Money Matters

Why Elon Musk’s Compensation Plan Wouldn’t Work for Most Executives

(Source: hbr.org)

The structure of Elon Musk’s new contract is actually not too different from other executives’. Effectively, Musk is being given the standard package of performance-vesting equity. Now, even though the structure is familiar, the numbers really are radical — because Tesla is radical, in terms of its potential future value. And this part of the plan is good practice: It’s tailored to Tesla. Yet Musk’s new scheme is far from perfect. Just like performance-vesting equity in general, it may lead to unintended consequences. So, what’s the alternative? Typically, it’s simple time-based vesting, where the executive receives a fixed number of shares at the end of a specified time period (say, 10 years), regardless of performance.

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Mel Svenson/Getty Images

Elon Musk’s new pay package has attracted almost as much divided opinion as Elon Musk himself. Advocates have claimed that it is “radical” and “bold,” praise often used to describe Tesla. Others argue that it is a publicity stunt. But, as with most things, the reality is likely in between these extremes.

The structure of Musk’s contract is actually not too different from other executives’. Effectively, Musk is being given the standard package of performance-vesting equity. He is awarded shares in his own company, where the number of shares that he receives (that “vest”) depends on whether he hits certain performance targets for Tesla’s market value, revenues, and profits.

Now, even though the structure is familiar, the numbers really are radical, in terms of both the targets themselves and the payout upon hitting the targets. Tesla’s market value must exceed $100 billion by 2028, otherwise Musk receives nothing, with further targets at $150 billion, $200 billion, and so on up to $650 billion. If he achieves all milestones, Musk can receive shares worth as much as $55 billion.

But the numbers are only radical because Tesla is radical, in terms of its potential future value. And this part of the plan is good practice: it’s tailored to Tesla. While some regulators and investors advocate “one-size-fits-all” schemes, such as the requirement that CEO-to-worker pay ratio not exceed a certain level, pay packages should be tailored to the company in question. Since Tesla’s potential value is substantial, it makes sense for Musk to be given very high targets. And, while $55 billion for a CEO would be egregious in any but the very largest companies and come at the expense of shareholders and other stakeholders, here it will only occur if Tesla becomes a $650 billion company. If so, Musk will have grown the pie tremendously, creating a standout enterprise that makes electric cars available to the masses and provides thousands of jobs, and his slice of the pie — just like customers’ and workers’ — will have grown. In short, by being given long-term shares, Musk will think and act like a long-term owner.

Yet Musk’s new scheme is far from perfect. Just like performance-vesting equity in general, it may lead to unintended consequences. In particular, having discrete targets may encourage manipulation to achieve the targets — as prior research has shown. The shareholder and societal value that Tesla creates is little different if the firm is worth $201 billion in 2028 than if it is worth $199 billion. But Musk’s pay is far higher in the first case. So, as 2028 rolls around, if Tesla’s market value is just below $200 billion, Musk will have incentives to cut investment or engage in earnings management to get it just above.

So, what’s the alternative? Typically, it’s simple time-based vesting, where the executive receives a fixed number of shares at the end of a pre-specified time period (say, ten years), regardless of performance. Critics argue that this decouples pay from performance, and so some proxy agencies automatically vote against equity packages without explicit performance conditions. But the value of an executive’s shares already automatically depend on performance. The higher the stock price in 2028, the more these shares are worth – even if the actual number of shares is fixed.

Indeed, the Norwegian Sovereign Wealth Fund and the UK House of Commons have both advocated moving away from performance targets in favor of straight equity. This is a much simpler scheme — no targets need to be set, avoiding the problem of what measures to reward (revenues, profits, market value or something else), how to weight the different measures, and what thresholds to set (is $100 billion too easy or too stretching?) And evidence shows that the long-term stock price is a pretty comprehensive measure of performance: it takes into account not just quarterly earnings, but innovation, employee satisfaction, brand value, and even to some extent environmental performance. It is also more transparent — stakeholders know what Musk is being paid on the basis of. Of course, if targets are removed, the executive should be given substantially fewer shares, to offset the fact that the number of shares (although not their value) is now guaranteed.

In fact, the more radical elements of Musk’s new compensation structure share elements with time-based vesting. The milestones are based on Tesla’s 2028 market value, whereas typical targets are based on performance three years out. Coupled with the fact that Musk must stay with Tesla until 2028 to receive his shares, this encourages him to take at least a ten-year horizon. Moreover, even if he achieves his milestones and his equity vests, he must hold onto it for at least five more years before he can sell it. This should dissuade a practice documented by prior research, that executives cut investment just as their equity is about to vest.

What should other companies take away Musk’s new scheme? Giving long-term equity is a simple way to get executives to act like long-term owners, and ensures they only get paid if they create long-term value. Complicating it with multiple performance targets may backfire by encouraging manipulation to achieve the targets. In innovation, the most powerful ideas are often the simplest ones. The same is true for executive pay.

More Info: hbr.org

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