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Tuesday, February 06, 2007

Fixing Executive compensation

By Adelino de Almeida

The press has had a field day in debating ways to curb outsize executive pay. In the wake of the MCI/Worldcom, Enron and other corporate scandals in the near-past, we are now treated to discussions of possible missteps by the iconic Steve Jobs as well as to expressions of outrage towards the mind-boggling severance package awarded to Robert Nardelli of Home Depot fame.
Of course the press gives voice to every expert that crawls out to the woodwork and it is in this spirit that I feel I should also pitch in to the pool of solutions.
My solution is simple (and lifted from the Economist): have senior executives pay to play!
The approach is as simple as it sounds: have executives buy shares of the company they are about to manage, and adjust bonuses according to growth targets as well as to the number of shares that the executives actually buy.
Just to clarify the process a bit further, I don’t propose that shares (restricted or otherwise) be attributed to the executive, and that she "buy them" at the time of sale in a "cashless transaction", I do mean what I said: have executives pony up the money up-front, and buy all the shares they can.
I cannot think of a better way to align the interests of senior management to those of shareholders: this way executives are no longer granted a notional ownership of the company, and given a free pass to gamble with shareholder’s money. By becoming actual owners and having invested a significant part of their worth in a company, executives clearly telegraph their commitment to growth and sensible management.
Let’s look at some more aspects and consequences of the approach:
Executives whose finances are not entirely in order or that have little savings will not be able to buy many shares. Then share ownership is a great litmus test: why hire executives that cannot keep a tidy personal life? If they are unable to save for themselves, I’d posit that they are unlikely to be fiscally responsible towards shareholders.
Recent arrivals to the corner office may not yet have enough to buy a significant portion of the company. Therefore they now have both a clear shot at dramatically increasing their gains as well as to prove that they have the right stuff to manage a company
By putting "skin in the game" executives have a strong incentive to succeed, they are no longer betting with other people’s money since they now face and share the same risk as the other shareholders for whom they are supposed to work. Their strategies are more likely to account for and prevent losses than if the executives had been granted options.
The employment agreement may also be structured so that:
There are limits on the times and amounts that the executive can trade
A payoff is a combination of shares and cash
Payoffs are scaled to results; for example, a 30% increase in profits results in a stock grant equal to 10% of the number of shares initially purchased by the executive, a 50% results in, say a 25% grant
We could carry on with the debate but, in summary, I cannot think of an approach that better aligns executive action with shareholder interests and that minimizes the downside risk of stock ownership.
Next time you hire a senior executive: have her pay to play.
Interesting approach, if you would like to debate this with Adelino , catch him on his blog,
link is on my Blog

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