Chapter Thirteen
Compensating Executives
Who are executives?
Executive compensation plans provide favorable tax
treatment. IRS recognizes employees who play
major role in company’s policy decisions:
Key employees:
Officer having annual comp > $130k ($5k increments
starting 2003)
5% owner of the employer
1% owner and annual comp > $150k
Highly compensated employees:
5% owner
Annual comp > $80k in 2000 (indexed for inflation)
Employee was among top 20% employees ranked by
comp in the preceding year & elected by employer for
this plan.
Figure 13-1
Examples of Key Employees
Chief
Exec. Officer
President
Executive
VP
VP
Accounting
VP
Finance
VP
HR
VP
Mftg.
VP
Marketing
Director
Accounting
Director
Finance
Director
HR
Director
Mftg.
Director
Marketing
Managers
Supervisors
Accountants
Clerical Staff
Managers
Supervisors
Fin. Analysts
Clerical Staff
Managers
Supervisors
HR Specialists
Clerical Staff
Managers
Supervisors
Prod. Workers
Clerical Staff
Managers
Supervisors
Specialists
Clerical
Staff
Executive Compensation Packages
Core Compensation
Base Pay:
It does not accord to the rational process used for other
jobs.
Bonuses:
Discretionary bonuses = f(profits, financial condition,
business conditions, future prospects)
Performance-contingent bonuses = f(perf. criteria);
see perf. Criteria in table 13-7.
Predetermined allocation bonus = f(profits)
Target plan bonus =f(minimal standard)
Short-term incentives: Profit and gain sharing plans
Table 13-7
Corporate Performance Measures (1 of 3)


Size
» Sales
» Assets
» Profits
» Market value
» Number of employees
Growth
» Sales
» Assets
» Profits
» Market value
» Number of employees
Table 13-7
Corporate Performance Measures (2 of 3)


Profitability
» Profit margin
» Return on assets (ROA)
» Return on equity (ROE)
Capital Markets
» Dividend yield
» Total return to shareholders
» Price/earning ratio
» Payout
Table 13-7
Corporate Performance Measures (3 of 3)


Liquidity
» Current ratio
» Quick ratio
» Working capital from operations
» Cash flow from operations
Leverage
» Debt-to-equity ratio
» Short-term vs. long-term debt
» Cash flow vs. interest payments
Executive Compensation Packages (cont’d)
Deferred Core Compensation
Stock compensation: intended to create a sense of ownership &
alignment of interests with those of shareholders.
Incentive stock options: future stock purchases resulting in (potential)
capital gains –not taxable until stock is disposed, not when
options are granted.
Nonstatutory stock options: do not qualify for favorable tax treatment –
pay income tax on the diff. between discounted price and stock
fair market value.
Restricted stock: executive cannot dispose of stock for a
predetermined period –often 5 to 10 years.
Discount stock options: stock granted at rate below market value.
Stock appreciation rights: award payment based on the difference in
stock price.
Golden parachute: Extend pay & benefits 1 to 5 years after
termination.
Table 13-2
Employee Stock Terminology





Stock option. A right granted by a company to an employee to
purchase a number of stocks at a designated price within a
specified period of time.
Stock grant. A company’s offering of stock to an employee.
Exercise of stock grant. An employee’s purchase of stock
using stock options.
Disposition. Sale of stock by the stockholder.
Fair market value. The average value between the highest and
lowest reported sales price of a stock on the New York Stock
Exchange on any given date. The Internal Revenue Service
specifies whether an option has a readily ascertainable fair
market value at grant. An option has a readily ascertainable fair
market value if the option is actively traded on an established
stock exchange at the time the option is granted.
Executive Compensation Packages (cont’d)
Fringe compensation: Enhanced protection
Supplemental Life Insurance:
Split-Dollar
Death Benefit Only
Group Term Life Insurance
Supplemental Retirement: caps qualified annual earnings
to $200k in 2003, indexed for inflation afterwards.
Perquisites (Perks): status, personal comfort or business
tools; cross-cultural differences.
Table 13-4
Common Executive Perks

Company cars

Financial services

Legal services (for example, income tax preparation)

Recreational facilities (for example, country club and
athletic club memberships)

Travel perks (for example, first-class airfare)

Residential security

Tickets to sporting events
Principles and Processes for setting
executive compensation
Executive Compensation Consultants: strategic analysis,
identification of competitors, potential conflict of
interest.
Board of Directors: 10 external + 3 internal members;
interplay between director and CEO compensation.
Avg. annual CEO compensation in 2003 = $15.7 million.
Differentials with avg. entry-level job in 1980 = times 42.
Differentials with avg. entry-level job in 2000 = times 475.
Firm size.
Directors’ pay in their primary job –implications for
directors’ selection.
Cross-cultural differences: U.S. differentials do not have a
parallel in Europe or Asia.
Principles and Processes for setting
executive compensation (cont’d)
Agency Theory: executives do not share the
interests of shareholders –agency problems
between agent and principal.
Tournament Theory: lucrative compensation as
prize in a series of increasingly competitive
contests among lower-level managers.
Social Comparison theory: CEO compensation =
f(board members’ own compensation, CEO
compensation in similar companies).
Figure 13-2
CEO Compensation as a Tournament
Chief Executive Officer
Compensation ($)
Pres.
Vice
President
Director
Manager
Professional
(for example, financial analyst)
Conflicts Faced By Corporate
Directors

Help set strategic plans that affect profits.

Face the possibility that disgruntled
stockholders may sue over corporate
strategies that are unprofitable or unpopular.
Direct Compensation to Corporate
Directors
Annual retainer
 Attendance fees
 Fees for participation on subcommittees
 Increasing emphasis on director
rewards that link to corporate
performance

» More pay is stock-based
Major Benefits Offered to
Directors






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Retirement programs
Matching director’s gift to college or university
Deferral of cash compensation until
retirement
Grants to charity
Medical insurance
Payment of spouses travel expenses
Death benefits
Supervisor Compensation
Supervisors and lower-level managers: internal
equity problem when there is little incentive to
take over extra responsibilities of supervisory
job & make less than top-paid supervised
employees.
Most companies prefer to pay supervisors a 5 to
30% differential with top-paid subordinate.
Discussion Question 13-1
Do you know anyone who has turned down a
supervisory or managerial job or have you heard
of such a case? What was the motivation for
turning down the job offer? Do you think that
corporations would have more and more
problems convincing people to accept supervisory
jobs in the future? Besides a salary differential,
what would you recommend that employers do to
make supervisory jobs more appealing?
Professional Compensation
Dual-career tracks for scientists and engineers:
prevents losing technical talent and/or unwanted
moves into management. IBM example:
Mgmt. Ladder
Executives
Functional management
Technical Ladder
IBM Fellow
Sr. technical staff
Senior
Senior
Development
Advisory
Project
Staff
Table 13-5
Securities and Exchange Commission Disclosure
Requirements for Executive Compensation
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Stock option and stock appreciation right tables
Long-term incentive plan table
Pension plan table
Performance graph comparing the company’s stock price
performance against a market index and a peer group
Report from the compensation committee of the board of
directors explaining compensation levels and policies
Description of the directors’ compensation, disclosing all
amounts paid or payable
Disclosure of certain employment contracts and golden
parachutes
Discussion Question 13-2
The recent fallouts of ENRON and other corporations have partly been
blamed on greedy executives who manipulated the business to benefit from
their stock options. Stock options were intended to align the interests of
executives (agents) and their principals (stockholders). One of the criticisms
has been the absence of a downside for executives in stock options. Do
some library or internet research on this issue to ascertain why stock
options failed to achieve their intended goal in cases such as ENRON.
Research also alternatives to stock options -but also involving stock- that
corporations are employing nowadays; be sure to understand why those
alternatives are more effective than stock options.