Why CEOs Are Like Art Auction Houses

Imagine that you have inherited the venerable family mansion in upstate New York. Hidden away in the attic is an extensive art collection that hasn't seen the light of day for more than 75 years.

In order to dispose of it and realize its value, you contract with an art auction house. They agree to appraise, repair and restore its pieces as appropriate, and to attempt to sell the pieces off by a combination of private placements and auctions. In return, they will receive a nominal upfront fee, billed expenses, and a 20% commission on all sale proceeds.

In the end, they end up with a commission of $20 million.

When you talk to your friends and/or social rivals afterwards, do you brag about your $80 million sale proceeds, or do you bitch about the $20 million commission?

The CEO of a public company is in a somewhat analogous position. He is compensated from and by a combination of diverse sources.

He will be partly compensated by a cash salary, but this will probably be limited to less than $1 million, as this is apparently the most that the company will be allowed to deduct for tax purposes, another random result of 'The World's Greatest Deliberative Body', and their junior ambulance-chasing associates.

He may receive perks of various kinds, such as private jet travel and/or a chauffeured limousine.

But the most significant part of his compensation will likely be stock options.

In return for this combination of compensation, the CEO is expected to perform a multi-faceted task.

First, he has the ultimate responsibility for the smooth and profitable operation of the business part of the company. This is a nuts and bolts job, not too dissimilar from the appraisal, repair and restoration tasks of the art auction house. While this is vital, it is only the preliminary to his real job of maximizing shareholder value.

Ultimately, the CEO must be successful in virtually selling the company to Wall Street and both institutional and individual investors. If he fails in this task, he will receive no sales commissison, in the form of stock options worth exercising.

Of course, in the real world, he will likely get more than he deserves if he fails in increasing the market value of the company, but this is largely beside the point.

When a newspaper reports that a CEO has received many millions of dollars in a given year, likely the result of option exercise and stock sale, nearly everyone bitches about it, hardly ever asking how the shareholders made out.

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Of course, in the real

Of course, in the real world, he will likely get more than he deserves if he fails in increasing the market value of the company, but this is largely beside the point.

Why is this beside the point?

Why is this beside the

Why is this beside the point?

Because the point is that public discussion doesn't often even note that the compensation isn't cash, let alone questioning whether the shareholders got their ownership dilution's worth.

In the case of the art auction house, there is no way even in retrospect to judge whether another house would have produced better results at some different compensation.

Regards, Don

phosphorious, Link that

phosphorious,

Link that statement with the following paragraph. Nobody complains about the guy making the $1M salary, at least not in our current corporate environment. They complain about the guy who cashed out with $400M (like the recent oil exec). It's beside the point because even if you accept the idea that simply running the company and not changing the market value is worth $500K and the CEO makes $1M plus $200K worth of perks, it's the $30M he would have made in stock options that gets attention, not the $700K over his true "value" that gets space in newspapers.

Phosphorius is correct: the

Phosphorius is correct: the fact that a failed CEO makes more than he is worth is not something you can simply dismiss out of hand. This is not to say that the problem can't be vacated, he may be worth X dollars adjusted for risk--we could simply view this as a cost in a broader scheme of CEO compensation. It is not correct to ask whether the shareholders made off well because this really can't be known. Consider that in a good year for the technology industry in general, a CEO of equal competence will appear better than another simply because of the year they held the position in. Some economist already pointed out that CEO pay makes no sense relative to the CEO himself; rather it makes sense as an incentive for the executives below him who are trying for the top job.

Stock compensation through

Stock compensation through options for CEOs (or for anyone, really) is a poor way to incentivize people. The market can be driven by forces that have weak ties to reality: look at any stock boom/bust for evidence of this. As such, why would you tie the biggest portion of a person's compensation to such a fickle thing as stock price?

Here are some more problems with options:

1. They are a slow bleed on the shareholder's stake in the company's equity. Their cost is often hidden this way. Even now with FAS 123R that requires companies to expense options, the real cost of options often goes sight unseen.

2. They can encourage CEOs to take a short-term outlook on a company in order to capitalize on options before expiration. Do you really want management making decisions simply on the whims of some analyst's rating?

3. They enable management to profit simply off of the accretive nature of capital: time passing results in compounding of wealth. Options enable management to profit off of this compounding without them really doing anything other than bide their time.

4. Do you really want management to try and pump the stock price and then sell off their stake in the company once they can really profit off of the market? The principal-agent problem is best countered by encouraging agents to act like owners. How do options solve this problem? How do they make it worse?

5.

Ultimately, the CEO must be successful in virtually selling the company to Wall Street and both institutional and individual investors. If he fails in this task, he will receive no sales commissison, in the form of stock options worth exercising.

Is it more important for the CEO to sell the company (not once, but over and over again) or to build a vastly successful company that sells itself?

6. They embolden management to trade on insider information; after all, isn't management most likely to know when the stock is overpriced? They then exercise and capitalize on their inside knowledge.

7. They're easy. This doesn't make them inherently bad. Rather, it just makes it easier for a Board (often run by the management they're supposed to be controlling) to continue compensating using the status quo instead of coming up with better ways (ways tied more clearly to performance) to incentivize.

8. The tax code actually encourages their use. The Clinton-era cap on salaries could very well have been one of the worst things for public company investors because it further encouraged the use of options as a viable way to compensate despite their many, many weaknesses.

This is all I've got for now, but I'm sure some more will come up in the discussion.

The granting of stock

The granting of stock options is rather a mutually beneficial voluntary exchange in which the shareholders offer a contingent ownership share in return for a reduced level of other compensation, including cash, that would otherwise be required to keep a CEO candidate from pursuing his alternate opportunities. A company whose shares and options have potential value to a prospective CEO will inherently be more profitable than a company whose shares and options do not. This is true in spite of the fact that a majority of companies likely do not drive a hard enough bargain.

I agree that granting stock options can be mutually beneficial. However, the obfuscation resulting from having thousands of shareholders bearing the cost of the decisions of a handful of agents works against the benefits of options (or any other compensation package).

Perhaps we disagree on how we each define "incentivization." Your explanation of the use of options is to keep management from pursuing alternatives. Could this not be rephrased in saying that stock options incentivize management to stick around? How are options, as explained, not incentivization? Furthermore, why would you compensate someone for any other reason than to incentivize them as agents )for your principal)?

In theory, options that take five years to vest would incentivize management to make decisions that would result in benefits that arrive in five years or more (but likely less than ten years since options typically expire in less than ten years). Often, a portion of the options vest each year - so say 1/5 per year for five years. Thus, the majority of a grant has vested after three years - two years if the vesting period is three years. Neither of these points in time (even five years) represents a long-term investment for a company that investors would want to remain successful for the forseeable future. Manufacturing companies often invest in equipment they expect (and the cash flow economics require) to provide returns for ten or more years.

Here's a quote from Warren Buffett's 1985 letter to the shareholders:

Of course, stock options often go to talented, value-adding managers and sometimes deliver them rewards that are perfectly appropriate. (Indeed, managers who are really exceptional almost always get far less than they should.) But when the result is equitable, it is accidental. Once granted, the option is blind to individual performance. Because it is irrevocable and unconditional (so long as a manager stays in the company), the sluggard receives rewards from his options precisely as does the star. A managerial Rip Van Winkle, ready to doze for ten years, could not wish for a better “incentive” system.

How do you get around the fact that options represent pure benefit to management once granted with little to no cost to management? I know I'm talking about incentivization here, but I would argue that you are as well. If options are a poor measure of performance over any period since they are tied to stock price, which is a fickle beast, why use them as a means to keep management from running off to other opportunities? Are there no better methods?

Neal, Stock compensation

Neal,

Stock compensation through options for CEOs (or for anyone, really) is a poor way to incentivize people. The market can be driven by forces that have weak ties to reality: look at any stock boom/bust for evidence of this. As such, why would you tie the biggest portion of a person’s compensation to such a fickle thing as stock price?

While there can be no question that stock options have been regularly and grossly abused, that doesn't really address the question of whether they can serve a valid purpose.

I completely disagree with your assumption that the proper purpose of stock options is incentivization. I would have no interest in hiring a CEO, or anyone else for that matter, if I didn't have a certain minimum level of expectation that I would receive their best efforts independent of how many stock options they might have been granted.

The granting of stock options is rather a mutually beneficial voluntary exchange in which the shareholders offer a contingent ownership share in return for a reduced level of other compensation, including cash, that would otherwise be required to keep a CEO candidate from pursuing his alternate opportunities. A company whose shares and options have potential value to a prospective CEO will inherently be more profitable than a company whose shares and options do not. This is true in spite of the fact that a majority of companies likely do not drive a hard enough bargain.

As far as your detailed points go, they probably split in thirds between agree, disagree, and neutral. I will only address #2 below:

2. They can encourage CEOs to take a short-term outlook on a company in order to capitalize on options before expiration. Do you really want management making decisions simply on the whims of some analyst’s rating?

Wrong problem, wrong cause. It is hard to see how options that take 5 years to vest and are often exercised at 1/10th to 1/100th the current market value of the company can have the problem that you assign to them.

Any short-term focus will be the result of the quarterly financial reporting interval. I am also skeptical of this being a problem as a truly competent CEO can either deliver results on this schedule or explain why strategic decisions make this undesirable. Also, problems that require a change at the top will tend to show up 4 times faster, maybe before the company has been run totally into the ground.

Regards, Don

"It is only busybody third

"It is only busybody third parties that are concerned with ‘measurement’."

Absolutely ridiculous. Shareholders are absolutely concerned with measurement: you say as much yourself,

". . . every shareholder can take his marbles and go home at whim if options offend his sensibilities."

You're absolutely correct. However, you're assuming that shareholders are fully aware of both the quality of the performance of management as well as the cost of compensating such management. You're further assuming that shareholders make rational decisions based on the entirety of the information out there - that they have even thought about how stock options incentivize management and understand such incentivization. This is rarely ever the case. Not only do huge information asymmetries exist between the shareholder and management (the principal and agent), but there are so many small shareholders that can be controlled by majority owners (often management) that management can easily impose negative externalities on shareholders by convincing gutless boards to issue options. It happens all the time. It's not that shareholders can't walk, it's whether or not the cost of the option compared to the benefit is great enough to push any individual shareholder to leave.

No doubt options have some positive attributes. However, why would you issue lottery tickets to management that pay off at the whims of the market and at the expense of shareholders? I understand how in theory options make sense, but in reality, do they actually work that way?

Neal, WB -- "...Once

Neal,

WB --
"...Once granted, the option is blind to individual performance....

Nonsense. The recipient is subject to termination or any lesser punishment that may be deemed appropriate by the board and any or all of the shareholders can vote with their feet every day that the market is open.

How do you get around the fact that options represent pure benefit to management once granted with little to no cost to management? I know I’m talking about incentivization here, but I would argue that you are as well. If options are a poor measure of performance over any period since they are tied to stock price, which is a fickle beast, why use them as a means to keep management from running off to other opportunities? Are there no better methods?

It is only busybody third parties that are concerned with 'measurement'. An option is a part of a MBVE betwen the recipient and the shareholders. It isn't meant to measure anything. It is a lottery ticket with a variable payoff that the recipient must avoid allowing to be run through the laundry. The recipient is free to avoid any agreement involving options and every shareholder can take his marbles and go home at whim if options offend his sensibilities.

Regards, Don

Did the CEO of Exxon

Did the CEO of Exxon organize a global conspiracy to drive oil prices up over $70? If he didn't, then he didn't do anything to earn the vast payment he got for Exxon's huge 2005 profits, which were caused by oil prices going up.

When a newspaper reports

When a newspaper reports that a CEO has received many millions of dollars in a given year, likely the result of option exercise and stock sale, nearly everyone bitches about it, hardly ever asking how the shareholders made out.

The entire business section of newspapers is dedicated to discussing how shareholders made out.

Jeremy, ...on something like

Jeremy,

...on something like CEO pay, which will not make that much difference on the bottom line...

But which may make a huge difference to a shareholder's portfolio value line if an overemphasis on compensation leaves the company with a second or third-rater as CEO.

Regards, Don

While I don't agree with all

While I don't agree with all of Dean Baker's ideas, I think his analysis of the organizational politics of corporations in his new, free book The Conservative Nanny State provides a reasonable explanation for high CEO pay:

CEO pay in the United States has exploded for the simple reason that CEOs largely get to write their own checks. CEO pay is determined by corporate compensation boards, most of the members of which are put there with the blessing of the CEOs themselves. Usually the CEOs have a large voice in determining who sits on the corporate boards that ultimately have responsibility for the operation of the corporation. These corporate boards then appoint a committee that determines CEO pay. In effect, we allow the CEO to pick a group of friends to decide how much money he should earn. When they are sitting on the boards of corporations that control tens of billions of dollars in revenue, their friends are likely to be very generous.

In principle, the shareholders can organize and put in place directors who will take a harder line on CEO pay, but organizing shareholders is a very time-consuming process, it’s just like running a campaign for public office. Furthermore, most corporate charters stack the deck against anyone seeking to challenge management’s plans. They allow the company to count stock proxies that are not returned as votes in support of management’s position.

It is comparable to allowing political incumbents to count all the people who don’t turn out to vote as voting in their favor. Few challengers would win elections under these rules. Similarly, there are not many occasions where outsiders can overturn corporate management’s decisions, especially on something like CEO pay, which will not make that much difference on the bottom line. It’s much easier to just sell the stock if you don’t like what’s going on.

But which may make a huge

But which may make a huge difference to a shareholder’s portfolio value line if an overemphasis on compensation leaves the company with a second or third-rater as CEO.

Assuming CEOs add signficant value, and are not simply positions required to be filled according to mandates of the government granted charter. :smile:

I thought the whole problem of high CEO pay was not that it was high, but that it wasn't correlating to performance?