Management Pay

When Michael Jordan retired in 1998, the NBA, was doing well: sell-out crowds dominated, sales of licensed goods soared and companies anxiously sought endorsement deals with basketball's newest superstars. Fans paid the salaries. Jordan commanded $30M per year deals. Few if any complained about his pay--though he arguably deserved more.

The public today is up in arms about the "egregious" practices of executive compensation, and understandably so. In a typical illustration of Wall Street's excesses, under pressure from board members and shareholders, Bob Nardelli last year jumped from an ailing plane called Home Depot with his clichéd "golden parachute." How was his landing? He walked with a cool $210M. Was he worth it? During his six-year tenure as chief executive he received $123.7M while the stock fell 5.6%. Meanwhile, rival Lowe's saw it's stock triple.

A nauseating look into a past Home Depot 10K exposes an 8400-word mess of legal jargon, colossal promises, and the root of his staggering severance. His December 2000 pay contract reveals a convoluted pay structure of millions of options, a $10M loan, accelerated vesting of stock options upon "resignation with good reason," and even a part that states: "Nothing contained herein shall prevent the committee from paying an annual bonus in excess of the maximum amount." The contract is devoid of operating improvement incentives, talk of long-term share price increases, and reasonable limits to the size of his severance package. It's little wonder he jumped when he did.

This example of corporate gluttony is worthy of scrutiny. There were too many guarantees for thumb sucking. Nardelli received a Grasso-like package to destroy value.

Few gripe, however, when high pay is commensurate with strong stock performance. In response to concerns about Gillette's James Kilts' options grant worth about $150M for a one year post-acquisition contract with P&G, Warren Buffett, a staunch voice against high executive pay said, "Jim quickly instilled fiscal discipline, tightened operations and energized marketing. Jim was paid very well—but he earned every penny." Even Buffett approves of the stratospheric compensation for those who can create substantial shareholder value by deftly navigating treacherous competitive waters.

That said, egalitarians lament the increasing disparity in top-level and "everyman" pay. Higher taxes, more regulation, and capped salaries are proposed tools to bridge the pay gap. Though their intentions may be good, such measures would likely be detrimental. Top talent would gravitate to higher pay and less regulated arenas such as hedge funds and private equity. According to a study by Steven Kaplan of the University of Chicago, for every $1000 in excess public corporation profits, management keeps $3. For private equity deals, the numbers are more lucrative - $63 dollars on every thousand in excess profit. In essence, public shareholders are getting a deal.

What does "excess" mean and who should make that determination? It's often quoted as excess when it meets a certain multiple of average worker pay (30x is ok; 1000x is not so good--or so it goes). Ultimately, it's in the hands of market forces. Aflac is set to become the first US company to allow shareholders to have a direct say on executive pay starting in 2009. But could draconian pay restructuring at the hands of investors alienate management? This is possible. According to a survey by Ira Kay, of Watson Wyatt, a consultancy, 90% of institutional investors feel management is "dramatically overpaid." Shareholder input could be harsh and speed the exodus of talented managers into private firms Conversely, one could argue that institutional investors are sophisticated (read: smart) enough to realize the downside of dramatic pay restructuring.

High executive pay largely represents the value the market places on ingenuity and value creation. I prefer to see management as business owners, not short-term joy riders. To align management with the interests of shareholders, effective tools are: executives' stock option vesting periods to be no shorter than a 5-7 year range; a separation of market uncontrollables (e.g., high oil prices in the case an oil company) from the compensation equation.

In addition, short-term operating objectives such as inventory management, cost controls, and divestment of value-destroying projects should figure into the compensation formula. Established hurdles based on top-line organic revenue growth would encourage companies to honestly evaluate the supposed synergies and operating efficiencies of a potential acquiree; long-term stock price appreciation would be the reward for the well-executed merger or acquisition.

A portion of the pay should be determined by an ex-post independent board. Board independence with cogent short-term operating metrics and lucrative long-term stock option plans based on value-creation, i.e., increase in stock price, would limit the possibility of Nardellisms. This would piss fewer people off and help public companies find and keep the next Jordan of corporate superstars.


Disclosure: none