If you believe traditional stock options align management’s interests with those of shareholders, then CFOs increasingly are on the same page as their ultimate paymasters.
So finds the biennial CFO Compensation Survey, undertaken by the consulting firm of Towers Perrin.According to the survey of 630 companies (a significant majority of which have at least $500 million in sales), fully 53 percent — or $600,000 — of their CFOs’median total compensation in 1999 came in the form of long-term incentives, primarily stock options. The proportion of total pay represented by long-term compensation is up from 39 percent in 1995, according to Towers Perrin. All told, the survey shows that CFOs’ median total pay last year was $1,124,400, almost double the $649,730 they received four years earlier. Of the total last year, roughly $344,900 was cash and $201,200 was bonus money.
As a result of this growing reliance on stock options, of course, the personal fortunes of finance executives are now increasingly tied to the vagaries of the equity marketplace. “Top management pay in the U.S. is, in effect, decided mainly by the stock market, not by the compensation committee or by the company’s performance against internally set goals,” observes Richard Ericson, a consultant in the Minneapolis office of Towers Perrin.
The reason is clear enough. With the bull market producing spectacular stock- price gains for high-tech companies, and with the boom in Internet start-ups boosting demand for managerial talent, options are increasingly seen as the easiest way to attract, motivate, and retain key employees. No less clear is the result, at least in personal terms, for the CFOs who made the list of the 25 highest-paid traditional-economy finance executives, among companies with at least $1 billion in revenues. The No. 1 earner on the list, James H. Hance Jr., of Bank of America Corp., for instance, received a whopping $26.8 million in options last year. The second most highly paid CFO, Lehman Brothers Holdings Inc.’s John Cecil, also did well by options, winning a grant worth $10.8 million. That’s based on the value of those options at the time they were granted, using the Black-Scholes option pricing model.
Of course, linking pay to stock prices can eviscerate wealth as rapidly as it can produce it. Witness the carnage inflicted by the technology sector’s recent nosedive. Yahoo Inc.’s soon-to-retire Gary Valenzuela, for example, was holding options worth more than $1.6 billion at the peak of Yahoo’s stock on January 3. Their value had been cut in half by the time this issue went to press, even after he took 75,000 off the table. Warren Jenson of Amazon.com Inc. has also experienced a market-driven meltdown in net worth. His options’ market value has fallen from $85 million at Amazon’s peak last December 10 to around $43 million on May 1.
Even so, most recipients defend the use of options on the grounds that they instill a greater incentive to maximize shareholder value than does cash compensation. But critics contend that while options reward management and shareholders alike when stock prices rise, the risk is borne exclusively by the latter, because shareholders alone experience actual losses if the price of the underlying stock falls and the options expire worthless. And that risk, though not apparent in income statements, is growing apace, thus threatening to undermine the very value that options are supposed to help create.
That has left some CFOs scratching their heads. Just how far should a company go with option grants? “It’s a question we’ve discussed here” without being able to answer definitively, admits Mike Van Handel, CFO of Manpower Inc., a $12 billion (in sales) supplier of staffing services, based in Milwaukee. “While our goal is to be competitive in the marketplace,” Van Handel explains, “from an overall corporate standpoint, [option grants] really are a hidden cost.”
In response, a few companies have altered their approach to long-term incentives. American Home Products, Boeing, John Deere, Hewlett-Packard, and Super Valu, for example, have linked the vesting of restricted stock grants — those of stock that cannot be sold for a specified period — to specific performance targets. But their use of restricted stock is much more limited than their stock option grants, and those remain only loosely linked to performance.
Among major publicly traded companies, in fact, only Broomfield, Colorado-based Level 3 Communications has actually tied option grants to performance — taking the radical step of adopting indexed options, which link grants to the degree to which the company’s stock price outperforms the S&P 500 index. Level 3 is likely to remain a minority of one when it comes to options, however, unless its program succeeds in motivating and retaining top talent. Otherwise, the vast majority of firms are likely to stick to traditional grants, if only out of fear that they cannot otherwise compete for talent. “There is a tidal wave of great ideas, but a limited number of people available to execute them,” says Larry Best, CFO of Boston Scientific Corp., a $2.8 billion medical-device maker based in Natick, Massachusetts.
Certainly the current trend has created an unparalleled pay environment for CFOs. How long it will last, of course, is anyone’s guess. But as long as compensation costs themselves don’t threaten stock prices, and options continue to be the favored recruitment vehicle, shareholders are unlikely to complain. “Everybody’s fine with [the trend] as long as [the market] goes up,” says David Leach, national director of compensation consulting for Buck Consultants, in New York.
The use of stock options has been rising along with stock prices since the early 1990s, but has widened beyond top management during the past few years, thanks largely to the New Economy. And not surprisingly, Internet CFOs get the highest proportion of their pay — 73 percent — in the form of options and other long-term incentives. Yet the survey also found that Internet CFOs weren’t the highest-paid finance executives. On the contrary, on average, finance chiefs in more-traditional industries, such as pharmaceuticals, all took home bigger paychecks.
What explains the discrepancy? At this point at least, CFOs within the Old Economy exercise responsibility over a far greater amount of capital than do Internet CFOs. “The scope of [the former's] responsibilities is much greater than those of an Internet CFO,” notes James Knight, a partner at SCA Consulting, a management consultancy in Chicago. And though much more of the New Economy’s assets may be intellectual, finance executives still aren’t paid as much to manage intangibles. Of course, there are some glaring exceptions to this rule, as reflected in our list of the 10 most highly paid New Economy CFOs.
In any case, the use of options isn’t limited to CFOs in the New Economy or the Old. The Towers Perrin survey indicates that companies are using options to reward divisional CFOs as well as corporate finance chiefs. While receiving an average of $306,900 in salary and bonus, group-level CFOs, for instance, earned an average of $243,900 in options and other long-term incentives last year. In fact, the pattern holds throughout the hierarchy of corporate finance. Corporate-level treasurers earned an average of $245,700 in the form of options and other long-term incentives. Group-level treasurers got an average of $80,000 in this fashion. Group-level controllers earned even more — an average of $114,000 via long-term incentives.
But is the trend toward options ultimately a good thing? Despite the widespread use of options, a growing body of evidence suggests they may end up killing the golden goose. A study by Wm. Gerard Sanders, a professor of strategy at The Marriott School of Brigham Young University, is only the latest to find that options encourage managers to make acquisitions.
To some degree, this reflects the fact that traditional options are not truly linked to operating-performance targets or even superior stock performance. In virtually all cases, executives who deliver less shareholder value than their peers or the overall market are nevertheless handsomely rewarded. And while their options’ value requires the stock’s price to go up, that may not take much.
Consider again the top earner on our top 25 list, James Hance of Bank of America. He was awarded $49.2 million in long-term incentives, half in stock options, even though the company’s stock lagged the overall market last year by 35 percentage points, as well as those of other large banks by 3 percentage points. Investors in Bank of America were disappointed by the effect of the Federal Reserve’s interest rate hikes, as well as with poorer-than-expected results from the bank’s 1998 merger with NationsBank. A company spokesperson explains that Bank of America outperformed its peers in 1998 and wanted Hance “to stay with the company for the next number of years.” The spokesperson adds that such incentives are “an accepted way” of retaining executives.
Worse still, compensation policies at many companies have allowed options that are out of the money to be repriced downward, so executives who fail to deliver shareholder value ended up being rewarded anyway. Repricings will no doubt dwindle in the wake of a recent ruling by the Financial Accounting Standards Board that requires companies to take a charge to earnings for such actions. Witness Microsoft Corp.’s move to double the number of options granted to its employees in the wake of the stock’s recent sharp decline. Instead of repricing options that are now underwater, the company chose to issue new, lower-priced ones.
A Mere Detail?
But even options that aren’t repriced represent an expense to shareholders, though it isn’t fully reflected on corporate income statements. That’s because the expense associated with the traditional grants needn’t be included in income statements, but merely footnoted. As a result, companies that depend heavily on option grants report inflated earnings growth. A recent study by the Federal Reserve Board estimates the inflation to amount to roughly 1.5 percent annually. And while investors may not notice or care in the short run, they eventually will, or studies suggesting that the market is efficient are mistaken.
In fact, there is evidence to indicate that investors do care about the cost of stock options, at least insofar as the grants dilute their earnings. That dilution is reflected in the difference between basic earnings per share and diluted EPS on the income statement. And a study of market data from 1989 to 1995 published in the November/December 1997 issue of the Financial Analysts Journal found significantly greater correlation of stock prices to diluted earnings than to undiluted.
While most companies buy back enough shares in the open market to soak up the dilution, that same study by the Federal Reserve Board suggests that that will become increasingly difficult to do. The study found that the average company now spends about 40 percent of its net income mitigating dilution from option grants, which, together with dividend payments, leaves only about 20 percent of earnings to reinvest in the business.
To understand why pay for performance occurs so rarely, one must go back to the early 1990s battle over the accounting treatment of options. Companies fought FASB tooth and nail over requiring their expense to be recorded on income statements, and the companies won. But the result has been two different accounting treatments — footnote disclosure for traditional options, income statement disclosure for performance-based options.
More precisely, the value of options that depend on some measure of performance must be charged as an expense against earnings, unless those options vest within 10 years.
To be sure, anecdotal evidence suggests a growing number of Old Economy companies are moving away from stock options to restricted stock, which must be expensed on the income statement. But that isn’t necessarily done to link their incentives more closely to performance. Instead, such companies, ranging from BoA and Goldman, Sachs to Philip Morris and UAL Corp., are looking for another means to motivate and retain managers who might otherwise be tempted to jump to Internet start-ups. While restricted stock grants are no less dilutive than options, these grants, unlike those of options, retain value even if the price of the shares remains below the options’ strike price.
More than a few of last year’s 25 most highly paid traditional-economy CFOs, in fact, got there by dint of restricted stock. Here again, Bank of America’s Hance is a prime example: almost 43 percent — $22.4 million to be exact — of his $51.7 million in total pay materialized as restricted stock. And he was far from the only case. Restricted stock accounted for anywhere from 23 percent to 46 percent of total 1999 pay for the next four biggest earners — Cecil of Lehman Brothers; David Viniar of Goldman, Sachs; Peter Hancock of J.P. Morgan; and Robert Wayman of Hewlett-Packard — each of whom got awards of at least $2.7 million. But only in Wayman’s case does vesting depend on explicit performance objectives.
Of course, the dual accounting problem applies only to publicly held companies. For that reason, privately held Carlson Cos., a marketing, hospitality, and travel company based in Minneapolis, has no aversion to incentive plans based purely on performance. Carlson links long-term as well as short-term compensation to operating profits in excess of its cost of capital, because that “creates the best correlated connection between our shareholders’ and executives’ interests,” insists CFO Martyn Redgrave.
While Carlson has only one major shareholder — the family of deceased founder Curt Carlson — Redgrave contends that makes little difference. And he insists that managers who claim to have shareholders’ interests at heart thanks to the use of traditional options are misleading those shareholders. Honesty, Redgrave says, would require such managers to admit that their compensation is “as dependent on things I don’t control as things I do, such as market fluctuations that are not tied to performance.”
Granted, many other companies offer options that vest more rapidly if some measure of performance is met. But these typically vest within 10 years anyway, no matter how managers perform, which keeps the cost off the companies’ books. Consequently, Redgrave says, such programs create “artificial value.” His reasoning: “If I own 100 percent of a company, give away 10 percent, then claim it doesn’t matter because it’s a noncash charge, that’s problematic.” When, moreover, the value of such grants escalates along with stock prices, and that is used as a justification to provide still more, as has been the pattern in recent years, the system, says Redgrave, amounts to a “pyramid scheme.”
Leveling the Playing Field
So why has Level 3 bucked the trend? “We took the view that this plan is right for the company and its shareholders,” says CFO Doug Bradbury. Of course, the accounting treatment is less of an issue for Level 3 because it doesn’t have any earnings at the moment. And while the charge for indexed options deepens its losses, the stock currently trades on cash flow. What happens when Level 3 moves into the black? Bradbury says he’ll “spend time talking [to investors] about it if we have to.”
While no other public company seems prepared to do that, others have at least taken the same step as Hewlett-Packard with regard to restricted stock. Senior managers at Boeing Co., for example, won’t get at least a portion of their restricted stock unless their company’s stock price meets minimum standards. And American Home Products, Fort James, John Deere, and Super Valu have gone even further, linking their restricted stock grants to operating performance goals. But because of the hit to earnings that any restricted stock grant produces, it is unlikely to replace options as a long-term incentive for anyone but the most-senior executives.
That, of course, assumes the stock market keeps rising. If not, the focus on traditional options will surely diminish. In fact, if enough employees begin jumping ship merely because their net worth has grown volatile, companies may even begin to embrace indexed options. Nasdaq’s volatility “has pinched people in terms of their expectations,” says G. Mead Wyman, CFO of Mercury Computer Systems Inc., in Chelmsford, Massachusetts. “In that environment, indexed options may seem more appropriate.”
The ultimate question, however, is whether the use of options might actually prevent the market from moving higher. That depends, of course, on whether companies can continue to fund stock repurchases to mitigate dilution — and if they can do it without adversely affecting their cash flow. Here, however, the issue becomes chicken-and-egg-like. Many high-tech companies point to the effect on cash flow as the basis for their view that the benefits of expenditures on options are worth the cost. Since the grants are necessary to retain the employees that produce the cash flow, the companies argue, the money effectively underwrites enough growth to more than offset any dilution that isn’t soaked up by share repurchases. The issue, as Manpower’s Van Handel puts it, is, “Can we get value for that?”.
And a challenge may soon become more acute, according to a study of repurchase practices by the Federal Reserve. It suggests that when companies have to buy back increasingly high-priced stock to offset the dilution, they may be hard-pressed to grow their cash flow sufficiently to fund further grants. “It seems unlikely that the total payout rate [net outlays for grants and buybacks] can increase much further,” says the study, “absent a sizable increase in debt or a cutback in investment and, presumably, future growth.”
For companies whose primary asset is people, then, there may be no essential difference between operating results and stock performance. So in their case at least, options linked only to the latter may make just as much sense as those linked to operating goals, assuming the grants don’t vest within 10 years no matter what. And until cash flow suffers, grants only loosely linked to performance are unlikely to spark a shareholder revolt at those companies or others, and may simply be too lucrative for management to resist.
Even as harsh a critic as Martyn Redgrave failed to do so when he worked at publicly traded PepsiCo for 14 years prior to joining Carlson. Back then, he freely admits, “I wanted as many stock options as I could get.”
Ronald Fink is a senior editor of CFO.
With annual bonuses tied to budgets, more than two out of three corporate managers have an incentive to sandbag performance targets. Or so one would conclude from a Towers Perrin survey.
Under this arrangement, managers at the beginning of a year all too often argue that their targets should be lowered because of tough business conditions, when in fact conditions are better than projected. If their arguments are successful, they can easily surpass the targets. And with those budget goals typically expressed in terms of earnings per share, managers nearing year’s end are also encouraged to find noncash items to make their numbers look even better.
But because this approach to short-term objectives often results in subpar operating performance, some public companies are shifting gears. Among the latest is Vectren Corp., an Indiana energy company recently created from the merger of two smaller utilities in the state. For starters, its incentives are tied to ROA and Ebitda targets instead of EPS, so its managers will find it more difficult to pad their results. And by setting their objectives well below actual budgets, the company offers managers no incentive to sandbag projections.
Given Vectren’s budgeted projections, aren’t its performance targets too easy? On the contrary, says CFO Jerry Benkert. Not only are they above industry benchmarks, but they are also precisely what’s required to make Vectren’s publicly stated objective for annual earnings growth. What’s more, the size of the actual bonuses is tied to the amount by which they exceed their targets. “That’s the beauty of it,” says Benkert. “We think the plan you’re following should get you to the answer you want.”
But the Towers Perrin data suggests that most other companies are in danger of getting just the opposite. —R.F.