When I prepare this draft, I was thinking using “One of the most outrageous things”. However, after another round of reading, I decided to drop the structure and stick to “The most outrageous thing” in the subject. Frankly speaking, nothing else comes close to this.
This time of the year is the usual period when you receive lots of proxy materials from various companies. We always take our responsibility as a co-owner of the business seriously so when we receive such material, we actually read them (and without a doubt we will vote on the proposals).
Every time the degree of executives’ compensation stood out of the page, and more often than not, those proposals are “non-binding” shareholder guidance.
When was last time you saw a CEO’s salary coming in less than $1 million dollars, regardless the profitability of the company? I can only recall Warren Buffett of Berkshire Hathaway, Elon Musk of Tesla (despite a multi-billion dollar package recently proposed by the board for future compensation) and Mark Zuckerberg of Facebook.
According to Washington Post, “Major company CEOs made 271 times the typical U.S. worker in 2016”. This is quite stunning fact, isn’t it? Essentially we are saying, the contribution to the company of these CEOs is equivalent to as many as 271 average workers’ combined contribution over the year to the company. I recognize that many CEOs are brilliant, energetic and smart. I am not sure they are 271-average-worker smart or 271-average-worker energetic.
We read some international company’s annual report from time to time. I never saw some similar pay scale difference in those companies. It makes me wonder: CEO in America is probably the same mysterious species like Doctors or Lawyers in America; they are just super humans that deserve a lot more money.
However, if you look at their track records, a lot of questions are raised. Marissa Mayer of Yahoo, Jeff Immelt of GE and countless ex-CEOs of major Wall Street banks leading to financial crisis, they all had one thing in common: using Shareholder’s money to gain their own wealth and driving down company value at the same time.
Typically we know there are two types of leverage: financial leverage and operating leverage. Financial leverage looks at amount of debt vs. total asset base. Say, if you have $50 dollars worth of debt and $50 dollars worth of equity. If the cost of debt is $4 (8% yield), whenever your asset value goes up $10, you are enjoying 12% return on equity. Without the debt, your return on equity is 10%.
Operating leverage means if you have revenue of $100 and operating income of $50. Assuming out of $50 operating expenses, $40 is fixed expense and $10 is variable expense, your operating margin is 50%. Whenever your revenue goes up 10%, you fixed expense is still $40 and your variable expense is $11, however your operating income is now $59, a 18% gain over previous operating income. This difference over revenue gain is a result of your operating leverage.
Now, in the world of CEO club, I think there is third kind of leverage in their calculation: executive leverage. A CEO’s compensation will be drastically different if he/she is managing a company with enterprise value of $100-million vs. a company with enterprise value of $10 billion. If a CEO’s annual compensation is $1 million, his salary is 1% of the $100-million company but 0.01% of a $10-billion company. The owners of the $10-billion company may be more forgiving on this “rounding error” than the owner of the $100-million company.
That essentially gives the incentive of CEOs to expand the company whenever there is an opportunity and they can make a case of it. And if such expansion can have some delayed negative effect then it is even better. You will see many CEOs’ bragging about “newly merged” company will be able to realize strong synergies and operating efficiencies in their presentation to shareholders to certain acquisition, but what is really efficient, is their pay post-acquisition. They will be rewarded handsomely while shareholders bear the risk of overpaying or unwise acquisition using company’s resources down the road.
Unfortunately I don’t see a solution to today’s issue with CEO and other executive pay. You may say, we need to motivate smart people to take over the top job. My response will be, if that’s the case, let’s make sure those incentives are well aligned. CEOs should be paid in form of shares (not Options!), not outright cash. CEOs should be evaluated on a multi-year window not next year’s earnings. CEOs’ compensation plan should have a strong claw-back clause that in future, their bonus will be at risk of company’s performance, not a guaranteed wealth as long as some short-term goals are met.
I am not holding my breath to such changes. However, if we don’t recognize this is something that we need to change to create better alignment, the story of CEOs destroying values while getting rich will never end.