12 Oct 1999  Research & Ideas

Paid for Success: Options for Compensating CEOs

When large public companies perform poorly, do the CEOs running them share the financial pain? That question, according to HBS associate professor Brian Hall, is not answered by looking at their salary and bonus but rather by a careful examination of their stock and stock option packages.

"Our research shows that the relationship between CEO fortunes and the fortunes of the companies they manage is quite strong," says Hall, who has been working on this topic for nearly four years.

Along with Kennedy School of Government assistant professor Jeffrey B. Liebman, Hall has combed through the proxy statements of 478 large U.S. companies, analyzing executive compensation between 1980 and 1994. "We built a database that enabled us to measure with great precision, using the Black-Scholes formula, how much top executives were making in total and how their pay correlated with firm performance," he says.

The results show that for any given shift in firm value, changes in CEO wealth due to stock and stock option revaluations are more than fifty times larger than changes in wealth due to salary and bonus. "Take the average CEO whose firm increases in value by 10 percent," Hall explains. "We estimate that his salary and bonus will increase by only $23,000. The value of his stock and stock options, however, will go up by $1.25 million. Salary and bonus changes thus account for only 2 percent of pay-to-performance sensitivity, while stock and stock option changes account for the rest." But he contends that many stock option packages do not tie executives' pay to performance as effectively as they might.

According to some of Hall's other research, a classic error is giving chief executives stock options up front in one lump sum. That way, if the stock price falls substantially, the CEO will be left holding options that have lost most of their value (a scenario economists describe as "out of the money"). And while there may be some chance of getting these options back "into the money" (meaning that the current stock price is higher than the exercise price of the option) within the agreed upon time frame, the likelihood can be so slight that they no longer provide much incentive. Hall has found that when options fall out of the money in this way, one of two undesirable outcomes typically occurs. "Companies either decide to reprice the old options, a response that helps going forward but rewards past failure," he says, "or insist that the CEO continue to hold a bunch of near-worthless options that provide very weak incentives down the road."

Instead, Hall states that giving options on an annual basis as part of an annual pay package is a much more effective stimulus for success. For example, if a CEO is given options and the stock price drops, compensation is diminished, too. But incentives are preserved for the future if a significant portion of the CEO's annual pay is in the form of new options; these offer another opportunity to reach the pot of gold and even recoup previous losses. "The upshot of this approach," says Hall, "is that CEOs have a carrot and a stick in front of them on a regular basis -- a situation that motivates them to align their incentives with those of the owners."

Hall's research has led him to conclude that annual option arrangements such as "fixed value" and "fixed number" plans are typically preferable to one-time option grants. A fixed value package, he explains, gives chief executives the number of shares necessary to reach a specified value. The number of options may vary, but their valuation, according to the Black-Scholes formula, will be the same each year. "This way," says Hall, "CEOs receive a fixed percentage of their compensation each year in the form of options."

Under a fixed number package, on the other hand, CEOs receive the same number of options each year -- an arrangement Hall prefers. "A key problem with fixed value plans," he says, "is that a rise in the value of the company one year results in fewer options the next in order to keep the value of these options the same. A fall in the market price leads to more options the following year for the same reason. But fixed number plans don't have this difficulty," Hall continues. "If CEOs succeed in raising the share price one year, they are not penalized by receiving fewer options the next -- which means they get a raise the next year, because their options are worth more. Since the converse is also true, fixed number plans provide higher-powered incentives."

At the same time, Hall warns that with fixed number plans, "executive compensation can get way out of whack with competitive pay levels, since the annual value of options is not anchored by a connection to annual salary and bonus." Hall therefore advises firms using this method to reset the number of options every four years or so to prevent the CEO's pay level from soaring too high or falling too low relative to that of other corporate leaders.

No stock option package can provide motivation, however, if it isn't understood. Given the complexity of these arrangements, this is often a problem, even among those who serve as chief executives of major companies. Hall recommends that firms give their top executives a quarterly overview, showing how the value of their options shifts with changes in the company's worth. "If executives have out-of-the-money or unvested options they mistakenly regard as worthless, then they aren't being motivated by them," Hall points out. "But if we put this information in front of them on a quarterly basis as an integral part of the corporate governance system, it will help CEOs understand how closely they are tied to the firm and its stockholders."

Finally, in a recent study with HBS professor George Baker, Hall has compared pay-to-performance incentives across firms of various sizes. They found that even the top executives of giant corporations, who own only a tiny portion of the business, can have strong incentives to raise their company's share price. In fact, the stakes for these CEOs can be immense. "Jack Welch, for example, may own less than 0.1 percent of General Electric," Hall explains, "but if he were to make some changes that raised GE's value by just 5 percent, he would increase his own net worth by about $8 million."

The explosion of stock options and equity built up by CEOs over the last twenty years has caused a dramatic change in the way CEO pay is connected with corporate performance. "CEOs are being pushed to think and act like owners," Hall observes. And that's the whole point: to encourage top managers to treat the companies they lead as if they were their own.

From Working Knowledge: A Report on Research at Harvard Business School, Fall 1998