Wednesday, August 13, 2008

Executive Pay: Confusing "Doing Great" with a "Rising Tide"

Image: Not great surfer still managing to "ride the tide".

That executive pay, particularly for the top 5-10 corporate jobs in most large companies, needs reform, is no secret to any informed shareholder in a public company, especially with the recent implosions in the financial sector. With stock compensation schemes that can balloon the leaders pay in excess of $10, $50 and $100 million annually, without materially benefiting the corporation over the long haul, things have gotten totally out of control.

Executives should be well-paid, but in keeping with the idea that they are "employees" of the shareholders rather than corporate owners (what a quaint notion!). Further, their management expertise and acumen should be valued in comparison to a competitive peer group, rather than the stock market in general (stock options). What must happen is for compensation schemes to measure a competitive group of managers, rather than thinking they are great because the tide in that particular sector is rising.

In other words, former Home Depot CEO Bob Nardelli (quarter-billion dollar Bob) shouldn't be compensated for Alan Greenspan's decision to inflate housing prices, and all the subsequent housing market activity that renovation and home-building retailers benefited from. His contribution to Home Depot's fortunes should be measured and paid against a competitive market sub-set (like home building/renovation retailers & home-building companies, for instance). Shareholders should pay a great manager very well for doing great against his/her competitors, rather than rewarding (penalizing) for the rising (falling) tide of the sector they operate in.

With this idea in mind, here's my top 10 list for executive pay reform structure:

  1. Stock options are completely and forever ceased to be granted, and instead low-interest loans are offered to the executive team to BUY stock in the company;

  2. Corporate boards become far more activist in protecting shareholders from egregious pay structures based on results that are later re-stated, by dispensing employment contracts that call for the return of incentive pay based on erroneous original measurements;

  3. Measuring and paying for (incentive pay) performance against a proper set of five to ten market competitors - in the Olympics, the swimmers aren't measured against the rowers, and this needs to stop in the economic marketplace;

  4. Measurement should include benchmarks like: changes in return on invested capital (ROIC) compared to the competitor subset;

  5. Inventory turns, compared to the competitor subset;

  6. Debt ratios, again compared to the subset;

  7. Changes in market share against the subset;

  8. Changes in profit and free cashflow (or profit/cashflow ratios) against the subset;

  9. Changes on all of the above, 2 and 5 years after the executive has left their position, so that the "long-tail" of their decisions, for good or ill, are properly rewarded or penalized;

  10. A "hold-back" on a certain percentage of all of the above incentive pay, so that the Board doesn't have to go "cap in hand", begging the CEO for a return of some improperly rewarded gains.

Reforms like this would provide the proper and necessary alignment of shareholder's interests, with management's desire to achieve maximum pay - all the while, keeping both the risk and reward of any potential action clearly in mind.

Executive pay reform: an idea whose time must come.


The Confused Capitalist

1 comment:

David said...

Great ideas to reform the Execs. pay issue.I am not sure how many boards are interested in looking deeper into the problem.