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In Defense of CEO Pay – Part 2: Different Bargains

Tuesday, October 25, 2011
By Dan

In part 1 of this series, I explained how the CEO pay ratio is an overstatement, and compares apples to apple pies.  Now, we’re going to look at the different economic bargains and incentives for the types of actors in a corporation.  Next, we will look at why CEO pay is, and should be, much higher than “average worker” pay, (whatever that means).

Different Bargains:
In a simplified model of a corporation, there are four different roles, each with their own risk and reward profile:

  1. Shareholder
  2. Director
  3. Management
  4. Employee

Shareholders invest their capital to form the company (or, in companies that already exist, to grow the company or provide liquidity for exiting shareholders).  Their bargain is simple: I will put in my money, and I expect a return on my investment.  That return can come as dividends (profits paid to shareholders) or increased share price (i.e., the company becomes more valuable).  Their reward is based on the value of the company, and their risk is limited to the amount of money they paid for their shares.  (If they invest $10, they can only lose $10–the company cannot force them to invest more.)  Their incentive is to make the company as profitable as possible to maximize the return on their investment.

Directors have an unusual bargain–not one you should take without legal advice.  They are hired by the shareholders to oversee the strategic development of the company and select and oversee management.  Their reward is usually cash compensation and/or stock awards.  Their risk is that the company, the shareholders, the government or other directors will sue them, and they will be personally liable for the Company’s conduct.  (Most companies indemnify (agree to defend and reimburse) their boards for this, but certain conduct, if later deemed illegal is not covered.  The point is that the director can be liable for the company’s conduct, not just their own.)  Their reward is based on the value of the company and their risk is unlimited (i.e., incarceration).  Their incentive, therefore is to make the company as profitable as possible, within the known bounds of the law.

Management is a hybrid of Employees and Directors: they are charged with conducting the day-to-day management of the company, but are also focused on growing the company long-term.  Like directors, they can be held personally, criminally liable for conduct that is later determined illegal.  Their rewards are their salary, as well as stock-based compensation (which usually vests over a period of 3 to 5 years) and bonuses based on performance metrics (like increase revenue, increased margins, etc.).  Their risks are (a) being incarcerated; (b) being fired (not laid off, fired) if the company does poorly, and (c) their stock grants being either taken away or being worthless (an option to purchase the stock granted at $10 is worthless if the stock price is $9.99).  Their incentive, then, is to maximize the profitability of the company within the bounds of the law over both the short (bonus and not being fired) and long (stock award) time frames.

Employees have the simplest bargain: they perform a job and are compensated whether the company does well or poorly.  In many companies, employees receive stock grants and bonuses, but the overwhelming majority of their compensation is a fixed salary or hourly wage.  Their reward is compensation for their work, their risk is limited to being terminate if they or their company performs poorly.

So among the four actors, from most risky to least is, Management, Directors, Shareholders then Employees.  Management can lose their job, their investments and their personal liberty.  Directors, similarly can lose their liberty and their directorship, but it is not usually their only source of income.  Shareholders have their capital at stake, and Employees, generally are only responsible for their own conduct, but can be laid off if the company performs poorly.

So the question is, should those who have the most to risk be compensated more than those who have relatively little?  Or, put another way, should reward be linked to risk? I will address that in Part 3.

Tags: , ceo, compensation, ows, pay, , wages

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