ENTREPRENEURSHIP AND EXECUTIVE COMPENSATION: TURNING MANAGERS INTO OWNERS.

Rogers, John W. Jr.

Abstract

During the past fifteen years, compensation paid to senior executives has far outstripped the pay increases for other levels in the corporation and for other members of society. Most commentators justify higher compensation packages as the result of pay for performance. In fact, much thinking about executive compensation derives from Agency Theory, the contention of economists that there is a fundamental divergence between the interests of managers (agents) and owners (shareholders). The use of stock options and other ownership tools are designed to align the interests of the two parties to this economic transaction. An analysis of results and of current compensation practices suggests that the divergence may still persist. Moreover, the pay inequities resulting from this new compensation philosophy may be sowing the seeds of divisiveness within the corporation and within society.

When Michael Milken, junk bond king of the 1980s, was asked to justify the economic and ethical dimensions of the corporate restructuring that he engineered, he would often cite the experience of his father, an accountant and advisor to small businesses. Milken explained that, in his accounting practice, his father saw at first hand the difference in performance of businesses run by their owners and those run by hired professional managers. Because the owner treated business assets and investment choices as a personal financial decision, the motivation to optimize financial returns was clear and direct. With a professional manager, on the other hand, one could never be sure about motivation because the money came from someone else's pocket (Bruck, 1988).

Milken's simple insight is at the heart of a revolution that has transformed executive compensation in the United States and is now spreading to Europe and the rest of the world. The objective of the revolution is to make the employee managers of publicly held corporations think and act like business owners, in short, to recreate the spirit of entrepreneurship and to recognize it as a basic motivator of performance in all businesses. The results of the revolution have been impressive. In large U. S. firms, an average of 79% of CEO pay is now at risk through stock options and both short and long-term bonuses (Pearl Meyer & Partners, 2000). While bonuses and other incentives have been a standard component of executive compensation since the 1920s, the portion of compensation attributable to stock options has soared (Bok, 1993). This extension of the pay for performance philosophy, grounded in the granting of stock options in large quantities and combined with a raging bull market, has rewarded those senior executives who have successfully embraced this new approach to compensation.

While boards of directors and compensation consultants have acted forcefully and effectively on their belief in this new form of pay for performance, these developments have also raised some troubling issues of business ethics and social values. According to a recent survey, the average American chief executive now takes home 419 times the wage of the average factory worker. In 1980, a CEO made only 42 times as much (J.K. Galbraith, 1998). Injecting an entrepreneurial component into the executive compensation mix has been accompanied by a dramatic escalation in the total amount earned by executives in both absolute and comparative terms. So far, these questions of social justice and inequality have been drowned in the great sea of economic prosperity. But a debate is going on, not only among social scientists but also in boardrooms among experts concerned with issues of corporate governance. How much money is really needed to reward performance, and is the current widespread use of stock options necessarily the best guarantee that shareholder interests will be taken into account? These questions are at the heart of a growing debate over the fundamental principles of executive compensation.

AGENCY THEORY: TURNING MANAGERS INTO ENTREPRENEURS

Michael Milken was an important participant, but by no means the principal architect or leader of this revolution in compensation. In fact, underlying these changes have been steady, inexorable trends in thinking about the role of the business enterprise and the people who manage it. The theory of the firm, the basic focus of microeconomics, has provided much of the background for changes in the way that shareholders, public officials, and academics view executive compensation. This development gives new meaning to the famous boutade of John Maynard Keynes that in finding solutions to practical problems in the real world, even the most hardheaded businessperson may inadvertently be a slave to the ideas of some past economist. The movement to build entrepreneurial values into mainstream executive compensation testifies to the surprising impact of ideas put forward by economists over five decades leading up to pay off time in the 1980s.

Beginning in the 1930s, economists noted the increasing importance of a split between ownership and management. Adolph Berle and Gardner Means, in The Modern CorPoration and Private Property, described how the modern public firm, owned by a diverse and fragmented group of shareholders, delegates broad authority and responsibility to professional managers whom it hires to direct resources and make investment decisions in the interests of shareholders. To elucidate this phenomenon, Oliver Williamason and others introduced the principal-agent model of management utility maximization (Baumol, 1959; Williamson, 1963). In the modern corporation, the separation of management from ownership frees managers (agents) to maximize their utility -- as measured by their compensation and benefit package, size of staff, image in the community, direct control over resources, lavish offices and perks -- in ways that often conflict with the interest of shareholders (principals) in maximizing long term profits. To strengthen the argument, agency theory points also to different time horizons. As an employee, a professional manager's time horizon is of necessity limited, whereas that of the owner may span generations. A manager who makes "the big mistake" is likely to be fired or, at the very least, lose influence in the organization, whereas an owner can plan for the long term.

As a result, managers have an incentive to be risk-averse and to engage in "satisfying" behavior -- striving for satisfactory decisions that are acceptable to key constituencies but not necessarily optimal in terms of maximizing the long term wealth of the firm through exceptional performance in profits, sales growth, market share and return on investment (Simon, 1949).

In his book, The New Industrial State, published in the 1960's, John Kenneth Galbraith popularized this notion, arguing that the growth of powerful oligopolies had fundamentally modified the free market system by creating managed competition among the dominant players in each industry. The manager of a publicly held company, in Galbraith's view, had more in common with a government planner than with the classic entrepreneur (Galbraith, 1967). Trends in compensation tended to reinforce this view of the senior manager's role as being very different from that of the entrepreneur.

With the lackluster performance of the stock market in the 1970s, companies focused on paying their executives competitively in relation to other firms of comparable size and complexity rather than on tying pay aggressively to performance. Mainstream corporations constructed their executive compensation packages around a competitive, merit-driven base salary with bonuses tied to achievement of objectives. While the philosophy may have been pay for performance, in fact, the bonus reflected a complex negotiation over standards and targets more than a direct reward for maximizing the wealth of shareholders.

The trend to increase the total compensation of top executives began only slowly in the 1970s, with paychecks growing by a modest 2.5% in real terms throughout the decade (Bok, 1993). As late as 1986, Forbes prefaced its annual survey of executive pay by opining "that the people who run major corporations, while scarcely in want, are at best in the middle ranks of the big earners in our society." Forbes drew attention to the contrast between New York Knicks star center Patrick Ewing's contract for $ 16 million over six years and the average CEO salary of $600,000 in 1985 (Bamford, 1986). Michael Jenson and Kevin Murphy of the Harvard Business School, experts in the area of executive compensation, argued that senior managers were, in fact, underpaid (Jensen, 1984) (Murphy, 1986). These experts felt that the lack of real incentives to create wealth for executives and the companies they ran damaged society by causing an under-utilization of scarce corporate resources. The objective of a well-designed compensation plan should be quite simply to align the interests of managers and shareholders by giving executives a chance to participate directly in the creation of wealth for the firm. Conversely, they should suffer when their wealth-creating programs do not produce results. The corporate executive, in short, should be made to behave like an entrepreneur, not like a bureaucrat, and should be rewarded in the same direct fashion.

EXECUTIVE COMPENSATION IN THE GOLDEN AGE

In the mid 1980s, senior management and the boards of directors of major U. S. corporations realized that their organizations - beset by globalization, an overvalued dollar, high interest rates, and fundamental demographic changes in their customer base -- must restructure or die. Under the banner of "unlocking shareholder value," companies embarked on a massive wave of continuous reorganization designed to improve overall efficiency and the return on shareholder investment. The ability to conceive, initiate and lead these restructurings became the primary mission of senior management and success in accomplishing this mission the primary criterion for evaluating their performance.

Such a context fit perfectly with the prescriptions of Agency Theory as it had been developed under the tutelage of academics and executive compensation consultants. The instrument of choice for aligning the interests of managers with those of owners has been the stock option plan. The purpose of stock options is, quite simply, to apply the insights of Agency Theory by turning paid managers into part owners, allowing them to profit from an increase in the share price as do the firm's owners and, therefore, giving them the incentive to undertake the tough initiatives necessary to make their firm's stock more attractive to investors. An influential article in 1990 in the Harvard Business Review argued that paying executives of large firms like bureaucrats would give them an incentive to behave like bureaucrats (Stewart, 1990). But the rewards in business really belong to the entrepreneur. Just as a start-up entrepreneur assumes the risk of launching a new venture, so the corporate entrepreneur takes on the potentially even riskier challenge of restructuring a major enterprise. In both cases, the rewards of ownership will focus actions on an essential social role that only the entrepreneur can perform -- maximizing the wealth of the firm over the long run.

The triumph of this economic thinking has been impressive:

* In 1998, according to compensation consultants Pearl Meyer & Partners, the 200 largest American companies granted stock and stock options equal to 2% of equity. Adding these awards to total shares and other options not yet exercised; the total amounted to 13.2% of corporate equity or $ 1.1 trillion or 15% of GDP (Pearl Meyer & Partners, 1999).

* In 1998, ninety-two of the chief executives of these 200 companies received "mega-options" worth at least $10 million when used. This number of eligible executives was up from thirty-four in 1996.

* Using the Black-Scholes formula of options valuation, (Black and Scholes, 1973) stock options accounted for a record 53.3% of compensation earned by executives of the top 100 U. S. companies in 1998. This compares with 26% in 1994 and only 2% in the mid 1980s.

* For some companies the portion is even more dramatic. In 1998 alone, Apple Computer granted options and stock equal to 18% of total equity. PacifiCare Health Systems made grants of 13% and Lehman Brothers awarded almost 12%. Merrill Lynch has committed 53% of its total shares to equity incentives (The Economist, 1999).

It is tempting to correlate profit performance and results of the broad indices of stock performance to this shift in compensation methodology. In 1998 the profits of firms in the S&P share index were double what they had been in 1990. The index itself was four times higher than at the beginning of the decade.

In reality, underlying the stock market boom are many factors -- the end of the Cold War, lower interest rates, globalization, a revolution in information technology. Whether the new economic climate would have propelled the market to new heights regardless of how many executives earned or in what whatever manner they earned it will never be known. What is clear is that economic efficiency has been placed at the center of the debate on economic performance. The restructuring revolution launched by Milken and others is on-going and relentless, as major firms from Coca-Cola to Xerox adjust to the vicissitudes of the new economic environment through continuous realignment of their human and capital resources.

HAVE CORPORATE EXECUTIVES REALLY BECOME ENTREPRENEURS?

While results as measured by economic achievement have been impressive, other indicators call into question the link between executive pay and corporate performance. Many top managers have been rewarded simply because their company's share prices rose with the overall market. A recent study by Kevin Murphy, an economist and expert on Agency Theory concludes, "there is surprisingly little direct evidence that higher performance sensitivities lead to higher stock performance." In other words, the theory that stock price reflects absolute corporate performance is highly distorted by broad shifts in market valuation (Murphy, 1998). A study by Professor Gerry Sanders of Brigham Young University looks at two ways of motivating managers: pay them for proven performance by looking at how well their company did over the past year, or pay them for future performance with stock option grants. Sanders found that compensation was highest -- and performance worst -- among companies (including Digital Equipment Corporation, General Motors, Kellogg) that granted large amounts of options and tied only a small portion of pay to actual performance. The companies whose CEOs got relatively few options but had lots of compensation tied to past performance (including hardware chain Lowe's and supermarket chain Kroger) had the best performance (Coy, 1999).

Other experts have pointed to the effect of the rise in overall market valuation as the key driver of individual stock performance. Graef Crystal, an executive compensation consultant and relentless critic of "corporate excess," has calculated the impact if options were valued only for performance superior to a broad market index. Among the S&P 500 companies, using conventional stock option plans, chief executives received an average of $ 8 million between 1995 and 1998. However, if option plans had required share performance above the index, only 32% of these same executives would have received any payment at all (The Economist, 1999).

A second problem with heavy use of stock options, as an executive compensation tool is the means of accounting for their cost. In 1995 corporate lobbyists killed efforts by the Financial Accounting Standards Board (FASB) that would require firms to set the cost of options against corporate profits. Warren Buffet, the guru of value investing, remarked that

 Accounting principles offer management a choice: pay employees in one form
 and count the cost, or pay them in another form and ignore the cost. Small
 wonder then that the use of option has mushroomed. If options aren't a form
 of compensation,what are they? If compensation isn't an expense, what in
 it? And, if expenses shouldn't go into the calculation of earnings, where
 in the world should they go?(The Economist, 1999, p.19)

FASB did succeed in requiring that companies footnote option costs in their annual financial statements. Using these footnotes, a London research firm, Smithers & Co., has calculated that U. S. companies may have overstated their earnings by as much as one half for the year 1998. Where firms are heavy users of options, this disparity may be even greater. For instance, whereas Microsoft declared a profit of $ 4.5 billion in 1998, the cost of options awarded that year plus the change in the value of options outstanding would reduce this profit to a loss of $ 18 billion, according to Smithers.

While there is a genuine dispute over how to assess option costs, and while these calculations certainly exaggerate the problem, it is difficult to escape the feeling that stock options have many of the characteristics of a "free lunch" (Smithers & Co., 1999).

Economists have seen the tendency of managers to engage in unwise acquisitions as one of the most important areas of divergence in the interests of agents and principals. However, there is some evidence that building the entrepreneurial spirit through stock options may, in fact, be encouraging the very behavior it is designed to correct. In an unpublished study, Professor Sanders of Brigham Young University found that executives holding "underwater" options -- options that are worthless at the current market price -- have an incentive to undertake risky acquisitions. If the acquisition pays off, they win by boosting the value of their options back above the value of their strike price. If it does not work out, they have lost nothing, since the options were already worthless (Coy, 1999). Ira King of Watson Wyatt Worldwide, executive compensation consultants, analyzed 20 companies identified by a 1998 Securities and Exchange Commission study as having made very good or very bad acquisitions. He found that the compensation package of the worst acquirers was five times more dependent on options that the package of the best (Watson Wyatt & Company, 1999).

The heavy reliance on options may also tempt companies to revalue them either directly through repricing or indirectly through stock repurchase schemes. The use of repricing to boost option values has been hemmed in by the FASB requirement that the cost of these repricings be charged against earnings in the year that they occur. However, share repurchase is a flourishing activity. In 1998 companies announced repurchases of $ 220 billion worth of shares, compared with only $ 20 billion in 1991 (The Economist, 1999). The logic share repurchase rather than dividend payments is supported by the infamous double taxation of dividends, making repurchase a more tax effective method of returning cash to shareholders. However, this technique also boosts share prices and the related value of stock options more directly than a dividend payout, and hence is more attractive to the executives who make share repurchase decisions.

WHERE DO WE GO FROM HERE?

The extraordinary abundance enjoyed by senior executives of U. S. corporation's raises broad questions about the relationship of pay to motivation. Differences between the pay of U. S. executives and those in other industrial countries are staggering. According to executive compensation consultants at William M. Mercer, the median total compensation of CEOs in the United States in 1998 was $ 8.6 million (Pearl Meyer & Partners, 2000). In 1999 this figure rose to $ 9.4 million. This compared to $ 1.6 million in the U. K. and less than $ 1 million in the major Continental economies of France and Germany (Ernst & Young, 1999).

While many argue that the prevalence of stock options in the United States and their relative absence elsewhere is one of the main reasons for superior U. S. economic performance, the dimension of the shift in rewards begs the question of whether so much money is really needed to motivate managers. If CEOs earned only $ 4 million per year, would economic performance really suffer? Many people exercise positions of great responsibility and do so very effectively at rates of remuneration far below the princely sums doled out to corporate chieftains (McLaughlin, 1991). The logic of matching the pay rates of competing companies also ratchets up the compensation of all executives in a category. Are most executives really so mobile that they can switch jobs to earn more? It is more likely that the pay engine simply takes on a life of its own, generating higher and higher rewards as companies benchmark each others compensation plans and the markets reflect strong overall economic performance more than superior individual achievement. While some have applied the free agent model to the market for executive talent, only a few senior corporate managers have the proven money making power of top athletes or movie stars. They are employees who function only within the confines of a corporate structure and whose performance is hard to measure apart from the performance of their entire organization. It is true that money is a motivator, but does the motivating instrument really have such a close relationship to performance?

It is also clear that putting into practice the lessons of Agency Theory has allowed executive to participate in the fruits of a market boom, but has only partially achieved the objective of aligning the interests of owners and managers. The aim of stock options is to turn employee managers into entrepreneurs by increasing their exposure to the undiversified risk of firm's shares so that there is personal hardship just as there is for the entrepreneur when the firm's share price falls. But the prevalence of stock repurchase, the use of option repricing, and the fact that options do not represent actual costs of ownership all tend to loosen the ties that bind a manager to the firm's fortunes.

The explosion of executive wealth also poses questions about economic justice within the firm as rewards accrue to a tiny elite at the top. One response is to spread options to lower levels of the organization. A Watson Wyatt study found the use of widely-distributed option increasing -- 19% of all employees were eligible for options in 1999, up from 12% in 1998 (Watson Wyatt & Company, 1999). But here the links between incentive and performance can become hopelessly blurred. Many employees excel while option values decline and do a bad job as they rise. Such randomness is demotivating. To succeed, a company requires a sense of shared commitment among its workers. Moreover, the real payoff from application of Agency Theory is that recognized by Michael Milken a decade and a half ago. Shareholder value may require that the firm take hard decisions to restructure, downsize, and close operations in the name of economic efficiency or strategic coherence. Executives earn the payoff from these maneuvers, while many rank and file employees suffer. Even the gain on their stock options is usually a poor recompense for loss of a job with accompanying seniority and benefits. As long as the economy booms, these tensions will probably lie well below the surface of economic life. But if the economy or the stock market dips significantly, pay inequity will become a real concern. This may be the right time to bring reason and proportion to the issue of executive compensation by applying Agency Theory with reference to other variables than the rising price of company stock.

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John W. Rogers, Jr. Assistant Professor of Management American International College Springfield, MA 01109