CEO Pay-How Should it Be Attached to Performance?

Over the last several years, there has been a lot of consternation about CEO pay.  Recently, it’s been shown the CEO’s of the big banks received 7.7% pay increases.  A lot of folks hate the big banks, and so any increase in pay is unsettling to them. Or, they see a big number and a wave of envy or jealousy seeps through them.

But, the C level execs in a company have the most material affect on success or failure of the firm.  That fact holds true for large publicly traded corporations, and it scales down to the startup firm just launching.  The media outlets reporting on CEO pay generally don’t understand the nuances of what a successful CEO does, or can mean to a company.

Academics have done quite a bit of research on CEO pay.  Professor Steve Kaplan has found that public company CEO’s are underpaid.   CEO pay peaked around the year 2000.  He has also identified some key characteristics of success for CEOs.  Former public company CEO Jeff Minch blogs about all kinds of things targeted toward CEOs.  The Musings of The Big Red Car is a good read for anyone running a company.  He has a C level employment series that is quite interesting.

University of Chicago Professor Michael Gibbs teaches a class in human resources.  It’s quantitative.  It takes the touchy feely concepts around organizations and organizational development to a mathematical and statistical level so objective decisions can be made easier.  One of the complaints of a lot of folks is that CEO pay isn’t tied to market performance.  As anyone who ever took Professor Gibbs class knows, it’s practically impossible to tie pay to stock market performance, even though the decisions of the C suite have a lot of effect on the share price.

The professor points out that trying to correlate CEO pay with stock returns is a doomed exercise because of the Efficient Market Hypothesis. The right way to do it is either to look at other metrics such as improvement in accounting earnings, or see how the market reacts to a change in CEO compensation package. Both methods tend to find that incentives appear to improve firm performance. Of course, firm performance is very noisy as there is a lot of uncontrollable risk, so one should not expect a large correlation.

For the startup, it’s not necessarily about the pay.  It’s about the equity.  CEO’s of startups generally make enough money to feed themselves.  I have seen a wide range of pay, and it’s very dependent on the negotiations between the people financing the company on the people running the company.  The key in startups is to make sure the CEO will have enough equity to give them incentive to create a blow out business.  Equity is their bite at the pay window.

In the lifecycle of a startup, the management team begins with 100% of the equity.  At exit, in general they own around 15-25% of the equity.  Of course, this depends on a lot of factors so it’s a pretty broad statement.  Once everyone starts thinking in those terms, corporate finance becomes a strategy for the firm.

Like everything in life, there is a marketplace for CEO’s.  There is a finite number of people that have the necessary skills to be a CEO.  That’s why their pay seems so high. Demand is high, and there isn’t enough supply.

Here is a video of Steve Kaplan speaking on CEO pay.  It’s 30 minutes, but has good information.

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