Why a lot of executive packages are outrageous and stupid
A loyal executive of 20 years reaches the rank of CFO. He’s smart, thorough and committed. He does a great job, earning options that convert at $10 a share. No one begrudges his package. He’s put in the yards and delivered the results.
The share price rises to $15. He plans to retire at 65, exercising his options and using the profit of $5 per share to finance his remaining years.
Then the stock markets tanks. The price falls to $5, his options expire worthless and after 20 years contributing to shareholder value, he retires with zip.
His replacement gets the same package. The exercise price is reset to current market at $5; they vest in two years. He’s less effective and less commited, but markets recover. The share price rises to $10. He converts, liquidates and walks; taking with him the value his predecessor had left behind.
Both illustrations are real life examples drawn from the last five years. The compensation of both was tied to increases in shareholder value via the stock market. Did the policy work?
Creating shareholder value vs. timing and luck.
Four things determine share prices. Management performance can impact on the sustainability and growth of three of them: earnings, cash flow and dividends. If there is more than one shareholder, the benchmark is how much of those things can be attributed per share.
If you chart the performance of those things, they form a mean to which the share price invariably reverts over time. If they are strong, so is the share price, relative to market, over time.
What's the most important driver?
It's the state of the market, not of the shares. Management has no control over the market. In recent years, it’s been decided by anything from Lehmann Brothers risk management to Icelandic banks. Lately, Greek voters have been in the driver’s seat.
Basing compensation or appraisal on share prices is ridiculous. It’s like expecting your managers to solve the Euro crisis.
Management needs to have a chance. To encourage that, focus yourself and your team on real increases in shareholder value over time – the extent to which they optimize cash flow and boost earnings per share. These are what determine the ability to pay real things like dividends in real money and lift your value rating over time.
If you get that right, you create value
The worth of your business – quoted or not – will increase relative to the marketplace. It will make a private company command a higher sales price and a quoted one a higher share price, relative to where the market is at any time.
As to where the market is at any time, that ‘s a gamble, a matter of timing and luck. It’s not something management can do anything about. Shareholder value, on the other hand, is their primary responsibility. Their job is to optimize that value regardless of prevailing conditions. A market is where you realize value, not where you create it.