firm meets certain performance targets. Executives cannot exercise options before they have vested.

One problem with stock options is that they reward executives even if the reason for the firm’s stock price increase is completely beyond their control. Suppose that the world market price of oil increases significantly; the stock prices of oil companies increase too, but for reasons that have no relation to anything an oil executive may have done. One potential solution is to benchmark the exercise price of executive stock options to the overall stock market or to a portfolio of firms in the firm’s industry—i.e. oil companies in this example. In practice, however, such indexed executive stock options are extremely rare.

Another form of equity-based compensation is stock grants. One argument in favor of stock grants is that options provide executives with an asymmetric incentive because their value goes to zero if the stock price falls below the exercise price; the value of a stock grant does not go to zero. Restricted stock is a form of stock grant that involves common stock of the firm, but with the condition that a certain period of time, for example 10 years, has to pass or a target has to be met before the executive can sell the shares. Performance shares are another form of stock grant. These consist of common stock granted to an executive provided that specific firm performance targets, for example EPS, are met. The performance shares become more valuable if the stock price goes up after the grant is made.

In addition to the three forms of compensation discussed above, severance pay packages, also referred to as “golden parachutes,” are also common. There are several reasons why appropriately designed severance pay for a firm’s CEO can be in the interests of value-maximizing shareholders. First, shareholders want to avoid a situation in which a CEO is resisting a value-enhancing takeover of the firm because the executive’s job will then be eliminated. A golden parachute can provide an incentive for a CEO to step down rather than trying to fight a takeover threat. Second, the severance pay can compensate the CEO for signing a restrictive and lengthy noncompete contract with the firm. Such a contract can be in the interest of value-maximizing shareholders, especially in R&D-intensive industries, because it prevents the individual who knows the most about the corporation’s business practices from sharing them with the competition.

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Further reading

Books:

  • Ellig, Bruce R. The Complete Guide to Executive Compensation. New York: McGraw-Hill, 2007.
  • Lipman, Frederick D., and Steven E. Hall. Executive Compensation Best Practices. Hoboken, NJ: Wiley, 2008.

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