How to Fix Executive Pay: Get Skin in the Game

Executive pay–particularly at public companies–is broken, and I know how to fix it.

The problems come down to agency theory, the idea that CEOs and managers (as agents) have the incentive and ability to look after themselves at the expense of the principals (you, me and everyone else who owns stock or invests in a mutual fund). Basically, it’s much easier for a CEO to convince the Board of Directors to pay him a bunch of money from the company coffers than it is for shareholders to act together to stop it.

Stock options and restricted stock grants are two solutions that are supposed to align the interests of managers and shareholders. In theory, making the management an equity holder in the business drives them to seek long-term stock appreciation, which is what shareholders want, too. But there are two big flaws in this theory:

  • Managers game the system by focusing on short-term appreciation and cashing in options based on those gains, getting in-the-money option grants, repricing out-of-the-money options (among other shenanigans); and
  • Option and restricted-stock grants are asymmetrical rewards, meaning that the managers have a lot more to gain from the grant they they stand to lose from this equity stake.

The first point is the one that people generally focus on: back-dating option “scandals,” new option grants, CEOs who take bundles of money off the table by selling options are all standard business-section features. I think the second point is the more important one.

CEOs, asset managers, traders and other “agents” don’t have real skin in the game. Option and restricted stock grants are all gravy on top of their base comp and bonuses. If they pay off–kaboom! Massive, often dynastic wealth follows. If they don’t, then in the worst case the options expire un-exercised or the restricted stock declines in value reducing the upside that the manager hoped for, but otherwise not changing the managers’ status quo ante wealth. And let’s face it, these guys get plenty wealthy from pay that is completely decoupled from the performance of their company or fund. (That’s for another post.)

So, how do you get skin in the game? The way company founders, entrepreneurs and old-style banking partnerships do: require a big investment from the manager if they want equity.

In my last post on conservative entrepreneurs, I talked about how risk averse true entrepreneurs are. That’s because they stand a lot to lose if they screw up: most entrepreneurs have almost all of their net work tied up in their companies. That means that they gain a lot if the company does well, but get wiped out–comprehensively, “lose-the-kids-college-money” wiped out. That kind of risk focuses the mind like nothing else, so that entrepreneurs tend to carefully manage their downside while looking for the opportunity to maximize their wealth.

It’s that kind of entrepreneur we want running companies and managing funds: not swashbuckling CEOs who bet the farm and rake in millions in salary and bonuses even when shareholders see their portfolios decimated, or traders who lever up 30-to-1 on a derivatives bet because they get massive gains on the upside and a government bailout if the trade goes to hell.

So here’s my prescription for turning the business and financial leadership of the country into true entrepreneurs, with all of the risk and reward that entails:

  1. Award no stock-based compensation as a grant.
  2. Any equity participation must be in the form of an investment by the manager of his or her personal wealth. No stock purchases funded by company loans, unless they are full-recourse loans with personal guarantees by the manager. (To soften the blow, the personal guarantee can exclude the primary residence and maybe some minimum asset threshold–like $100,000.)
  3. All management equity positions must be disclosed at least quarterly. I’d like to see the stake as a % of the manager’s total net worth as long as I’m asking.
  4. To sweeten the deal, the Board could offer 100% warrant coverage of any investment made by the manager.
  5. There should be a lockup period (6 – 12 months) after the manager leaves the company before he or she can sell the equity stake.

I’d also like to see a requirement that senior management invest a significant (50%+) portion of their personal wealth in whatever company they lead, but I’d settle for very full and rapid disclosure of how much they invest and how big a chunk of their wealth it represents.

This is what old investment banking partnerships looked like: to become a partner (and thereby receive equity participation in the profits) you had to put real skin in the game. When business was good, you made a lot of money. When it was bad, you tightened your belt. And if you let your partners get careless with their trading bets, you got wiped out. There was no agency risk because the managers were as focused on shareholder wealth and profits as any investor.

I’d like to hear what you think.

2 thoughts on “How to Fix Executive Pay: Get Skin in the Game

  1. I’d like to ask you what you think the word “decimate” means. Because in my dictionary, it means “to kill one in every ten”. To decimate something is to reduce it by 10%.

    I’m sure most stockholders would LOVE to have accepted a 10% drop in their portfolios over the last 2 years.

    I’d like to see senior executives compensation based on long term performance, and to limit their share selling until at least 1 year after they leave the company, and possibly two years.

    • Yes, you’re right that the strict definition of decimate is to reduced by a tenth, as was done in the Roman legions. More colloquially, it has come to mean “to wipe out a lot of something.” But I take your point.

      “Long term performance” is hard to define and lends itself to gaming. What I’d like to see is that managers–especially the most senior ones–are exposed to the risk of catastrophic loss of wealth if they do a lousy job running their companies.

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