Recent article in the WSJ about Fixing Executive Compensation

There is nothing earth shattering in this article but is it good for identifying concise issues. The essentials of including debt in the calculations is an excellent concept, long term growth, and flexible compensation packages (adapting to market changes) are important for CEO and Senior Executive Packages.

However, even beyond these issues, it might have mentioned the need for a pro-active Board that demands financial transparency and accountability, and good external financial audits to highlight problem areas. Human capital growth is also needed for sustainability and should be included in some form. Last, it is essential to identify organic growth from acquisition growth, as acquisitions can hide a number of sins and problems, not to mention, many times adding debt to the corporation.

Here is the article with a hot link to the original article at the end:

• FEBRUARY 27, 2012

How to Fix Executive Compensation

For starters, don't link pay packages just to stock. Tie them to debt as well.

By ALEX EDMANS

The secret to reforming compensation isn't so much looking at how much bosses get paid—but how they get paid.

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It's easy to understand why critics focus on the gaudy awards of cash and stock that executives take home. And, yes, it's hard to deny that some bosses get paid a lot more than they deserve. But the structure of compensation is ultimately a lot more important than its level, because it gets to the heart of how managers run companies and create value for shareholders.
Pay packages should give managers strong incentives to run companies correctly, to make them think in the long term and avoid taking excessive and potentially destructive risks. In many cases, they are well-designed and provide CEOs with the correct motivation. But in others, pay packages not only fail to achieve that goal but push executives in the other direction.
There are creative ways—yet simple and easy to implement—to tie executives' fortunes to the long-term health of their companies. Tying bosses' pay to the levels of debt at the business, for instance, will dissuade them from taking risks that might alienate creditors. Preventing executives from selling company stock until several years after it's granted will give them a powerful incentive to think long term. And updating the compensation package to reflect changing conditions in the market and the company will ensure that managers' interests are always aligned with those of the company and its shareholders.
Here's a closer look at those proposals.

Pay Them in Debt

An effective way to deter executives from taking excessive risk is to compensate them with debt-based pay as well as equity. However, many compensation packages feature only cash and equity.

Consider what happens when a boss who gets paid only in stock is facing a big choice that affects debtholders.
Let's say the company has $1 billion in debt but assets of just $900 million. If the CEO liquidates the business, debtholders get 90 cents on the dollar, but equity holders (like the CEO) are wiped out. Obviously, that's not an attractive prospect for the boss.
Now imagine that the CEO has before him a proposal that has an equal chance of gaining $200 million and losing $400 million. Clearly, the project is undesirable from a company-value perspective. However, since the manager holds only equity, he has little to lose by taking it. Stockholders are going to get wiped out anyway, so they're not going to lose more if the move fails. But if it succeeds, the company is worth $1.1 billion—and equity holders have $100 million to share, after the debtholders get paid off.
Looking at things from the debtholders' point of view, though, the move is clearly undesirable. If the boss doesn't take on the plan, they recover 90% of their money. If the boss goes through with it and succeeds, they get an additional 10% back. But if the strategy fails, they collect just 50% total.
Boards of directors, who design pay packages, are elected by shareholders. So, why should they care about debtholders at all? Because if potential lenders expect the CEO to take such gambles, they will demand a high interest rate and restrictive covenants, ultimately costing shareholders. A high interest rate cuts into profits, and restrictive covenants may prevent managers from undertaking desirable investment.

Qi Liu of Wharton and I have shown that the optimal pay package involves giving managers debt-based compensation as well as equity. Contrary to intuition, the CEO's optimal equity/debt ratio typically differs from the company's. If the business is financed with, say, 60% equity and 40% debt, it may be best to give the CEO 80% equity and 20% debt-based pay. The optimal debt ratio for the CEO is usually lower than the company's, because equity is typically more effective at inducing effort. However, the optimal debt ratio is still nonzero—the CEO should be given some debt compensation.
As for what kind of debt to give as compensation, it can take any number of forms. First, defined-benefit pensions and deferred compensation are already frequently used in practice. These instruments have equal priority with other unsecured creditors in bankruptcy, giving the CEO a strong incentive to look after their interests. And they seem to work: The research of Raghu Sundaram and David Yermack of New York University finds that CEOs with large defined-benefit pensions manage their companies more conservatively. Similarly, a paper by Divya Anantharaman and Vivian Fang of Rutgers University and Guojin Gong of Pennsylvania State University finds that debt compensation leads to fewer loan covenants and a lower cost of debt.
Second, compensation can be explicitly tied to debt values. American International Group Inc. used that kind of system in 2010, before its recapitalization, for certain elements of compensation for highly paid employees. In that plan, 80% of the pay was tied to the price of some of the company's bonds, and 20% was tied to the price of its stock. Third, the CEO can be granted actual debt securities such as corporate bonds, just as CEOs typically hold stock and options.

Make Them Wait to Cash In

Another critical change companies should implement is to lengthen the time that executives must wait before they can cash in their shares and options. All too often, stock and options have short vesting periods, sometimes as little as two to three years. This encourages managers to pump up the short-term stock price at the expense of long-run value, since they can sell their holdings before a decline occurs. A CEO can, for instance, write subprime loans to boost short-term revenue and leave before the loans become delinquent, or scrap investment in R&D. This is possible since, in many cases, stock and options immediately vest when the CEO leaves the company.
In a paper with Xavier Gabaix and Tomasz Sadzik of New York University and Yuliy Sannikov of Princeton, we show that optimal compensation packages involve long vesting periods. In particular, the pay packages don't vest more quickly when a CEO leaves a company—the executive must still wait several years before cashing in.
Just how long should a CEO wait? It depends on the kind of company. The waiting period should be longer in businesses where the CEO can take actions with very long-term consequences. It might be seven years or more at a drug company with a lengthy product pipeline. But the wait might be shorter at, say, a commodity chemical company, where CEO decisions usually don't have an impact more than a few years ahead.
Of course, there is a trade-off. If companies make CEOs wait too long to collect, the former bosses might be exposed to risks outside their control, such as regulatory changes that eat into profits. Companies need to find a balance that works best for their situation.

Change to Fit the Times

Even a compensation plan that's well-designed at the outset can fail to keep pace with the market and the company's fortunes. Take the case of a corporation that pays its boss in stock options. If the company hits a rough patch and its shares plummet, an executive's stock options become close to worthless and lose much of their incentive effect. This problem may still exist even if the executive has all stock and no options.

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Let's say the CEO is paid $4 million in deferred cash and $6 million in restricted stock. At the outset, boosting the value of the company by, say, 1% is worth $60,000 to him—a good inducement to put in more effort or drop a costly pet project. But if the share price halves, his restricted stock is now $3 million. So, this incentive is slashed to $30,000.

To maintain the power of the incentives, the CEO must be required to hold more stock after a stock-price decline. How much more? In the paper with Profs. Gabaix, Sadzik and Sannikov, we show that the CEO's stock should remain a roughly constant percentage of compensation.
In the example above, this target was 60%. At the start of the CEO's contract, that meant $6 million out of $10 million total compensation. We call this the CEO's "incentive account." Now that the stock has halved, the incentive account is worth only $7 million—$4 million in cash and $3 million in stock. To keep the equity level at 60%, the CEO must have $4.2 million of stock. This is achieved by rebalancing the CEO's incentive account: exchanging $1.2 million of cash for stock, so that the executive now has $2.8 million of deferred cash.
Since the additional stock is accompanied by a reduction in cash, it isn't given free. This addresses a major concern with the repricing of stock options after company value falls: Repricing rewards the CEO for failure by giving him a lower stock-price target to reach. Note that, even if the board is reluctant to amend the terms of previously awarded compensation by exchanging existing stock for cash, the desired rebalancing can still be easily implemented; next year, the board simply pays the CEO more equity and less cash.
If companies employ the three above principles—debt-based compensation to reduce risk, long vesting periods to dissuade short-termism and rebalancing to ensure incentives at all times—executives will be aligned with the long-term health of their companies. And that will not only help keep individual companies safe, it will reduce the risk of another financial crisis.
Dr. Edmans is a finance professor at the University of Pennsylvania's Wharton School, a faculty research fellow of the National Bureau of Economic Research and a research associate of the European Corporate Governance Institute. He can be reached at reports@wsj.com.

Fixing Executive Compensation 

Ethics, Drugs and Morality: How they affect Communication, Productivity and everyday life Part I.

This is a broad but critical and essential topic(s) for the C-Suite, Board of Directors, and HR Heads. Why? Because, these impact almost every corporation at some point in time and on multiple levels. This costs trillions, not just billions of dollars/local currency on a global basis. The retail sector probably recognizes and deals with these issues the most often, however we are all confronted with them, and it is on a large scale.

In my many years in business, there has been some discussion about this topic but normally in general terms, and not with the URGENCY it deserves. It has been dealt with in a spotty manner at best, and non-existent during many others. This is not to say that the “sky is falling” but we need to address this and hear the drum beat.

You don’t hear the drums and cadence? Well let’s just mention a few instances: Bernie Maddoff and multiple ponzi schemes recently in the news running into the billions of dollars, WaMu, the Catholic Church’s issues with sexual abuse, Enron, Fannie Mae, Freddie Mac, Solyndra,…the list is endless, unfortunately.

A recent replay of an interview with David Millar, a professional cyclist who was found to be doping and now openly admits it, brought this topic into sharp focus at this time and provides an excellent reference point. This interview provides the essence of what we are confronted with, not only in professional and amateur sports, but in our day-to-day business and management lives as leaders. To ignore it, or down play it, is at our company’s risk.

Recently, a couple of companies have asked in our discussions, why, after conducting assessment screening around these topics during the pre-hire, they have still found a few people stealing? The answer to the question is because at different points in our lives, we are challenged by circumstances that may dislodge us from our values, depending on how deeply they are ingrained within us and this is so frankly discussed by David Millar.

It is David Millar’s interview which so clearly addresses this issue. He had rejected doping for 7 years of his career and had no intention to ever dope. However, when he fell on a tough period, when he was no longer performing at the level of before, he decided he would and he did Dope!

He says that he didn’t do it so much for the money, but for his ego and to regain his reputation in the sport (the irony was lost on him at the time: that by doping and getting caught it had an even a greater negative effect on his reputation, than if he had just retired from the sport when he was no longer competing at the level of before).

Each of us is confronted with similar issues at various times in our lives and career. However, it is our ethics, view of drugs (and this takes many forms) and morality, and the depth we are inculcated with these values that provides the guidance for us to avoid these issues….. or, we surrender to the issue at hand.

A way to help provide the foundation for a company and it’s employees, is through reinforcement with written policies that need to be signed by each employee each year, regular training, and corporate communication around these values on an ongoing basis.

Some statistics that may be eye opening (from SHRM and other sources):

31 % admit to abusing drugs or alcohol

41 % say they falsified records

56 % of working people admit they lied to their supervisors

64 % use the Internet for personal use while at work

80% of computer crime is committed by company insiders

A majority of applicants stretch the truth on resumes!

  More than half, 55%, lied about the length of past employment.

  Past salaries, 52%

Criminal records, 45%

  Former job titles, 44%

Former employers, 34%

 Driving records, 33%

Degrees, 28%

Schools attended, 22%.

 Some 15% percent even falsify their social security numbers!

So, if you are not convinced by these statistics, then look around you at work. How many people do not show up to work on time? How many feel that if they work 7-8 hours a day, that is all that they need to do because that is what they are getting paid for? How many really understand where their salaries, commissions and bonuses come from? How many have a basic understanding of profit and loss?  Just because it is clear to you, is it really clear to others?

It is every employee’s responsibility to help articulate and support these issues. Only through vigilance can the theft of time, property, and erosion of values be prevented!

The challenges are for the C-Suite and Human Resources:

1)      Are pre-hire techniques being used to help avoid bringing in future employees with the wrong values?

2)      Once onboard, how much corporate communication and time is spent around core values, and especially these particular issues? Are policies in place in Employee Manuals?

3)      Are they reinforced and training provided, regularly? Are the investments being made? This affects all shareholders in one form or another.

Values come from the top down, but can be supported by all employees! These can clearly be shown to impact sustainability, survivability and profitability, as well as personal success, individual health and life issues and values.


Link to the interview:

David Millar, Cyclist, Drugs, BBC Interview

Not all Acquisitions or Strategies, Work

Not all acquisitions or strategies work, but you do need to know when to change before disaster strikes. Two recent articles have borne this out. The first is that HP will not sell off their PC unit and Republic Air decides to spin off Frontier Airlines.

Two questions might be asked.

How do you arrive at making an acquisition, and then deciding to sell it off?

Well, even sophisticated organizations make mistakes, but many times it is because of insufficient efforts in due diligence. Not only do you need to look in the area of financial diligence, but in the integration of "culture fit," "core values," and "strategy" integration. While Republic Air blames it on "fuel costs" it really appears to be much more. Most probably on of entirely different strategies that Republic Air has compared with what Frontier was. One is a "feeder line" versus a regional airline.

The other question, is why might you say you are going to sell off a business and decide to keep it?

Sometimes, it sounds like a good idea but when you look into the depths of the financial impact on the company, it doesn't look so great.  There can be hidden synergies within the company. Also, there can be the expediency in wanting to look like you are doing something, but in the end it isn't a good decision. Many times these are created by internal political powers that push or pull decisions or shareholders.

In the end, a good CEO will retract or make a hard decision to change course. One of the hardest had to have been Roberto Goizueta's famous decision to reformulate Coke in 1985. Massive amounts of PR and inventory had been expended. Then, 77 days later, the formulation was returned to it's original, being labeled "Classic." Mr Goizuleta's strategy was to encourage risk taking, and he remained as CEO for many years afterward, in spite of this massive mistake and cost to the corporation. Even most recently Coke changed their packaging back in the article below:
A Frosty Reception for Coca-Cola's White Christmas Cans

On the same day as the "Frosty Reception" above article about Coke, there is one about AT&T and T-Mobile (Deutsche Telekom AG) changing their acquisition strategy:
AT&T, T-Mobile Mull Plan B

So own up to mistakes, and cut your losses sooner rather than later. Hopefully, there will not be too many of them.


Republic Air Changes Course

Even CEOs and Presidents Report to someone or something

As young workers and executives, we always thought that when we got to the top, we could then do what we wanted, because we would have no one to answer to, or report to. How wrong we were and for those of you who hold to this view, this is the purpose of this posting.

CEOs and Presidents of public companies, report to their shareholders and their shareholder's expectations. Shareholders can be investing in a company for asset growth, which is reflected in stock price appreciation with an intention at some point in time of selling the shares and reaping the rewards. Other shareholders invest in a company for dividend payments which provides cash flow and an income stream for them. Obviously, some invest for a mixtures of these two situations. In any case, the Senior Executives and especially the Chairperson, CEO and President is charged, in one form or another, to deliver on share holder expectations. If they don't, they will most likely not last with the company or in that position.

Non-Profit companies, while not paying dividends, are in business to provide, generally, services and are required to remain financially viable, or else, they too will close. Profitability takes the form of fund raising and/or financing their operations through sales.

In private companies, in most instances, C-Suite executives are still expected to deliver results, because the financiers (banks and private investors), still expect to see similar results as those of share holders in public companies, because they need to receive money for the financed debt. Failure to make these payments on debt, results in the bank taking over the company in one manner or another, or investors withdrawing support and funds from the organization.

In rare instances, there are private companies that do not have any debt and fund their growth through internal profits and cash flow. Even here, many times, this kind of private company is being positioned for family members and relatives to benefit from the growth. In the meantime it provides cash flow to the owner or owners and spouse(s) to support their life style. So the purpose of such a company is either positioning it for ultimate job opportunities for family, relatives and friends, or with the intent in the future to sell the business and cash out at some point in time. So even in this unusual situation, the C-Suite Executive(s) still have pressure from within to deliver in one form or another, driven by expectations: voiced and unvoiced.

So, everyone answers to someone or something, regardless of position and circumstance. This does not take into account personal beliefs. It's never as easy as it appears on the outside.