Bold thinking - compensation of chief executive officers

Chief Executive, The, Jan-Feb, 1992 by David R. Meredith

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 CEO's

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/A-COM 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/A-COM 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 provide 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.