Rethinking Executive Compensation

By Cote, Marcel

For the past 30 years, to foster a better alignment of the interests of
senior management with those of shareholders, a large portion of their
variable compensation has been share-based, generally through stock
option plans. Roger Martin, dean of the University of Toronto's Rotman
School of Management, is now challenging this principle. According to
Martin, shares and options are not good incentives because they
encourage executives to rely on short-term strategies and to take
excessive risks. Performance- based compensation should be tied solely
to a company's actual results, i.e., profit or earnings before
interest, taxes, depreciation and amortization (EBITDA), and not to
what's happening in the stock market. Martin's proposal, introduced in
his new book, The Design of Business: Why Design Thinking is the Next
Competitive Advantage, is worthy of serious debate. He uses a football
analogy to illustrate his point. What would happen if a quarterback's
pay depended on the number of times the team beat bookmakers'
expectations - the spread they offer the betting public - and not on
the number of games won? If a quarterback beats the spread
systematically, bookmakers would increase it, anticipating actual
results and levelling the odds for bettors. In the long run, beating
the spread wouldn't work as a compensation system, and quarterbacks
would fail as often as they won, although it would encourage them to
take more chances.

Executives whose variable compensation is
stock-based are in a similar situation. Stock prices reflect investors'
expectations. Management can surprise the market, but not consistently.
So unless the game is fixed, stock options are an unreliable way to
reward executive performance.

Stock options are issued at
market prices. To benefit from them, the stock price has to increase,
which implies that senior managers have to increase investor
expectations. Since there is no reason why investors would
systematically underestimate the value of a stock, how can management
win at this game?

For a while, management can invent a rosy
story, wait for share prices to go up and cash out on their options
before investors realize they are being fooled. But that would be
illegal. Another way is for management to be lucky and benefit from a
general rise in stock market value, as experienced from 2002 to 2008. A
booming stock market allows executives to pocket huge, often
undeserved, profits. That's just luck, but it does work in bearish
markets.

Another way to beat investors' expectations is for
management to surprise the market by taking on more risks, which often
involves betting the farm.

Stock-option plans can also
demotivate management when options go under, either because of stock
market crashes, as in 2002 and 2008, or when a company reaches maturity
and its stock peaks. Holders of stock options are then penalized
regardless of their actual performance. Managers at

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