Here’s a radical idea for reforming executive compensation: Pay executives only in cash. Ditch the equity.
You object: “But without equity, they won’t think like owners.” To me, that’s a feature, not a bug. Managers should think like managers. Owners should think like owners. Things get confused when we expect our managers to think like owners and like managers.
But what about incentives? With equity, a manager’s main incentive is to increase the stock price. The problem is, the stock price depends on a lot of variables, many of which are out of the manager’s control. At best, the stock price is just an indirect and distorted reflection of what the manager actually did. At worst, the stock price will have nothing to do with the manager’s efforts, as we’ve seen when market bubbles rewarded the incompetent and market crashes punished the competent. Might as well pay our managers with lottery tickets.
A cash-only compensation system requires us to set incentives the old fashioned way: Figure out what we want our managers to accomplish, and pay them based on what they actually accomplish. This isn’t easy to do well. It requires a good understanding of the business, where it is going, what needs fixing, which achievements are probable, possible and nearly impossible, and how much it’s worth to the company to accomplish these goals. This is the sort of finely-tuned understanding we’d expect a knowledgeable board of directors to have. But many don’t. And others do but aren’t sufficiently independent of the manager to implement it. And it’s a lot of work. It’s so much easier to load up on the equity and let the stock market sort it out.
Imagine if a CEO paid the heads of his subsidiaries this way. Instead of figuring out what they needed to accomplish and how much that would be worth, and then monitoring their performance throughout the year and adjusting as needed, the CEO just handed them shares in their subsidiary and left them alone, figuring they’d act like owners so everything would work out. I doubt anyone would view that CEO as managing effectively. So why is it okay to manage our CEOs that way?
Equity brings complexity. Complexity brings compensation consultants. That alone should be enough to scare us away from equity. But even worse, equity brings obfuscation. We all know what a dollar’s worth. We never know what equity is worth. This leads to crazy results. Every year there’s a new poster boy for over-compensation, some lucky dog we read about pulling down a nine-figure pay-day. In every one of those cases, I’ll bet, no one actually thought they’d be paying out nine-figures for a year’s work. No, they thought they’d be allocating a mix of X options, Y restricted shares and Z performance units based on some ostensibly scientific formula that, once run through the requisite black box, will magically spit out the right value. Who knew it would all add up like that? If they’d been dealing exclusively in dollars, they would have known. I guarantee that none of them would ever have agreed to write a check for those amounts if they’d been denominated all along in dollars.
Similarly, I feel for the managers who have a great year when the stock market happens to be having a bad year. All their hard work wiped out by the vagaries of the market. That makes no sense. If the manager did valuable work, accomplished what we asked of him, we should pay him for it.
But shouldn’t we pay in equity because it is tax-advantaged? Any tax advantage of equity only matters if it exceeds equity’s other costs. I expect those other costs – distorted incentives, unintended payouts, shareholder dilution – are substantial but rarely factored into the analysis. In any event, tax is subordinate. The goal is to build a sensible incentive structure, not a tax-avoidance scheme.
And we shouldn’t require a cash-compensated manager to invest in our stock, either. The manager is already heavily invested in the company just by being its manager. It is only prudent for him to diversify his holdings away from the company. No one should be forced to put all his eggs in one basket. I expect that forcing our managers to do this is what led some to take irrational, all-or-nothing bets. Which manager do you think is more likely to throw the dice with the company assets: the manager with everything in company stock or the manager who keeps his assets in index funds?
Equity is too often the currency of choice for executive compensation. Last I checked, cash was still legal tender for all debts, public and private, even executive compensation.