Ch 8 CEO Compensation

What is the point of executive compensation

-attract and retain the best talent

-motivate them to create value for shareholders

-align interests of shareholders and executives

Optimal contracting theory

CEO compensation is an effiicent process driven by competitive market forces, the compensation is innately fair per the market

Rent extraction theory

CEO compensation is a result of a market failure, CEO’s exert influence over boards to extract compensation above what they would be given in a competitive process

Who sets executive compensation

Depends on the company but key players include:

-compensation consultants (external)

-compensation committees (internal)

-board of directors (internal)

-shareholders (internal)

Why use compensation consultants

-understand market norms

-provide expertise and objectivity that enhances board credibility

-may be subject to conflicts of interest

Ratcheting effect

Companies benchmark CEO pay against compensation provided by comparable companies, the ratcheting effect can drive the median compensation to continually increase:

-this is because if all companies seek to pay median or slightly above it drives overall compensation up

-this means compensation is not purely due to value creation and benchmarks can be skewed based on what comparables are used

What did Bizjak, Lemmon and Naveen conclude

They concluded comparables used in competitor benchmarking led to competitive compensation

What did Faulkenderand Yang conclude

They concluded comparables used in competitor benchmarking led to inflated compensation

Executive compensation types

-annual base pay: fixed amount of annual cash compensation

-bonuses: discretionary and are often performance oriented

-equity: providing some form of option to get equity in the company

Equity compensation types

-stock options

-restricted stock units

-stock appreciation rights

-phantom stock

-employee stock purchase plans

What are stock options

The right for the CEO to buy equity at a specific price

-a key aspect is vesting, this is the gradual right to excercise stock options, over a specific time a gradual portion of options will be available to be excercised

What are restricted stock units

A promise to give the CEO actual shares

-can be subject to vesting conditions as well

What are stock appreciation rights

Similar to restricted stock units but CEO never has to excercise stock rights to receive income, instead they are given the difference in stock price between the time the company granted the rights and the end of the given time period as income

What is phantom stock

A bonus that is equivalent to the value of the company shares or the increase in value over a time period

What are employee stock purchase plans

-executives can purchase stock after a set time period

-executives sets aside money through payroll deduction to afford it

What is severance

A component of CEO compensation where unless they are removed due to a breach of contract they are provided severance payments

What are golden parachutes

CEO compensation that is due when ownership changes or M&A occurs:

Pros

-good in industries with high M&A activity where CEOs can lose their job easily (hiring CEOs becomes easier)

-ensure CEOs do not stop an M&A that is good for the company

-it increases costs to the acquirer which can reduce threat of M&A

Cons

-the scale of M&A is already huge, golden parachutes are negligible

-not tied to performance or value creation

What are clawback provisions

-allow board to take back performance based compensation when performance targets not hit

What are perquisites

They are perks given alongside compensation, however they are getting less popular:

-company assets (company car, company phone etc.)

-security services

-loans with low interest

-legal services (financial planning, estate planning, insurnace, etc.)

-recreational facilities (country club membership, etc.)

-travel perks (company plane, first-class air travel, etc.)