Why Do So Many CEO Compensation and Employment Contracts Go So Wrong?
Originally published October 2014
Michael Graham examines the challenge of creating a responsible value exchange strategy to attract and retain the right CEO to head a business, while at the same time ensuring this is compatible with the over-all objectives and business strategy of the company.
The controversy that surrounds executive pay and employment contracts which was criticized most vividly in the press starting in the early years of this century carries on. To this day it is nearly impossible to pick up a newspaper or fan through a business magazine without reading about how excessively business leaders are paid. October is upon us and Boards are turning to the annual ritual of reviewing the organization’s performance and setting the CEO’s pay along with that of other key executives. These efforts will no doubt become material for the 24 hour news cycle in February and March when proxy reviews will focus on finding the most egregious examples of corporate excess.
Boards may feel their compensation decision for executives are fair, but the media and public will no doubt remain outraged at many seven and eight figure compensation packages (especially if corporate performance is less than stellar). In my forty years of experience negotiating executive and CEO compensation programs and employment contracts let me offer some suggestions on a better approach to this process that includes the important consideration of who should participate.
The Business Case
Frankly, we agree what most organizations are doing today in the area of CEO and executive compensation isn’t working all that well. But regardless of all the hype, the “problem” of excess pay is limited to a small number of companies. However, due mostly to media frenzy, Americans (who are not CEOs) now believe that CEOs are overpaid. Do we think that CEO pay and employment contracts are properly set at most companies? Honestly, no, we don’t. We think in many instances, companies, shareholders and other stakeholders and even in some cases the CEOs themselves, are underserved by these programs.
But here is the truth: if you get all your information about CEO pay from the newspapers and cable news you too are underserved! In these venues, the excesses get covered excessively. We don’t hear about the instances, and they exist, where the poor performance of the organization has resulted in substantial reductions to the chief executive officer’s pay. Although it shouldn’t be this way, cutting a CEO’s pay in many cases can severely undercut his authority and effectiveness. What CEO pay cuts should signal is that the CEO is accountable for results, and when results are down, so too should be the CEO’s pay.
In the last 10 years, since 2002 with Sarbanes Oxley, Boards are charged with not only the responsibility of setting CEO (and other executive) pay with but the requirement to more completely disclose the entire “value exchange” between the organization and the CEO. And even further, since “say on pay” was passed, they must obtain shareholders nonbinding approval for the pay and key aspects of the employment contract. Boards and CEOs of publicly traded companies have become more robust in their deliberations.
With the public outcry regarding CEO pay, key stakeholders are being asked, and asking themselves some pretty direct questions designed to get to the heart of the matter. Are these high-level rewards doing what they are supposed to, motivating executives to perform in a way that best benefits the organization and its stakeholders? Or have these hefty pay packages had the opposite effect, encouraging the executive to make decisions based on greed and self-interest?
The Challenge for Boards
CEOs of most firms represent an investment. Under normal circumstances this type of investment should provide a significant return in the form of a high performing organization that sustains itself over a long period of time. (The fact is our research shows that the return on a top decile performing employee is over 300% greater than an average employee in knowledge based positions.) However the successful investment in a CEO has proven to be a challenging task that has been disrupted by many other factors:
1. Extreme competition in the marketplace for this level of priceless talent, talent that can make or break the “Corporate Ship of State”. This sense of business desperation can lead to overcompensation scenarios, which can continue to escalate.
2. The inability of the Board to link significant performance metrics to CEO compensation, thus giving the CEO a free ride to high compensation, no matter how he or she performs.
3. The over-cozy relationship between the CEO and the Board of Directors. Sometimes this can be for financial, as well as personal reasons.
4. The CEO is often a determining factor in nominating and selecting the members of the Compensation Committee (and the Board). This can be problematic in developing rewards and contracts that protect the company’s interests.
5. Conflicted outside advisors such as the legal counsel or the compensation consultant or other key advisors can ruin the objectivity required for the best results.
6. The short-term lifespan of a CEO in today’s companies: today, the CEO (like many others in his organization) has limited job security.
7. The corporate culture, which, in raising compensation levels of the CEO and other executives has created a class of corporate citizen somewhat isolated from rank and file employees. The goals of this “ruling class” are often based on maintaining the security and profitability of their own position, rather than the good of the company.
8. CEO greed and power tripping which if unchecked can lead to epic problems (think Enron and Tyco).
So the challenge is how can a responsible value exchange strategy be created to capture the right CEO to head a business and, at the same time, be compatible with the over-all objectives and business strategy of the company?
First – Consider the Larger Context
In order for your CEO employment contract and total rewards strategy to be successful, it must align with all of the organization’s unique environmental factors; key stakeholder issues; vision, mission, and values; and business and people strategies.
Every organization is unique, and has its own industry environment, key stakeholders, business strategy, organizational capabilities, and people strategies. We believe success in meeting the challenge starts with the realization that each organization should have its own unique CEO employment relationship consisting of a reward strategy, linked closely to these areas and an employment agreement respectful of the organizations needs but also its values. Organizations who don’t understand these when designing their employment relationships—or worse, companies that ignore these areas completely—end up with employment relationships that don’t attract, motivate, and retain, but rather confuse, irritate, and sometimes even damage the reputation or cause the bankruptcy of the organization.
And not only should the employment contract align with the organization, it should communicate the need for the CEO to embrace the organization’s unique culture, and, especially its mission, vision, values and beliefs (MVVB). Essentially the CEO value exchange needs to “fit in” or it could contribute to his failure and the failure of the organization. With many CEOs recruited from the outside, it is no wonder that the Harvard Business review found that “…two out of five chief executives fail in their first 18 months on the job”. On the other hand, if the organization is not performing well, it is appropriate for the contract and the compensation not to “fit in”, in fact it probably ought to “rock the boat”.
The value exchange needs to focus not only on financial values but on how and if the CEO measures up to the company’s ideals.
Second – the Architecture
When we talk about evaluating or building the “value exchange” between the CEO and the organization we refer to the complete relationship which consists of both the employment agreement and the reward strategy and refer to this as the architecture.
When determining the CEOs “value exchange” (or employment agreement and total reward program) first carefully examine the goals and needs of the company, than structure the CEO’s package in a way that motivates him to see those goals to fruition and provides appropriate protection when unforeseen events occur. The key is to take the information you have and use it in a way that aligns the successes of the company to the successes of the CEO. A good CEO value exchange strategy answers the CEO’s main questions, which is, “What’s in it for me?” But it doesn’t stop there. It then goes on—in no uncertain terms—to demonstrate to the CEO how this connection is made.
Of course, the real skill lies in demonstrating the connection. How do you do this? The key lies in four strategic axes—money, mix, messages and management. Let’s look at the dimensions of this “architecture”.
The Four M’s of Architecture
Money. This axis, often referred to as Market Attachment, is defined as the level of competitiveness, as compared to the marketplace, of the overall program and the reward levels and contract provisions a CEO enjoys.
Mix. This axis determines how the CEOs program of contracts and rewards are distributed among reward components such as base salary, short-term incentives, mid-term incentives, long-term incentives, perquisites, and benefits and even how the contract provisions are developed. This is the land of tradeoffs. For instance, should there be more fixed base salary and less short-term variable incentive, or more long-term stock? Should there be more protection in the form of severance for a “change of control” or a termination “not for cause”? These tradeoffs need to be an active decisions, not passive results.
Messages. This axis reinforces the business goals and aligns the rewards plan with the CEO’s efforts and more importantly the organization’s results. Messages either in the reward plan or the employment agreement tell the CEO what to accomplish. These messages represent the “philosophy” behind a total rewards program.
Management. This axis determines the responsibilities for administering, interpreting and making the necessary changes when the program needs modification. Also this architectural axis fulfills the obligations to the shareholders if the company is publicly traded.
Many boards, compensation consultants, and CEOs become fixated on how much money the CEO is making but forget mix, messages, and management. Although focus on the actual amount is not without merit, its importance is insignificant when compared to the importance in determining the make-up of the actual reward components and the contract provisions. Efforts in considering the mix between short-term, mid-term, and long-term incentives, and even more importantly, when or what “pay for performance messages” should be incorporated into the various reward components, are the actual engines that drive CEO performance on the job. They incentivize the game. They make things happen.
After the overall CEO value exchange architecture has been properly identified, the next stage is to address the individual CEO reward components (base salary, short-term incentives, mid-term incentives, long-term incentives, wealth accumulation, executive benefits, perquisites, and developmental rewards) and the various contract provisions. Generally, if the architecture is correct, its components will be well designed.
Why Are So Few Successful? We believe that few organizations have an effective employment relationship for one or all of the following reasons: 1) participants in the process are conflicted, 2) participants do not have the necessary information or knowledge, 3) the process is not linear, and 4) the negotiation process is flawed. Let’s look at these challenges:
Participants and their Issues:
1) Chairman of the Board of Directors – who may have reputational concerns reflecting on his or her chairmanship if he doesn’t recruit and retain a CEO with appropriate status and qualifications.
2) The Board of Directors – who may have membership concerns given that the CEO often can reshape the Board over a five year period.
3) The Chairman of the Compensation Committee – who will answer to the entire Board of Directors if he fails to develop a compensation plan that recruits and retains the CEO which the Board has selected.
4) The Compensation Committee – all of whom have their own favorite approaches to the design of CEO compensation that worked “where they came from” or what they were told was a “best practice”.
5) The CEO – whose own program creates a reference point that makes all the sense to him, but may not fully support the organization’s objectives and culture.
6) Head of Human Resources – who often can’t see further than a need to obtain his boss’s favor.
7) The Chief Legal Counsel – similar to the Head of Human Resources but in addition to fearing the effects of not catering to his boss has the responsibility of negotiating an employment contract.
1) Recruiters – in the case of a new CEO search, their financial interests are tied to the successful completion of the search and the level of the first year’s compensation which determines their firm’s commission.
2) Auditors – who have their audit fees in jeopardy on an annual basis should they misinterpret the potential range of financial outcomes or model the exposure in a way that suggests it is inappropriate.
3) Lawyers – typically similar to the above two groups of outside advisors, the lawyers for the firm have ongoing fees and future additional legal advisory opportunities at risk.
4) Actuaries – well who knows what they think since we never understand what they are saying anyway.
5) Compensation Consultants – may be more concerned that they protect other service revenues for their firms by securing high pay for the CEO
Now we aren’t saying that every participant actually has these issues, but it is not unusual for us to encounter these issues when working with the various participants.
Information vs Assumptions
Most of the participants don’t have access to information and an integrated set of tools that can develop answers sufficient to make decisions necessary on the complex issues associated with the CEO compensation and contracts. Decision points include the right comparator organizations, the marketplace for the CEO, the most appropriate reward components, contract duration, the most effective ways to designate competitors for the non-compete, and hundreds of additional factors. Where information and tools are absent, decisions are dangerously based on assumptions.
The Process Isn’t Linear
The third significant reason why the value exchange is difficult to “get right” is that by its nature the process of negotiating a fair and reasonable value exchange between the CEO and the organization is not linear. Often we can attain agreements on key aspects of the reward program that fall apart when key provisions of the employment agreement change the outcomes for the CEO. I’ve never seen a single negotiations follow exactly the process that was laid out in the beginning of the effort.
The Negotiating Process is Flawed
Too often the negotiating team is not up to the challenge because their expertise does not cover all of the needed areas. This process demands a fully effective team including experts in financial analysis, accounting, actuarial, employment contracts, leadership assessment, recruiting and compensation. Team members should have many years of experience, but even more important they must bring no conflicts of interest, and understand that they are working for the shareholders.
But even with a team of experts, the process of negotiating a contract can be challenging. Sometimes the CEO’s motivation and values are not fully aligned with the business. Usually this lack of alignment is due to fundamental differences between the CEO’s personal values and the corporate vision and mission. On the other hand, problems can stem from the team’s failure to take a holistic view of the value exchange. Participants must focus on the big picture rather than on their individual issues and interests (like those we discussed earlier).
A Principled Approach
We believe that it is important to provide an integrated team with holistic solutions, founded on principles, and one that utilizes tools, information and procedures which can provide transparency and logic to a process that is too often mired in self-interest, assumptions, and misunderstanding.
We also believe that not only is the process important but the participants and their qualifications are critical. The individuals that should be integrated into a constructive process are at least the following: a) recruiters, b) accountants, c) lawyers, d) actuaries, e) psychologists and f) compensation consultants. All of the individuals should be working together and have a single goal: to develop a value exchange that motivates and appropriately compensates the CEO to deliver value to the shareholders, as the Board should demand. As you can see, there’s a lot to consider, much of which leads to lengthy discussions on not only what the CEO can do for the company, but what the company can do for the CEO.
Michael Dennis Graham can be reached at Michael.firstname.lastname@example.org