Tuesday, November 29, 2011

Should CEO's have to invest in their companies?

If CEOs had to invest in their company's stock with their own money would they make better CEOs?

There is a lot of healthy discussion stimulated by Occupy Wall Street going on right now on the income disparity in the US, and more importantly the lack of upward mobility, but the focus of the discussion is sometimes misdirected. As Fortune points out "The much-referenced 1% -- the global elite that controls a disproportionate percentage of global wealth -- is not made up solely of hedge fund managers, investment advisors and traders. It is made up of executives and leaders of non-financial firms in every sector" ... and their pay has been set by their company boards.

CEOs behave the way their boards pay them. The majority are hard working, well meaning executives who care passionately about their companies and their careers. But they are human and how they are rewarded will impact their behavior.

Investors want the CEO to focus on Total Shareholder Return - this is seeking positive return over time - and it is not clear that stock options are aligned with that. Stock options are of high value if the stock price goes up and worth nothing if the stock price goes down, but they don't have negative value to the option holder.

Jim Collins - author of Good to Great - took an extreme position on NPR earlier this week that CEOs should no longer be granted stock options. His position is that CEOs should be required to invest their own savings into their company and that this would lead to longer term thinking on the part of the CEO, and shared risk as well as shared reward. Here's an excerpt:

INSKEEP: So you are saying you want to attract a different kind of executive by requiring each executive to take a chunk of their life savings, and throw it into the company.

COLLINS: Yup. What it would say is, if you're not willing to put your own skin in the game, if you're not willing to live with the same kinds of potential costs and consequences for a failure to manage well that you're going to expose everybody else to, then you're not showing that you are truly ambitious, first and foremost, for this company doing well over time. And therefore, you don't deserve to be an executive in this company.

The way some boards are now dealing with this issue is by granting RSUs (Restricted Stock Units) instead of, or along side of, options. RSUs are outright grants of shares - the executive owns the shares once they have been granted and they can be set up so the grant happens on a vesting schedule or based on company performance.

Because these are actual stock grants they are like cash compensation. They are taxable on the grant and are liquid so they act as a supplement to cash bonuses. In many cases you will see a CEO or EVPs compensation has several components - cash base, cash bonus, stock options and RSUs and the options and RSUs will have some time based vesting component and some performance based vesting component. Then the company will have a holding requirement for the board members and the executives that they must hold a multiple of their cash compensation in stock and as a result, the CEO does build up ownership in the company over time - aligning their long term interests with the shareholder.

But all this complexity is not the same thing as asking a CEO to put his/her own money into the company up front. For me, it's a good idea. I invested in my last company Simplex, and I have also made a significant investment in FirstRain. It's clarifying to me, and it aligns my interests with my investors... and combined with the opportunity cost of the time I put into FirstRain my investors are very clear that I am in with both feet and for the long term.

But to require a CEO to do this? The discussion between the board and the CEO would certainly be interesting and would give the board insight into the CEO's motivation. What isn't clear is whether it would make hiring a world class CEO more difficult. And in cases where the company is a turnaround, or the board is mercurial and inconsistent (think HP or Yahoo) requiring an investment could be too high risk for the incoming CEO.

But Jim makes a very valid point. If you are not willing to put your money in alongside of your investors, and so share financially in the risk (as well as reputationally) are you less committed to the long term growth of the company?

Disclosure: I chair the compensation committees of both JDSU and RMBS and the topic of how to align executive pay with long term shareholder return is a continuous, active discussion as we strive to continuously improve and motivate excellent executives. While we have holding requirements we do not have up front investment requirements.

2 comments:

Sidney Bostian said...

As a CEO who is not wealthy, instinctively I recoil at requiring CEO's to invest. However, having a substantial portion of an executive's fixed compensation be in the form of restricted stock allows the executive to put sweat equity into the game. This is only true if the executive is not also receiving top of the market cash compensation.

Doug Brown said...

It's not a bad idea, but three risks should be considered.

A direct invesment could expose the CEO to financial ruin or family conflict. It could encourage the CEO to dismiss input from the Board of Directors by creating a false sense of absolute authority. It could muddy a Board's evaluation of CEO's performance and succession.

The goal is to align the shareholders' and the CEO's interests. Whether or not this tool should be utilized depends on facts and circumstances.

There was an error in this gadget