Maybe some executives are overpaid. The good ones, however, are not. In fact, a good case can be made that many of them are underpaid.
Executive pay gets a bum rap. Looking at a total compensation number without context, it’s easy to understand why. Examine the real magnitude of what high-performing top executives actually do, though, and they morph into one of the best bargains around.
Politics and optics sometimes confound the situation. Don’t get so wrapped up in multiples of lower-paid employees (i.e., the CEO pay ratio; has there ever been a dumber metric?) and other unrelated formulas.
Top executives are heavily “leveraged.” Just as a highly leveraged financial transaction uses a low amount of equity and a high amount of debt, top executives can expend a low amount of effort to get huge results. For example, a CFO may spend 20 hours and send a couple dozen emails to negotiate a debt refinancing that saves the company 100 basis points or more.
There are all kinds of ways that small positive movements can make astronomical differences in shareholder returns, jobs, and long-term value, which are reflected by their compensation. If the compensation package is structured correctly, the executive is paid from a bucket of cash not otherwise available. Some examples from my client companies:
- A manufacturing operations executive empowered an hourly workforce, creating higher levels of employee satisfaction while reducing finished product costs by almost $0.11 per pound. At a production rate of 16.5 million pounds annually, that’s almost $2 million per year, excluding the indirect savings via a more engaged workforce.
- A $650 million client company altered a key part of its business model, increasing the need for more growth investment and decreasing the emphasis on simple cost control. The CFO pivoted instantlyfreeing up cash and capital to fund the new initiatives without going to external sources of money. The initiatives dropped almost $4 million to EBITDA in the first year, with no added costs.
- An HR executive for an upstream energy company restructured health-care benefits to more closely match employee needs and utilization, saving over $1.5M in direct annual costs and increasing employee satisfaction with the new plan’s structure.
These are simple, real examples of value provided by executives. The organizations needed the value-add at a specific time. What was that worth?
Realize that most stakeholders would object less to executive compensation if we could throttle back on the Lake Wobegon effect. Not all top executives are 75th-percentile performers simply because of their business cards. But most senior executives are at least satisfactory, as truly underperforming CXOs tend to get whacked in short order.
That line of thinking matters, since the results of compensation surveys show the same percentile continuum (usually, the 25th, 50th, and 75th percentiles) for CEOs as they do for auto mechanics. In reality, though, the lower end of that continuum seldom applies to incumbent executives.
Market-based surveys misleadingly show executive pay ranges based on other survey participants, rather than actual performance. For instance, one prominent survey shows total compensation for the CFO of a $1 billion energy company as ranging from $360,000 to $1.1 million. But the differentiation along that range should be based on the CFOs’ value contribution to their specific organizations, not some perceived comparison to other CFOs in the general market.
More unique value, more pay. The equation seems incredibly simple to me.
LeBron James made $77 million last year, but the Cleveland Cavaliers’ value as a franchise increased from $515 million in 2014 to $1.2 billion in 2016. Dwayne (The Rock) Johnson made over $65 million in 2016, but his films grossed more than $2 billion.
The message is clear: you should be paid for value created. Is an executive who delivered $2 million in first-year tangible value overpaid if he or she makes 50% more than an executive who successfully maintained the status quo? I don’t think so.
D. Kevin Berchelmann is CEO and founder of Triangle Performance, a Houston-based management consulting firm.