- Email: [email protected]
Dollars and sense: The implications of CEO compensation for organizational performance
Business Horizons (2013) 56, 537—542
Available online at www.sciencedirect.com
www.elsevier.com/locate/bushor
ORGANIZATIONAL PERFORMANCE
Dollars and sense: The implications of CEO compensation for organizational performance Shelley A. Davis *, Jason D. DeBode, David J. Ketchen Jr. Raymond J. Harbert College of Business, Auburn University, Auburn, AL 36849-5241, U.S.A.
KEYWORDS CEO compensation; Corporate governance; Organizational performance; Board of directors
Abstract Crafting a compensation package for an organization’s chief executive officer (CEO) that will help the firm maximize its performance is a vexing challenge for a board of directors. Management theory offers boards several practical hints. A board can put its CEO and the firm in the best position to be successful by (1) creating strong incentives for the CEO to act in the firm’s best interest at all times; (2) benchmarking a CEO’s performance and compensation relative to that of very high performing CEOs in the industry; (3) diagnosing and responding to CEOs’ feelings about equity relative to their peers; (4) paying a CEO with uniquely valuable knowledge, skills, and ability at the top of the market; (5) offering retention incentives if a proven performer with unique skills is leading a company; (6) resisting the temptation to simply mimic the compensation packages that work for leading firms; and (7) considering candidates’ social ties when recruiting a new CEO. # 2013 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved.
‘‘There is nothing so practical as a good theory.’’ –—Kurt Lewin (1951, p. 169) The compensation of chief executive officers (CEOs) has long been and remains a source of controversy. A look at how much CEOs are paid illustrates why this is so. According to a USAToday study, from 2009 to 2010, median CEO pay in the United States rose 27% to $9.0 million and median CEO bonuses jumped 47% to $2.2 million (Krantz & Hansen, 2011). In 2012, CEOs of U.S.-based companies received an average of
* Corresponding author E-mail addresses: [email protected] (S.A. Davis), [email protected] (J.D. DeBode), [email protected] (D.J. Ketchen Jr.)
$12.3 million in total compensation while the typical American worker received less than $35,000. In other words, CEOs made 354 times what workers were paid. This ratio is a huge increase compared to 281:1 in 2002, 201:1 in 1992, and 42:1 in 1982 (AFL-CIO, 2013). Defenders of high CEO pay point to skilled CEOs’ ability to lead their organizations to exceptionally strong performance. From their perspective, paying a CEO many millions of dollars annually is a great investment if the CEO rescues a struggling firm from doom or increases a solid company’s profits dramatically. For example, former Apple CEO Steve Jobs was paid a whopping $162.3 million between 1999 and 2009. During that time, however, the firm’s market value increased by $153.4 billion and its
0007-6813/$ — see front matter # 2013 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.bushor.2013.05.008
538 stock value increased by 860% (Steverman, 2009). Critics, on the other hand, suggest that CEO pay is often excessive and is driven by factors other than the CEO’s performance. They believe that it is hard to justify, for example, why Jeffrey Immelt was paid $125.5 million from 1999 to 2009 to lead General Electric despite a $217 billion drop in market capitalization and a 58% decrease in stock value. To shed new light on this ongoing controversy, we examine CEO compensation using six prominent theories from management research. Although some executives view management theory as disconnected from organizational reality, we echo social psychologist Kurt Lewin (1951) by suggesting that good theory is very practical. Specifically, applying a series of theories, each of which is based on different assumptions and logic, can reveal important aspects of CEO compensation and its implications for organizational performance. Such applications also offer guidance to firms about how to best manage CEO compensation in order to maximize organizational outcomes.
1. Show me the money: How CEOs get paid CEO compensation packages typically include three basic elements: (1) cash compensation, consisting of a base salary and annual bonus; (2) long-term incentives, which may include stock options, restricted stock, or other forms of deferred compensation; and (3) perquisites (‘perks’) and supplementary benefits such as supplemental executive retirement plans (SERPs), insurance, memberships, and other non-cash rewards. Some compensation packages also include a ‘golden parachute’ that provides the CEO with additional compensation if she/he is removed due to a merger or some other change in ownership. In an extreme example, Bill Johnson, the former CEO of then-newly merged Prospect and Duke Energy companies, was in office for approximately 20 minutes before being dismissed and walking away with a $44 million buyout (Bates, 2012). In publicly held U.S. firms, CEO compensation is generally developed by the compensation committee of the board of directors for final approval by the entire board (Fredrickson, Davis-Blake, & Sanders, 2010). Recent legislation affects the composition of the compensation committee, as well as how this committee does its work. For example, the DoddFrank Wall Street Reform and Consumer Protection Act (Dodd-Frank) mandates that compensation committees contain only independent directors (i.e., board members who are not employed by the firm or otherwise closely tied to the CEO) and that these
ORGANIZATIONAL PERFORMANCE committees may hire compensation consultants in order to further their independence from the CEO. Dodd-Frank also gives shareholders a ‘say on pay’ through the right to a non-binding vote on executive pay and golden parachutes (Dodd-Frank, 2010).
2. Six theories on CEO compensation 2.1. Agency theory Studies have found that CEO pay tends to increase as a firm gets larger. After an acquisition is made, for example, the CEO can argue that he now has a bigger domain to run and should be paid for this added responsibility. Shareholders may be left wondering to what extent self-interest influenced the CEO’s decision to acquire another firm. Was the acquisition made purely out of a concern for the company’s wellbeing or did the desire for a bigger paycheck influence the CEO’s thinking? Agency theory tackles such sticky situations. The owners of a firm delegate authority to make strategic decisions on their behalf to an agent: the CEO. Agency theory highlights the existence of an agency problem: a CEO and the firm’s shareholders often have differing interests such that the CEO may make moves that are in her best interests, even if they hurt the firm (Jensen & Meckling, 1976). The shareholders’ main watchdog is the board, whose job includes monitoring the CEO and managing the CEO’s compensation package. Ideally, the board will craft a compensation package that aligns the CEO’s goals with those of the shareholders (Eisenhardt, 1989). Many boards, for example, emphasize stock options and other forms of contingent compensation. By drawing a connection between the CEO’s pay and firm performance, the board strives to motivate the CEO to pursue courses of action that maximize shareholder returns. In crafting a compensation package, the board should consider not only the overall value but also the mix of the pay elements in the compensation package. One company that seems to have perfected the compensation mix is Comcast Corporation. Comcast offers its CEO an annual cash bonus to encourage strong short-term performance, though no bonus is received unless minimum performance goals are met. To encourage a long-term performance commitment and focus, Comcast relies on equity compensation in the form of stock options and restricted stock unit grants to motivate increased stock prices and shareholder value. The results have been good for both Comcast and its CEO. In 2012, 74% of Comcast CEO Brian L. Roberts’ approximately $29 million compensation
ORGANIZATIONAL PERFORMANCE Table 1.
539
Insights on managing CEO compensation offered by prominent management theories
Theory
Main Assumption
Practical Implications for Managing CEO Compensation
Agency Theory
Left unchecked, CEOs may make moves such as unwise acquisitions that increase their compensation but that harm their firms
The board must craft a compensation package that creates strong incentives for the CEO to act in the firm’s best interest at all times
Social Comparison Theory
People assess their situation relative to their peers’ situation
Benchmark a CEO’s performance and compensation relative to that of very high performing CEOs in the industry
Equity Theory
People act to restore balance if their ratio of effort given to pay received differs from others’ ratios
Workers may reduce their efforts if they view the CEO as overpaid Boards need to diagnose and respond to CEOs’ feelings about equity
Resource-Based Theory
Institutional Theory
Firms can achieve competitive advantages and superior performance if they build their strategies around resources that are valuable, rare, not easily imitated (i.e., inimitable), and non-substitutable
If a CEO’s knowledge, skills, and ability make her a strategic resource, pay her accordingly
Firms tend to imitate the behavior of their peers, especially the very successful peers
Resist the temptation to simply mimic the CEO compensation packages that seem to work for leading firms
Offering retention incentives if a proven performer with unique skills is leading a company
Craft the CEO’s compensation package in a way that matches the firm’s unique situation Social Network Theory
Friendships and other interpersonal relationships among executives influence organizational actions and performance
When recruiting a new CEO, consider not just the candidates’ past performance, but also the ties to other firms that they possess To avoid losing a well-connected CEO, keep her compensation competitive with the market
package was contingent upon performance, with 36% being derived from an annual cash bonus and 38% from equity compensation (Comcast Corporation, 2013a). Meanwhile, from 2011-2012, the company achieved a 12% increase in revenue to $62.6 billion and a 14% increase in operating income to $12.2 billion. The value of Comcast stock rose approximately 60% over the same time period compared to the S&P 500 Stock Index, which only rose about 16% (Comcast Corporation, 2013a). The board credits this strong performance to both its compensation practices and Roberts’ leadership (Comcast Corporation, 2013b). Table 1 summarizes the key implications for CEO compensation offered by agency theory and the other perspectives.
2.2. Social comparison theory According to social comparison theory (Festinger, 1954), people assess their situation by comparing themselves with similar others. Though similarity is
often gauged using job position, ability, or demographics, it is common to select others seen as slightly ‘better’ or more expert to make these comparisons (Fredrickson, Davis-Blake, & Sanders, 2010). Compensation committees will likely look to the compensation packages of CEOs in similar firms and industries as a guide for establishing both the total value and composition of their CEO’s compensation package. Because compensation committee members often are CEOs of other firms, they also frequently use their own compensation packages as a benchmark (Reilly, Main, & Crystal, 1988). Meanwhile, CEOs will look at what their peers make and try to negotiate a pay package that is at least comparable in composition and value. These practices appear to have been at play when establishing newly-hired Yahoo! CEO Marissa Mayer’s compensation. In fact, Yahoo! explicitly states that one of the factors it considers when determining executive pay is the compensation of similar positions at peer firms (Yahoo! Inc., 2013).
540 Disregarding her signing bonus upon joining Yahoo!, Mayer’s compensation package was similar to that of peer CEOs (Yahoo! Inc., 2012). Specifically, Mayer’s $1 million salary not only matched that of several peer CEOs–—including Expedia Inc.’s CEO Dara Khosrowshahi and AOL Inc.’s CEO Timothy Armstrong–—but was also comparable to the average peer salary of approximately $963,000. Although Mayer’s $6 million in stock awards (e.g., restricted stock) was greater than the approximately $5 million peer stock awards average, it made up roughly the same percentage of overall compensation at 40%. Social comparison theory offers implications for negotiating a CEO’s pay package. CEOs may attempt to increase their pay by selecting an especially wellpaid CEO as their comparison. The board might be wise, however, to downplay what other CEOs are paid and focus instead on how they perform. In particular, the board could examine how the CEOs of high performing companies within their industry are paid and use their packages as guidelines when setting their own CEO’s compensation. If stock options are emphasized by the best firms, for example, a board might be wise to follow the same recipe.
2.3. Equity theory According to equity theory, people compare their ratio of inputs (e.g., skills and effort) to outcomes (e.g., pay) to others’ ratios (Adams, 1963). If the ratios are out of balance, people act to restore balance. If a person believes that others are getting a better deal, for example, the person is likely to try to resolve the inequity by reducing her effort while maintaining the same pay level. Meanwhile, a person who is getting more rewards than others for the same amount of work may feel guilty about this and work harder in order to compensate. Boards need to be aware that many employees will analyze whether they are being paid equitably relative to the most visible person in the firm: the CEO. Morale problems are likely to erupt if the CEO is viewed as overpaid relative to rank-and-file workers. Whole Foods Market is a firm that appears to have taken this message to heart. Whole Foods espouses a philosophy of ‘fairness to all stakeholders,’ in part by placing a cap on employee salaries–—including the CEO’s–—at 19 times that of the average annual wage of all full-time employees (Whole Foods Market Inc., 2013). Co-CEO Walter Robb earned a total cash compensation of $1,461,567 but was required to forfeit nearly 50% of it to avoid exceeding the company salary cap of $736,200 for 2012. Meanwhile, CoCEO John Mackey has voluntarily taken a $1 salary since 2007 and has opted out of future bonus and stock option awards.
ORGANIZATIONAL PERFORMANCE Research has found that people fall into three categories based on how they react to equity issues. Equity sensitives experience discomfort when underpaid or overpaid. Benevolents have a surprising tolerance for being underpaid. Entitleds are perfectly happy to be overpaid, but become quite angry when they believe they are underpaid (King, Miles, & Day, 1993). Boards would be wise to carefully study their CEOs’ perceptions of equity and determine which categories they fall into. When dealing with an ‘entitled’ CEO, for example, board members must understand that this individual tends to overvalue himself and will have little or no tolerance for being underpaid relative to other CEOs. Extensive discussion with the CEO might be needed to ensure that the CEO feels adequately compensated, or at least understands why he is receiving a less-than-desired compensation package. The alternative is having a CEO whose feelings of inequity can lead to counterproductive behaviors such as not working to his full potential.
2.4. Resource-based theory The premise of resource-based theory (RBT) is that firms should, to the greatest extent possible, build their strategies around strategic resources: resources that are valuable, rare, not easily imitated (i.e., inimitable), and non-substitutable (Barney, 1991). The aim is to capitalize on these strategic resources in order to offer uniqueness to the marketplace and thereby gain a competitive advantage over rivals. As Apple has demonstrated, for example, building desirable products around patented technologies can enable a firm to separate itself from the pack. Other firms, such as Coca-Cola and McDonald’s, have enjoyed decades of success in part because they leverage their unique brand name reputations when choosing their strategies. Like patents and brand names, a CEO can be a strategic resource. Certain CEOs are unusually valuable and rare because of some combination of attributes such as decision-making skills, experience, reputation, and prestige. In some cases, a CEO and a firm mesh together in a unique way that allows the firm to excel. Boards need to recognize when they are blessed with such a CEO and pay the CEO accordingly. One example is Howard Schultz, the founder of Starbucks Corporation. After serving as CEO starting in 1985, Schultz stepped down in 2000. By 2008, Starbucks was struggling badly and Schultz reassumed the helm. He closed around 800 stores in the United States and famously shut down all U.S. locations for 3 hours of training to educate
ORGANIZATIONAL PERFORMANCE and energize employees (Grynbaum, 2008). Since Schultz’s return, Starbucks’ financial performance has been stellar. Net revenues have increased from $10.4 to $13.3 billion and operating income has increased from $504 million to nearly $2 billion (Starbucks Corporation, 2012). Meanwhile, the firm’s stock price increased by nearly 400% between 2008 and 2013. Schultz’s compensation package acknowledges his value as a strategic resource and as a source of sustained competitive advantage for Starbucks. In recognition of his superior leadership, the value of Schultz’s compensation package increased almost 80% in 2012 to approximately $28.9 million. In an effort to keep Schultz in his position, his package included a special equity award of $12.0 million that will fully vest after 3 more years of service (Starbucks Corporation, 2013). Offering such incentives is wise when a proven performer with unique skills is leading a company.
2.5. Institutional theory Ideally, business decisions are made based on sound logic. A central premise of institutional theory is that sometimes firms stray from making logical decisions and they get caught up in a desire to keep pace with their rivals (DiMaggio & Powell, 1983). This leads firms to copy what each other is doing, even if these actions are not good fits with their strategies. For example, most major fast food chains offer drive-through windows and dollar menus regardless of whether these offerings make good business sense for each chain. Applied to CEO compensation, institutional theory suggests that boards may look to imitate the CEO compensation packages in place at other firms in their industry, especially their more successful rivals. While boards may be tempted to simply mimic leading firms’ compensation packages, this practice is not recommended. Instead, the board is advised to tailor their CEO’s compensation package in a way that acknowledges what rivals are paying but also reflects the firm’s unique situation. The board of Ford Motor Company, for example, appears to have done so when setting CEO Alan Mulally’s compensation package. In line with institutional theory’s expectations, Ford overtly states that it considers the packages offered by its peer group–—including close rival General Motors–—when establishing executive pay (Ford Motor Company, 2013). The median peer executive compensation mix for 2012 was 19% base salary, 16% bonus, and 65% long-term incentives. The composition of Mulally’s compensation package was similar, with 20% coming from base salary, 18% from a target
541 bonus, and 60% from long-term incentives. Mulally’s $20.3 million total compensation package in 2012 was above the peer median, however, which seems appropriate given Ford’s success relative to its peers. In 2009, for example, Ford under Mulally’s leadership was able to avoid relying on bankruptcy and a government bailout while GM and Chrysler needed such assistance to avoid collapse. Meanwhile, Mulally’s leadership boosted Ford’s stock from below $3.00 per share in 2009 to more than $15.00 per share by mid-2013.
2.6. Social network theory Social network theory examines how interpersonal relationships among executives influence organizational actions and outcomes (Brass, Galaskiewicz, Greve, & Tsai, 2004). The friendships and business ties that a CEO has outside her firm serve as a source of information, power, and prestige. A welldeveloped social network can offer important benefits for her firm. A CEO with a rich and diverse social network is valuable to a firm, particularly when her network is rich in ‘structural holes,’ meaning that ties to two other executives are not linked except through their mutual connection to the CEO. Structural holes not only facilitate the flow of helpful information from these contacts but also allow control over how information is transmitted between the contacts (Burt, 1992). Margaret ‘Meg’ Whitman, CEO of HewlettPackard Company (HP), is an example of a sociallyrich CEO. The knowledge and connections Whitman possessed was cited by the chair of HP’s board as a factor that made her stand out as a CEO candidate (Hewlett-Packard Company, 2011). Whitman brought to HP the ties she had developed in her previous executive positions at eBay Inc., Hasbro Inc., FTD Inc., and The Walt Disney Company; moreover, she added links through her board memberships at Procter & Gamble, Zipcar Inc., and Teach for America. Importantly, while Whitman established ties with these organizations, she also established ties to these firms’ board members including W. James McNerney, Jr. (President and CEO of The Boeing Company), John Mahoney (Vice Chairman and CFO of Staples), David W. Kenny (Chairman and CEO of The Weather Channel Companies), and many other important executives. This array of connections could help HP reverse its sagging fortunes. When recruiting a new CEO, boards are wise to consider not just candidates’ past performance but also the ties to other firms that they possess. Naturally, well-connected and highly accomplished CEOs such as Meg Whitman command premium pay. Whitman’s 2011 compensation package was more than
542 $16 million (Hewlett-Packard, 2013), well beyond the $11.4 million average total compensation of the CEOs of close rivals. Once a well-connected CEO is in place, the board needs to be aware that such a person will be attractive to other firms. To avoid losing such a CEO to poaching by other firms, her compensation should be increased as needed to keep pace with market changes.
3. A final payoff More than 6 decades ago, social psychologist Kurt Lewin (1951) asserted that there is nothing as practical as a good theory. In the modern era, it is very challenging to craft CEO compensation packages in such a way that organizational performance is likely to be maximized. Boards of directors need all the practical advice they can get–—and they may be surprised to learn that management theory is a great source of straightforward and sensible guidance.
References Adams, J. S. (1963). Wage inequities, productivity, and work quality. Industrial Relations: A Journal of Economy and Society, 3(1), 9—16. AFL-CIO. (2013). Executive paywatch. Retrieved April 18, 2013, from http://www.aflcio.org/Corporate-Watch/CEO-Pay-andYou Barney, J. (1991). Firm resources and sustained competitive advantage. Journal of Management, 17(1), 99—120. Bates, D. (2012, July 9). The ultimate golden parachute — Energy company boss to get $44m exit package for TWENTY minutes in his post. Mail Online. Retrieved April 18, 2013, from http:// www.dailymail.co.uk/news/article-2170968/The-ultimategolden-parachute–Energy-company-boss-44m-exit-packageTWENTY-minutes-post.html Brass, D. J., Galaskiewicz, J., Greve, H. R., & Tsai, W. (2004). Taking stock of networks and organizations: A multilevel perspective. Academy of Management Journal, 47(6), 795—819. Burt, R. S. (1992). Structural holes: The social structure of competition. Cambridge, MA: Harvard University Press. Comcast Corporation. (2013a). Form 10-K. Retrieved May 27, 2013, from http://www.sec.gov/Archives/edgar/data/1166691/ 000119312513067658/d458593d10k.htm Comcast Corporation. (2013b). Schedule 14a. Retrieved May 26, 2013, from http://www.sec.gov/Archives/edgar/data/ 1166691/000119312513144100/d496632ddef14a.htm# toc496632_6 DiMaggio, P. J., & Powell, W. W. (1983). The iron cage revisited: Institutional isomorphism and collective rationality in organizational fields. American Sociological Review, 48(2), 147—160. Dodd-Frank. (2010). The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 12 U.S.C. §5301.
ORGANIZATIONAL PERFORMANCE Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57—74. Festinger, L. (1954). A theory of social comparison processes. Human Relations, 7(2), 117—140. Ford Motor Company. (2013, March 28). Schedule 14a. Retrieved May 27, 2013, from http://www.sec.gov/Archives/edgar/ data/37996/000104746913003543/a2214083zdef14a.htm Fredrickson, J. W., Davis-Blake, A., & Sanders, W. G. (2010). Sharing the wealth: Social comparisons and pay dispersion in the CEO’s top team. Strategic Management Journal, 31(10), 1031—1053. Grynbaum, M. M. (2008, February 27). Starbucks takes a 3-hour coffee break. The New York Times. Retrieved May 24, 2013, from http://www.nytimes.com/2008/02/27/business/27sbux.html Hewlett-Packard Company. (2011, September 28). Schedule 8k Exhibit 99.1. Retrieved May 26, 2013, from http://www.sec. gov/Archives/edgar/data/47217/000110465906063569/a0620427_1ex99d1.htm Hewlett-Packard Company (2013, January 11). Schedule 14a. Retrieved May 25, 2013 from http://www.sec.gov/Archives/ edgar/data/47217/000104746913000179/a2212404zpre14a. htm Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3(4), 305—360. King, W. C., Jr., Miles, E. W., & Day, D. D. (1993). A test and refinement of the equity sensitivity construct. Journal of Organizational Behavior, 14(4), 301—317. Krantz, M., & Hansen, B. (2011, April 4). CEO pay soars while workers’ pay stalls. USA Today. Retrieved April 3, 2013, from http://usatoday30.usatoday.com/money/companies/ management/story/CEO-pay-2010/45634384/1 Lewin, K. (1951). Problems of research in social psychology. In D. Cartwright (Ed.), Field theory in social science: Selected theoretical papers (pp. 155—169). New York: Harper & Row. O’Reilly, C. A., III, Main, B. G., & Crystal, G. S. (1988). CEO compensation as tournament and social comparison: A tale of two theories. Administrative Science Quarterly, 33(2), 257—274. Starbucks Corporation. (2012, November 16). Form 10-K. Retrieved May 23, 2013, from http://www.sec.gov/Archives/ edgar/data/829224/000082922412000007/sbux-9302012x10k. htm Starbucks Corporation. (2013, January 25). Schedule 14A. Retrieved May 24, 2013, from http://www.sec.gov/Archives/ edgar/data/829224/000119312512025113/d269120ddef14a. htm Steverman, B. (2009, September 23). CEOs and the pay-forperformance puzzle. Bloomberg Businessweek. Retrieved May 21, 2013, from http://www.businessweek.com/investor/content/sep2009/pi20090923_783858.htm Whole Foods Market Inc. (2013, January 25). Schedule 14A. Retrieved May 22, 2013, from http://www.sec.gov/Archives/ edgar/data/865436/000120677413000351/wholefoods_ def14a.htm Yahoo! Inc. (2012, July 19). Form 8-K. Retrieved May 7, 2013, from http://www.sec.gov/Archives/edgar/data/1011006/000119 312512307595/d384719d8k.htm Yahoo! Inc. (2013, April 30). Schedule 14A. Retrieved May 7, 2013, from http://www.sec.gov/Archives/edgar/data/1011006/ 000119312513187918/d501548ddef14a.htm
Available online at www.sciencedirect.com
www.elsevier.com/locate/bushor
ORGANIZATIONAL PERFORMANCE
Dollars and sense: The implications of CEO compensation for organizational performance Shelley A. Davis *, Jason D. DeBode, David J. Ketchen Jr. Raymond J. Harbert College of Business, Auburn University, Auburn, AL 36849-5241, U.S.A.
KEYWORDS CEO compensation; Corporate governance; Organizational performance; Board of directors
Abstract Crafting a compensation package for an organization’s chief executive officer (CEO) that will help the firm maximize its performance is a vexing challenge for a board of directors. Management theory offers boards several practical hints. A board can put its CEO and the firm in the best position to be successful by (1) creating strong incentives for the CEO to act in the firm’s best interest at all times; (2) benchmarking a CEO’s performance and compensation relative to that of very high performing CEOs in the industry; (3) diagnosing and responding to CEOs’ feelings about equity relative to their peers; (4) paying a CEO with uniquely valuable knowledge, skills, and ability at the top of the market; (5) offering retention incentives if a proven performer with unique skills is leading a company; (6) resisting the temptation to simply mimic the compensation packages that work for leading firms; and (7) considering candidates’ social ties when recruiting a new CEO. # 2013 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved.
‘‘There is nothing so practical as a good theory.’’ –—Kurt Lewin (1951, p. 169) The compensation of chief executive officers (CEOs) has long been and remains a source of controversy. A look at how much CEOs are paid illustrates why this is so. According to a USAToday study, from 2009 to 2010, median CEO pay in the United States rose 27% to $9.0 million and median CEO bonuses jumped 47% to $2.2 million (Krantz & Hansen, 2011). In 2012, CEOs of U.S.-based companies received an average of
* Corresponding author E-mail addresses: [email protected] (S.A. Davis), [email protected] (J.D. DeBode), [email protected] (D.J. Ketchen Jr.)
$12.3 million in total compensation while the typical American worker received less than $35,000. In other words, CEOs made 354 times what workers were paid. This ratio is a huge increase compared to 281:1 in 2002, 201:1 in 1992, and 42:1 in 1982 (AFL-CIO, 2013). Defenders of high CEO pay point to skilled CEOs’ ability to lead their organizations to exceptionally strong performance. From their perspective, paying a CEO many millions of dollars annually is a great investment if the CEO rescues a struggling firm from doom or increases a solid company’s profits dramatically. For example, former Apple CEO Steve Jobs was paid a whopping $162.3 million between 1999 and 2009. During that time, however, the firm’s market value increased by $153.4 billion and its
0007-6813/$ — see front matter # 2013 Kelley School of Business, Indiana University. Published by Elsevier Inc. All rights reserved. http://dx.doi.org/10.1016/j.bushor.2013.05.008
538 stock value increased by 860% (Steverman, 2009). Critics, on the other hand, suggest that CEO pay is often excessive and is driven by factors other than the CEO’s performance. They believe that it is hard to justify, for example, why Jeffrey Immelt was paid $125.5 million from 1999 to 2009 to lead General Electric despite a $217 billion drop in market capitalization and a 58% decrease in stock value. To shed new light on this ongoing controversy, we examine CEO compensation using six prominent theories from management research. Although some executives view management theory as disconnected from organizational reality, we echo social psychologist Kurt Lewin (1951) by suggesting that good theory is very practical. Specifically, applying a series of theories, each of which is based on different assumptions and logic, can reveal important aspects of CEO compensation and its implications for organizational performance. Such applications also offer guidance to firms about how to best manage CEO compensation in order to maximize organizational outcomes.
1. Show me the money: How CEOs get paid CEO compensation packages typically include three basic elements: (1) cash compensation, consisting of a base salary and annual bonus; (2) long-term incentives, which may include stock options, restricted stock, or other forms of deferred compensation; and (3) perquisites (‘perks’) and supplementary benefits such as supplemental executive retirement plans (SERPs), insurance, memberships, and other non-cash rewards. Some compensation packages also include a ‘golden parachute’ that provides the CEO with additional compensation if she/he is removed due to a merger or some other change in ownership. In an extreme example, Bill Johnson, the former CEO of then-newly merged Prospect and Duke Energy companies, was in office for approximately 20 minutes before being dismissed and walking away with a $44 million buyout (Bates, 2012). In publicly held U.S. firms, CEO compensation is generally developed by the compensation committee of the board of directors for final approval by the entire board (Fredrickson, Davis-Blake, & Sanders, 2010). Recent legislation affects the composition of the compensation committee, as well as how this committee does its work. For example, the DoddFrank Wall Street Reform and Consumer Protection Act (Dodd-Frank) mandates that compensation committees contain only independent directors (i.e., board members who are not employed by the firm or otherwise closely tied to the CEO) and that these
ORGANIZATIONAL PERFORMANCE committees may hire compensation consultants in order to further their independence from the CEO. Dodd-Frank also gives shareholders a ‘say on pay’ through the right to a non-binding vote on executive pay and golden parachutes (Dodd-Frank, 2010).
2. Six theories on CEO compensation 2.1. Agency theory Studies have found that CEO pay tends to increase as a firm gets larger. After an acquisition is made, for example, the CEO can argue that he now has a bigger domain to run and should be paid for this added responsibility. Shareholders may be left wondering to what extent self-interest influenced the CEO’s decision to acquire another firm. Was the acquisition made purely out of a concern for the company’s wellbeing or did the desire for a bigger paycheck influence the CEO’s thinking? Agency theory tackles such sticky situations. The owners of a firm delegate authority to make strategic decisions on their behalf to an agent: the CEO. Agency theory highlights the existence of an agency problem: a CEO and the firm’s shareholders often have differing interests such that the CEO may make moves that are in her best interests, even if they hurt the firm (Jensen & Meckling, 1976). The shareholders’ main watchdog is the board, whose job includes monitoring the CEO and managing the CEO’s compensation package. Ideally, the board will craft a compensation package that aligns the CEO’s goals with those of the shareholders (Eisenhardt, 1989). Many boards, for example, emphasize stock options and other forms of contingent compensation. By drawing a connection between the CEO’s pay and firm performance, the board strives to motivate the CEO to pursue courses of action that maximize shareholder returns. In crafting a compensation package, the board should consider not only the overall value but also the mix of the pay elements in the compensation package. One company that seems to have perfected the compensation mix is Comcast Corporation. Comcast offers its CEO an annual cash bonus to encourage strong short-term performance, though no bonus is received unless minimum performance goals are met. To encourage a long-term performance commitment and focus, Comcast relies on equity compensation in the form of stock options and restricted stock unit grants to motivate increased stock prices and shareholder value. The results have been good for both Comcast and its CEO. In 2012, 74% of Comcast CEO Brian L. Roberts’ approximately $29 million compensation
ORGANIZATIONAL PERFORMANCE Table 1.
539
Insights on managing CEO compensation offered by prominent management theories
Theory
Main Assumption
Practical Implications for Managing CEO Compensation
Agency Theory
Left unchecked, CEOs may make moves such as unwise acquisitions that increase their compensation but that harm their firms
The board must craft a compensation package that creates strong incentives for the CEO to act in the firm’s best interest at all times
Social Comparison Theory
People assess their situation relative to their peers’ situation
Benchmark a CEO’s performance and compensation relative to that of very high performing CEOs in the industry
Equity Theory
People act to restore balance if their ratio of effort given to pay received differs from others’ ratios
Workers may reduce their efforts if they view the CEO as overpaid Boards need to diagnose and respond to CEOs’ feelings about equity
Resource-Based Theory
Institutional Theory
Firms can achieve competitive advantages and superior performance if they build their strategies around resources that are valuable, rare, not easily imitated (i.e., inimitable), and non-substitutable
If a CEO’s knowledge, skills, and ability make her a strategic resource, pay her accordingly
Firms tend to imitate the behavior of their peers, especially the very successful peers
Resist the temptation to simply mimic the CEO compensation packages that seem to work for leading firms
Offering retention incentives if a proven performer with unique skills is leading a company
Craft the CEO’s compensation package in a way that matches the firm’s unique situation Social Network Theory
Friendships and other interpersonal relationships among executives influence organizational actions and performance
When recruiting a new CEO, consider not just the candidates’ past performance, but also the ties to other firms that they possess To avoid losing a well-connected CEO, keep her compensation competitive with the market
package was contingent upon performance, with 36% being derived from an annual cash bonus and 38% from equity compensation (Comcast Corporation, 2013a). Meanwhile, from 2011-2012, the company achieved a 12% increase in revenue to $62.6 billion and a 14% increase in operating income to $12.2 billion. The value of Comcast stock rose approximately 60% over the same time period compared to the S&P 500 Stock Index, which only rose about 16% (Comcast Corporation, 2013a). The board credits this strong performance to both its compensation practices and Roberts’ leadership (Comcast Corporation, 2013b). Table 1 summarizes the key implications for CEO compensation offered by agency theory and the other perspectives.
2.2. Social comparison theory According to social comparison theory (Festinger, 1954), people assess their situation by comparing themselves with similar others. Though similarity is
often gauged using job position, ability, or demographics, it is common to select others seen as slightly ‘better’ or more expert to make these comparisons (Fredrickson, Davis-Blake, & Sanders, 2010). Compensation committees will likely look to the compensation packages of CEOs in similar firms and industries as a guide for establishing both the total value and composition of their CEO’s compensation package. Because compensation committee members often are CEOs of other firms, they also frequently use their own compensation packages as a benchmark (Reilly, Main, & Crystal, 1988). Meanwhile, CEOs will look at what their peers make and try to negotiate a pay package that is at least comparable in composition and value. These practices appear to have been at play when establishing newly-hired Yahoo! CEO Marissa Mayer’s compensation. In fact, Yahoo! explicitly states that one of the factors it considers when determining executive pay is the compensation of similar positions at peer firms (Yahoo! Inc., 2013).
540 Disregarding her signing bonus upon joining Yahoo!, Mayer’s compensation package was similar to that of peer CEOs (Yahoo! Inc., 2012). Specifically, Mayer’s $1 million salary not only matched that of several peer CEOs–—including Expedia Inc.’s CEO Dara Khosrowshahi and AOL Inc.’s CEO Timothy Armstrong–—but was also comparable to the average peer salary of approximately $963,000. Although Mayer’s $6 million in stock awards (e.g., restricted stock) was greater than the approximately $5 million peer stock awards average, it made up roughly the same percentage of overall compensation at 40%. Social comparison theory offers implications for negotiating a CEO’s pay package. CEOs may attempt to increase their pay by selecting an especially wellpaid CEO as their comparison. The board might be wise, however, to downplay what other CEOs are paid and focus instead on how they perform. In particular, the board could examine how the CEOs of high performing companies within their industry are paid and use their packages as guidelines when setting their own CEO’s compensation. If stock options are emphasized by the best firms, for example, a board might be wise to follow the same recipe.
2.3. Equity theory According to equity theory, people compare their ratio of inputs (e.g., skills and effort) to outcomes (e.g., pay) to others’ ratios (Adams, 1963). If the ratios are out of balance, people act to restore balance. If a person believes that others are getting a better deal, for example, the person is likely to try to resolve the inequity by reducing her effort while maintaining the same pay level. Meanwhile, a person who is getting more rewards than others for the same amount of work may feel guilty about this and work harder in order to compensate. Boards need to be aware that many employees will analyze whether they are being paid equitably relative to the most visible person in the firm: the CEO. Morale problems are likely to erupt if the CEO is viewed as overpaid relative to rank-and-file workers. Whole Foods Market is a firm that appears to have taken this message to heart. Whole Foods espouses a philosophy of ‘fairness to all stakeholders,’ in part by placing a cap on employee salaries–—including the CEO’s–—at 19 times that of the average annual wage of all full-time employees (Whole Foods Market Inc., 2013). Co-CEO Walter Robb earned a total cash compensation of $1,461,567 but was required to forfeit nearly 50% of it to avoid exceeding the company salary cap of $736,200 for 2012. Meanwhile, CoCEO John Mackey has voluntarily taken a $1 salary since 2007 and has opted out of future bonus and stock option awards.
ORGANIZATIONAL PERFORMANCE Research has found that people fall into three categories based on how they react to equity issues. Equity sensitives experience discomfort when underpaid or overpaid. Benevolents have a surprising tolerance for being underpaid. Entitleds are perfectly happy to be overpaid, but become quite angry when they believe they are underpaid (King, Miles, & Day, 1993). Boards would be wise to carefully study their CEOs’ perceptions of equity and determine which categories they fall into. When dealing with an ‘entitled’ CEO, for example, board members must understand that this individual tends to overvalue himself and will have little or no tolerance for being underpaid relative to other CEOs. Extensive discussion with the CEO might be needed to ensure that the CEO feels adequately compensated, or at least understands why he is receiving a less-than-desired compensation package. The alternative is having a CEO whose feelings of inequity can lead to counterproductive behaviors such as not working to his full potential.
2.4. Resource-based theory The premise of resource-based theory (RBT) is that firms should, to the greatest extent possible, build their strategies around strategic resources: resources that are valuable, rare, not easily imitated (i.e., inimitable), and non-substitutable (Barney, 1991). The aim is to capitalize on these strategic resources in order to offer uniqueness to the marketplace and thereby gain a competitive advantage over rivals. As Apple has demonstrated, for example, building desirable products around patented technologies can enable a firm to separate itself from the pack. Other firms, such as Coca-Cola and McDonald’s, have enjoyed decades of success in part because they leverage their unique brand name reputations when choosing their strategies. Like patents and brand names, a CEO can be a strategic resource. Certain CEOs are unusually valuable and rare because of some combination of attributes such as decision-making skills, experience, reputation, and prestige. In some cases, a CEO and a firm mesh together in a unique way that allows the firm to excel. Boards need to recognize when they are blessed with such a CEO and pay the CEO accordingly. One example is Howard Schultz, the founder of Starbucks Corporation. After serving as CEO starting in 1985, Schultz stepped down in 2000. By 2008, Starbucks was struggling badly and Schultz reassumed the helm. He closed around 800 stores in the United States and famously shut down all U.S. locations for 3 hours of training to educate
ORGANIZATIONAL PERFORMANCE and energize employees (Grynbaum, 2008). Since Schultz’s return, Starbucks’ financial performance has been stellar. Net revenues have increased from $10.4 to $13.3 billion and operating income has increased from $504 million to nearly $2 billion (Starbucks Corporation, 2012). Meanwhile, the firm’s stock price increased by nearly 400% between 2008 and 2013. Schultz’s compensation package acknowledges his value as a strategic resource and as a source of sustained competitive advantage for Starbucks. In recognition of his superior leadership, the value of Schultz’s compensation package increased almost 80% in 2012 to approximately $28.9 million. In an effort to keep Schultz in his position, his package included a special equity award of $12.0 million that will fully vest after 3 more years of service (Starbucks Corporation, 2013). Offering such incentives is wise when a proven performer with unique skills is leading a company.
2.5. Institutional theory Ideally, business decisions are made based on sound logic. A central premise of institutional theory is that sometimes firms stray from making logical decisions and they get caught up in a desire to keep pace with their rivals (DiMaggio & Powell, 1983). This leads firms to copy what each other is doing, even if these actions are not good fits with their strategies. For example, most major fast food chains offer drive-through windows and dollar menus regardless of whether these offerings make good business sense for each chain. Applied to CEO compensation, institutional theory suggests that boards may look to imitate the CEO compensation packages in place at other firms in their industry, especially their more successful rivals. While boards may be tempted to simply mimic leading firms’ compensation packages, this practice is not recommended. Instead, the board is advised to tailor their CEO’s compensation package in a way that acknowledges what rivals are paying but also reflects the firm’s unique situation. The board of Ford Motor Company, for example, appears to have done so when setting CEO Alan Mulally’s compensation package. In line with institutional theory’s expectations, Ford overtly states that it considers the packages offered by its peer group–—including close rival General Motors–—when establishing executive pay (Ford Motor Company, 2013). The median peer executive compensation mix for 2012 was 19% base salary, 16% bonus, and 65% long-term incentives. The composition of Mulally’s compensation package was similar, with 20% coming from base salary, 18% from a target
541 bonus, and 60% from long-term incentives. Mulally’s $20.3 million total compensation package in 2012 was above the peer median, however, which seems appropriate given Ford’s success relative to its peers. In 2009, for example, Ford under Mulally’s leadership was able to avoid relying on bankruptcy and a government bailout while GM and Chrysler needed such assistance to avoid collapse. Meanwhile, Mulally’s leadership boosted Ford’s stock from below $3.00 per share in 2009 to more than $15.00 per share by mid-2013.
2.6. Social network theory Social network theory examines how interpersonal relationships among executives influence organizational actions and outcomes (Brass, Galaskiewicz, Greve, & Tsai, 2004). The friendships and business ties that a CEO has outside her firm serve as a source of information, power, and prestige. A welldeveloped social network can offer important benefits for her firm. A CEO with a rich and diverse social network is valuable to a firm, particularly when her network is rich in ‘structural holes,’ meaning that ties to two other executives are not linked except through their mutual connection to the CEO. Structural holes not only facilitate the flow of helpful information from these contacts but also allow control over how information is transmitted between the contacts (Burt, 1992). Margaret ‘Meg’ Whitman, CEO of HewlettPackard Company (HP), is an example of a sociallyrich CEO. The knowledge and connections Whitman possessed was cited by the chair of HP’s board as a factor that made her stand out as a CEO candidate (Hewlett-Packard Company, 2011). Whitman brought to HP the ties she had developed in her previous executive positions at eBay Inc., Hasbro Inc., FTD Inc., and The Walt Disney Company; moreover, she added links through her board memberships at Procter & Gamble, Zipcar Inc., and Teach for America. Importantly, while Whitman established ties with these organizations, she also established ties to these firms’ board members including W. James McNerney, Jr. (President and CEO of The Boeing Company), John Mahoney (Vice Chairman and CFO of Staples), David W. Kenny (Chairman and CEO of The Weather Channel Companies), and many other important executives. This array of connections could help HP reverse its sagging fortunes. When recruiting a new CEO, boards are wise to consider not just candidates’ past performance but also the ties to other firms that they possess. Naturally, well-connected and highly accomplished CEOs such as Meg Whitman command premium pay. Whitman’s 2011 compensation package was more than
542 $16 million (Hewlett-Packard, 2013), well beyond the $11.4 million average total compensation of the CEOs of close rivals. Once a well-connected CEO is in place, the board needs to be aware that such a person will be attractive to other firms. To avoid losing such a CEO to poaching by other firms, her compensation should be increased as needed to keep pace with market changes.
3. A final payoff More than 6 decades ago, social psychologist Kurt Lewin (1951) asserted that there is nothing as practical as a good theory. In the modern era, it is very challenging to craft CEO compensation packages in such a way that organizational performance is likely to be maximized. Boards of directors need all the practical advice they can get–—and they may be surprised to learn that management theory is a great source of straightforward and sensible guidance.
References Adams, J. S. (1963). Wage inequities, productivity, and work quality. Industrial Relations: A Journal of Economy and Society, 3(1), 9—16. AFL-CIO. (2013). Executive paywatch. Retrieved April 18, 2013, from http://www.aflcio.org/Corporate-Watch/CEO-Pay-andYou Barney, J. (1991). Firm resources and sustained competitive advantage. Journal of Management, 17(1), 99—120. Bates, D. (2012, July 9). The ultimate golden parachute — Energy company boss to get $44m exit package for TWENTY minutes in his post. Mail Online. Retrieved April 18, 2013, from http:// www.dailymail.co.uk/news/article-2170968/The-ultimategolden-parachute–Energy-company-boss-44m-exit-packageTWENTY-minutes-post.html Brass, D. J., Galaskiewicz, J., Greve, H. R., & Tsai, W. (2004). Taking stock of networks and organizations: A multilevel perspective. Academy of Management Journal, 47(6), 795—819. Burt, R. S. (1992). Structural holes: The social structure of competition. Cambridge, MA: Harvard University Press. Comcast Corporation. (2013a). Form 10-K. Retrieved May 27, 2013, from http://www.sec.gov/Archives/edgar/data/1166691/ 000119312513067658/d458593d10k.htm Comcast Corporation. (2013b). Schedule 14a. Retrieved May 26, 2013, from http://www.sec.gov/Archives/edgar/data/ 1166691/000119312513144100/d496632ddef14a.htm# toc496632_6 DiMaggio, P. J., & Powell, W. W. (1983). The iron cage revisited: Institutional isomorphism and collective rationality in organizational fields. American Sociological Review, 48(2), 147—160. Dodd-Frank. (2010). The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 12 U.S.C. §5301.
ORGANIZATIONAL PERFORMANCE Eisenhardt, K. M. (1989). Agency theory: An assessment and review. Academy of Management Review, 14(1), 57—74. Festinger, L. (1954). A theory of social comparison processes. Human Relations, 7(2), 117—140. Ford Motor Company. (2013, March 28). Schedule 14a. Retrieved May 27, 2013, from http://www.sec.gov/Archives/edgar/ data/37996/000104746913003543/a2214083zdef14a.htm Fredrickson, J. W., Davis-Blake, A., & Sanders, W. G. (2010). Sharing the wealth: Social comparisons and pay dispersion in the CEO’s top team. Strategic Management Journal, 31(10), 1031—1053. Grynbaum, M. M. (2008, February 27). Starbucks takes a 3-hour coffee break. The New York Times. Retrieved May 24, 2013, from http://www.nytimes.com/2008/02/27/business/27sbux.html Hewlett-Packard Company. (2011, September 28). Schedule 8k Exhibit 99.1. Retrieved May 26, 2013, from http://www.sec. gov/Archives/edgar/data/47217/000110465906063569/a0620427_1ex99d1.htm Hewlett-Packard Company (2013, January 11). Schedule 14a. Retrieved May 25, 2013 from http://www.sec.gov/Archives/ edgar/data/47217/000104746913000179/a2212404zpre14a. htm Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics, 3(4), 305—360. King, W. C., Jr., Miles, E. W., & Day, D. D. (1993). A test and refinement of the equity sensitivity construct. Journal of Organizational Behavior, 14(4), 301—317. Krantz, M., & Hansen, B. (2011, April 4). CEO pay soars while workers’ pay stalls. USA Today. Retrieved April 3, 2013, from http://usatoday30.usatoday.com/money/companies/ management/story/CEO-pay-2010/45634384/1 Lewin, K. (1951). Problems of research in social psychology. In D. Cartwright (Ed.), Field theory in social science: Selected theoretical papers (pp. 155—169). New York: Harper & Row. O’Reilly, C. A., III, Main, B. G., & Crystal, G. S. (1988). CEO compensation as tournament and social comparison: A tale of two theories. Administrative Science Quarterly, 33(2), 257—274. Starbucks Corporation. (2012, November 16). Form 10-K. Retrieved May 23, 2013, from http://www.sec.gov/Archives/ edgar/data/829224/000082922412000007/sbux-9302012x10k. htm Starbucks Corporation. (2013, January 25). Schedule 14A. Retrieved May 24, 2013, from http://www.sec.gov/Archives/ edgar/data/829224/000119312512025113/d269120ddef14a. htm Steverman, B. (2009, September 23). CEOs and the pay-forperformance puzzle. Bloomberg Businessweek. Retrieved May 21, 2013, from http://www.businessweek.com/investor/content/sep2009/pi20090923_783858.htm Whole Foods Market Inc. (2013, January 25). Schedule 14A. Retrieved May 22, 2013, from http://www.sec.gov/Archives/ edgar/data/865436/000120677413000351/wholefoods_ def14a.htm Yahoo! Inc. (2012, July 19). Form 8-K. Retrieved May 7, 2013, from http://www.sec.gov/Archives/edgar/data/1011006/000119 312512307595/d384719d8k.htm Yahoo! Inc. (2013, April 30). Schedule 14A. Retrieved May 7, 2013, from http://www.sec.gov/Archives/edgar/data/1011006/ 000119312513187918/d501548ddef14a.htm