Tuesday, April 10, 2012

How About Paying With Debt?

If you follow proxy statements or outrageous headlines, you'll know that Timothy Cook, CEO of Apple got nearly $400 million in compensation last year (I use the word got because he didn't actually receive that much, but he did receive equity compensation with a calculated value nearly that number). The headlines have made it even worse. With the run-up in Apple stock, that $400 million in equity is now worth more than $600 million.

Is Mr. Cook worth that much to Apple and its shareholders. I doubt it. But, how does one calculate how much Mr. Cook is worth to shareholders. Is it based on the shareholder value that he adds? That would be nice, but how do you calculate that? Stern Stewart used to (maybe they still do) like the idea of compensating executives based on Economic Value Added (EVA). EVA, in my opinion, was very precise, but not very exact.

At the end of the day, we don't know the exactly right way to compensate a chief executive. It's not an exact science. Here is what we do know. Institutional Shareholder Services (ISS) and other similar proxy evaluation firms would like for executives to be paid not above the median for their peer group. They would like for an executive's incentive payouts to be tied to performance and linked to shareholder return. They would like for no component to be excessive.

That's all nice. But, here are a few facts ... got that, these are FACTS!

  • Unless all peer groups are homogeneous and all CEOs within a peer group are paid at the median, some CEOs will be paid above the median of their peer group. The mathematical proof is simple, but will be left to the reader as my old math texts used to say.
  • Some CEOs are better than others.
  • Within a peer group, different CEOs have and should have different sets of goals.
  • Some companies within a peer group will be more mature than others in their life cycle.
  • No two companies within a peer group are exactly the same.
That's all nice, but where am I going with this?

Between outcries from advocacy groups, law changes pushed through Congress, and general screams from all who seem to care, executive compensation, especially for chief executives, has become very largely equity-based. That way, their compensation is tied to the returns of the owners of the company. In the case of Apple, maybe this is appropriate (maybe tends to imply maybe not as well). If you look at Apple's balance sheet, you are blown away by assets, including cash, but you don't see a company mired in debt.

That may not be representative of corporate America though. Suppose we look at a company that like many others today is mired in debt. I'm not going to pick one in particular, but if you've read this far, then I feel confident that you could. What happens if we paid the chief executive of the company partially in debt? What would this do?

When a company carries too much debt, it's credit rating tends to go down which makes the value of its debt go down. Doesn't this imply that a heavily debt-laden company should not take undue risk? (Yes, I understand that for a heavily-depressed company, the only option for survival may be to take seemingly undue risk, but that's not the point here.) Well, if the chief executive's compensation falls when he or she subjects the company to undue risk, perhaps that will be a warning to lay off the heavily leveraged bets. Under a structure like that, I can think of lots of chief executives who failed the company (and shareholders and debtholders), but ran off to retirement heaven as extraordinarily wealthy men, who wouldn't have fared so well. Perhaps their shareholders and debtholders would have done better if those chief executives had taken less risk.

I'm not saying that this is THE right way, or even part of the right way for every company, but think about it. Suppose the CEOs of all the failed banks had been paid with debt ... just suppose.

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