Joe Bartlett is the Founder of VC Experts, Inc. His thoughts are derived from a working paper that explores an entrepreneurial alternative for enhancing management creativity, while mitigating incentives for "gaming the system." This article is reprinted with permission from RealCorporate Lawyer, All Rights Reserved. Joe welcomes comments and criticisms, which can be addressed to firstname.lastname@example.org.
Broc: What are your general feelings about CEO compensation?
Joe: The critics are, as am I, flabbergasted at the inflation in CEO compensation over the past decade-$10 million a year is small potatoes for some executives. Think, in fact, $100 million a year, a fair amount in actual cash but principally driven by option awards. The seeming overpayments, particularly against the backdrop of company failure, has called into question the entire system of option compensation. If the CEOs made out like bandits and the little people lost their jobs and their savings, the system must be wrong. Stock options are under fire as the prime suspect for inducing "infectious greed."
Broc: Do you believe that options should no longer be used as an incentive device?
Joe: I submit that they are not the problem. Adequate penalties are already in place. There are plenty of sections of Title 18, U. S. Code, on the books which enable prosecutors to go after criminal behavior; and if the behavior is not criminal, then it is not fair to convict simply because somebody has to be the villain. This is not the American way. Moreover, scapegoating would not do much good even if it were legal; it never has.
The short of the matter is that reform in this space should focus on the "carrot" rather than the "stick." How do you preserve the risk/reward calculus which the reforms of the 1980s introduced into our economy without creating incentives to game the system? If we are able to do that successfully, we don't have to do much else.
Broc: So how did exec compensation practices get so out of whack?
Joe: A fair question - why has so much been paid to CEOs, CFOs, and other executives during the past decade? Lush stock options, huge bonuses, limitless loans went well beyond historical norms. The principal answer stems from relentless commitment, I think, to the pay-for performance mantra, which was all the rage in the 1980s, repeatedly chanted by critics (whom the liberal press applauded as tribunes of the people) of what was then perceived to be entrenched, sedentary, and risk-averse managers. Much of that criticism was self-serving propaganda by wolves in sheep 's clothing-i. e., the corporate raiders pretending to defend the moral high ground in aid of their pet greenmail and hostile takeover initiatives.
But the notion stuck-tie the managers' pay to the shareholders' outcomes. If the company remains stodgy, its stock performance less than outstanding, fire the senior management, replace the same with entrepreneurs. The SEC, indeed, put its official imprimatur on the movement; ironically, the very option schemes which are now reviled were heralded as the solution, the way to a solid future for Corporate America in the 1980s, the delight of the very "reformers" who are in the vanguard of today 's necktie parties.
As a consequence, the board 's view of the ideal CEO has changed, often morphing the board 's perception of the CEO to the equivalent of an asset manager, and in particular the manager of a private equity fund. The critics (the managers of leveraged buyout funds engaged in hostile takeovers) and the criticized (the CEOs) began, in terms of image and internal dynamics, to merge. Just as cops and robbers, husbands and wives, people and their dogs tend to take on common characteristics because of their continually being in each other 's company, so the raiders (i.e., the general partners of LBO funds who were doing all the talking during the heyday of private equity investing) and their victims (i.e., the managers of the target companies) began to resemble identical twins.
Broc: Can you explain that a little further?
Joe: Sure. Please recall Abe Lincoln's story about the two gents who wrestled with each other so long, they wound up in the other 's overcoat. If the likes of Harold Simmons, Boone Pickens, and Carl Icahn preached that Corporate America needed to be shook up, then maybe the CEOs should look and act like Simmons, Pickens, and Icahn. The logical extension of this thesis is that, since Icahn and crew normally took a 20 percent carried interest in the profits earned on their investors 'capital, why shouldn't an outstanding CEO be paid in like vein?
The logic had, in fact, enormous surface appeal. Consider the following scenario: Icahn, on behalf of KKR, criticizes management and seeks to take over Company X; the current team, he says, is too timid, too paranoid, too concerned about a regular paycheck versus shareholder value. Icahn takes control of Company X in order to unlock shareholder value, buying 50 percent of the stock, and installs Superhero as CEO. Superhero cuts costs and boosts profits. Company X 's market cap goes from $1 billion to $3 billion in a year 's time. Icahn, who owns only half of Company X, makes $200 million (20 percent of $2 billion x 50 percent). What should Superhero and his team make? Well, how about $300 million, or 15 percent of the $2 billion in new wealth created? The larger the company, the larger the award.
As the market boomed in the 1990s, management boomed along with it. If the stock prices tripled on Superhero 's watch, why shouldn't he get what amounts to a percentage deal-a carried interest in the appreciation in market cap? The directors were influenced by the fact that (a) good managers were and are scarce (and they are); and (b) everyone was making out, particularly (on paper) the very shareholders Icahn said he cared so much about. The huge awards, part stock (including options) and part cash, were not noteworthy as long as the music kept playing.
The asset-managers became super rich but only because they "deserved" to-their pay was tied to profits. And so, too, the CEOs, whose pay was tied to profits, thus perfectly aligned with investors, whether the public shareholder or the limited partner of the LBO fund. The problem, of course, is that the music stopped. Superhero became an ordinary mortal as the company share price stumbled.
In some cases, Superhero was fired-but with a generous severance award, negotiated when the music was in full swing. In others, the annual awards were cut back, but were still pretty rich in view of the lofty heights from which the cutbacks were calculated-a 90 percent cut in pay is not so punitive if the beginning point is $50 million. And so now, at last, we get to the real problem. The CEOs, during the boom years, were analogized to the managers of private equity and paid accordingly, but the analogy was not extended to its logical conclusion. The CEOs were and are paid like hedge fund managers, not the general partners of venture and buyout funds-a critical error. Hedge fund partners manage, by and large, public equities. They enjoy a big interest in profits, which they take annually and don 't give back-but their investors are relatively liquid because the fund itself is usually liquid (to a point). If the fund doesn't perform, the investors depart.
Broc: So how do you view the CEO?
Joe: The CEO is best analogized, if at all, to the managers of a private equity fund whose investors are stuck over the long term (i.e., venture or buyout). By and large, the limited partners in such funds are mired in place. To be sure, the individual shareholders of the public company Superhero is managing can sell; but the shareholders as a group, particularly the large institutions with unwieldy blocks, are stuck, like the limited partners of a venture fund.
Broc: So how should CEO pay packages be structured?
Joe: If CEO, our Superhero, is to be paid like a venture or buyout general partner (i. e., his pay a carried interest in the profits as measured by increases in market cap), then he should be burdened with the customary protective provision-the so-called "clawback."
In venture and buyout funds, the clawback operates to "true up" allocations and distributions of profits over the 10-to l2-year life of the fund. (Derived from carpentry, the term "true" or "true up" means to make even, to adjust, to make symmetrical.) If the general partner pockets big money because of extraordinary profits early on, and those early achievements are not sustainable, he owes hard cash back to his investors at the end of the day, when the fund liquidates. If it turns out the fund wound up making no money at all, then he has to give it all back.
Why not, in short, apply the clawback to Superhero, the CEO of Company X? The logic is that the CEO is, first, hired to obtain long-term results, likened, say, to Henry Kravis. He gets modest base pay annually and a carry-again, like Kravis. Finally, his carried interest in profits (net of what he needs to pay taxes) is escrowed until the end of the day (and why not 10 years?), when the hits, runs, and errors during his stewardship are calculated and his pay adjusted-again, like Kravis 's. After true-up, his escrow account may be a big number, or it may be zero. (A Booz Allen study, coincidentally, puts the average term of a U. S. CEO at 9.5 years.)
The point is that, since the boards have bought into only half the "fund manager" analogy, today's CEOs have it "heads I win, tails you lose." In good years, they take home big numbers: in bad years (like hedge fund managers), they don 't give anything back. Who wouldn't be tempted to try an accounting trick or two, or plunge into a glamorous but unwise merger, under those circumstances?
In short, if we were to measure long-term performance, the CEO obtains no advantage (or almost none) by loading up in a particular quarter. He can exercise his options and sell into a temporary rally; but the true-up means he will have to give it all back when and if the market takes its revenge.
Broc: Do you then replace option grants with some other form of compensation?
Joe: Some wag (H. L. Mencken, I believe) once said that all difficult problems have solutions that are both simple and wrong. The test of the foregoing analysis, assuming it survives as a plausible hypothesis, comes when the board of a public (or, indeed, a private) company attempts to implement the same. Can the present system in fact be improved upon in the abovementioned critical detail, and perhaps also in a number of other ways? The proof of the pudding, they say, is in the eating.
The seemingly simplest way to achieve "reform" is, as many of the loudest voices would have it, to junk stock option compensation entirely and shift to a bonus plan or, if you want to dress up a bonus plan and make it taste equity-flavored, a phantom stock plan. However, there are obvious problems with a straight bonus plan (and I will leave aside the accounting issues for the moment). If the management team is entitled to, say, a share of the upside (as measured by increases in market capitalization) which approaches stock option levels (say, 15 percent, plus or minus, of total outstanding shares), then the cash drain on the company could be out of sight.
Let's say the compensation committee eliminates the entire stock option plan and substitutes a phantom stock plan. In our hypothetical case, the company market cap surges from $1 billion to $3 billion, based on the promise of a couple of breakthrough oncology therapeutics; but the company still doesn't have much in the way of cash flow. How do you pay out $300 million in cash to the executive team (15 percent of $2 billion) without breaking the bank?
Currently, the only way to achieve that result (by and large) is with options. The cash representing the executive 's profit share comes not from the company, which doesn't have it, but from the stock market. Note, however, that the solution outlined here does not mean a retreat to fainthearted CEO compensation; the working assumption is that the essence of the 1980s analogy should be preserved-but radically improved. We need to offer extraordinary compensation to extraordinary CEOs. In the right circumstances, the opportunity for "venture capital"-type rewards is what generates an aptitude for constructive risk on management 's part and, in the process, helps create great companies.
The second, and equally necessary, element of option grants is that the tax paid by the recipient is postponed until realization . until there is cash with which to pay the tax. With rare exceptions, options are not taxed as of the date of grant; the tax is not due until exercise (in the case of nonqualifying stock options, exercise being usually accompanied by sale) or sale of the option stock in the case of incentive stock options. Stock grants lack that quality.
The keys, in short, to the underlying, and constructive, economics of option plans have little or nothing to do with accounting legerdemain or tax avoidance. They are: (a) the ability to pay a percentage of "profits" compensation; (b) the necessary cash requisitioned from the market, not the company; and (c) tax paid only when and if the cash is available with which to pay it.
Having concluded that stock options are a continual source of contention, I repeat the question: Can the entire concept be replaced with a new, improved version that preserves the economics mentioned above? Can companies bent on compensating desirable executives with equity simply junk the stock option plan, thereby eliminating the difficulties that are inherent in dealing with accounting for derivative securities, which are by their nature complex and entail hard-to-quantify impacts on a company's financial statements?
Let's say we eliminate the structure entirely. That done, we still need to face up to the cash-flow problem. We need to continue to tie executive compensation to performance and to reward the "best-in-breed" executives competitively. Cash from the company's resources is not the answer, not at the levels we are talking about. Restricted stock awards and other equity-flavored solutions lack one or more of the three key advantages discussed earlier, usually the tax postponement feature.
Broc: How would this all work in practice?
Joe: Rather than escrowing, in effect, some 20 percent of the company's outstanding stock into a stock option pool, the "fix" I am suggesting contemplates issuing outright 20 percent of the outstanding stock into a private equity fund, organized as a limited liability company (LLC). The question of accounting for dilution is, as of the date of issuance of the shares, settled. The shares are currently outstanding; they have been issued to an LLC (taxed as a partnership) of which the company is initially the sole member, with an opening capital account equivalent to the then fair market value of the shares so deposited. If compensation expense is required to be booked, then I would make it simple: capitalize the value of shares deposited and amortize the expense over a sensible period . say, ten years. To honor the KISS imperative (Keep It Simple, Stupid), assume for this purpose (whether or not the fact) that the entire value of the deposited stock is compensation expense . this simplifies "apples to apples" comparisons, with competing firms.
The managers of the LLC are the compensation committee of the company's board. The members (other than the company) are the executives who otherwise would have participated in the stock option pool. They each are issued profits interests that can be adjusted annually or periodically by the managers without the imposition of tax (as long as capital accounts are not shifted). New executives join the pool, others withdraw, and the assets are "booked up" annually so as to start all newcomers on a level playing field, so to speak, with the existing employee members.
Each executive will be required to contribute sufficient cash to the pool to qualify as a true "partner" for tax purposes, a reasonable burden usually pegged at I percent of the "value" of the fair market value of the shares. This is one of the tricky parts; if this solution has traction, I assume a relevant revenue ruling can be issued to bless the arrangements we are describing, so as to take any tax suspense out of the equation.
Each member has a special profits interest, representing an interest in a fixed number of shares. If a member dies, becomes disabled, or his employment terminates, the LLC sells the shares into the stock market and distributes the profit, meaning price minus tax basis as marked to market, and minus any contractual givebacks-if the CEO quits and joins a competitor, for example. The shares may be distributed (tax free) earlier, in whole or in part, on petition of the executive and agreement of the managers (death, disability, discharge other than for cause, pressing need), and presumptively will be distributed upon a change of control (subject to negotiated vesting restrictions), provided that, in the CEO 's case, shares of the acquirer may be held in his capital account to see if the merger works as the CEO advertised it.
The company's profits interest is, in effect, the reservoir; as awards are made and/or lapse each year, the company 's interest is enlarged or diminished. The compensation committee may elect to sell shares in lieu of distributions in kind and distribute proceeds, depending on market conditions and legal considerations. The shares in the account may be subject to a buy/sell arrangement if the parties so agree and, in any event, a right of first refusal in the company is presumed.
Distributions to the departing executives are subject to an escrow of, say, 50 percent of the profits to satisfy the clawback requirement. That means that the executive takes (depending on the provisions of the employment contract) half the realized profits, pays tax at capital gains rates, and puts the remainder in his pocket, subject to a clawback calculation which cuts in at the end of 10 years. (Note the clawback is a general claim on all the executive's assets, not limited to the escrow.) This solution entails no tax deduction to the Company and, thus, the U.S. Treasury is ahead of the game . vs. stock options (almost all non-quals these days) where the employee tax obligation is washed out against the corporation's deduction.
Until the expiration of the 10-year period, the executive leaves in his capital account escrowed profits in the form of stock, or cash which the managers can use to buy more stock, the capital account standing as collateral for the clawback at the end of the 10-year period when the true-up occurs and the departing executive either pays up or not, depending on the fortunes of the company over the period.
Broc: This has been very interesting. Any last words?
Joe: For companies to survive in today 's global economy, the fundamental imperative is "innovate or die." This necessarily requires a management which is, in very important respects, the opposite of risk averse, which entertains a healthy appetite for taking calculated risks in order to keep the growth curve in line with society's expectations.
You cannot ask an individual to take risks if he is paid according to a formula that is essentially static; the two notions are mutually exclusive. Accordingly, pay tied to performance, and generous pay for generous performance, are axioms which we accept as self-proven in our economy, a necessary cornerstone of modern prosperity in the United States.
© 2004 Joseph Bartlett. The views set forth above are Joe's personal views and do not necessarily reflect the views of the firm he is associated with. The views are also not intended to be legal advice.