"What pay for performance looks like: the case of Michael Eisner"
By Stephen F. O’Byrne, Stern Stewart & Co.
Journal of Applied Corporate Finance 5 (summer 1992), pp. 135-136
It’s easy to think of Disney CEO
Michael Eisner as a classic case of
executive pay run amok. His total
compensation in his first six years on the
job exceeded $250 million. In reality, he
is a classic example of what “pay for
performance” looks like.
When Eisner was hired in late
1984, he took over a troubled company.
Disney had just been through a bitter
takeover battle, theme park attendance
was declining, and return on equity had
fallen below 8%. When he joined
Disney, Eisner agreed to a six-year
employment contract with three main
compensation provisions: a base salary
fixed at $750,000, an annual bonus equal
to 2% of Disney’s net income in excess
of 9% of stockholders’ equity, and a tenyear option on two million shares
exercisable at Disney’s current market
price of $14.
While Eisner’s contract provided
for guaranteed payments with a present
value of only $3.9 million, its expected
value was, of course, much greater. The
expected value of his options, based on
the Black-Scholes option pricing model,
was $16 million. I also estimate that the
expected value of his total contract,
including bonus and pension rights, was
$22 million.
The Disney directors were
presumably willing to enter into a
contract worth $22 million because it
provided a tremendous performance
incentive that could provide great
benefits to Disney shareholders. The
contract made Eisner’s wealth even
more sensitive to Disney performance
than the shareholders’ wealth. A 200%
increase in Disney’s stock value – above
the company’s CAPM-expected return –
would increase the value of Eisner’s
contract by 279%. A 67% decline in
Disney’s shareholders’ wealth would
reduce the value of Eisner’s contract by
71%.
What happened? Eisner and his
team took risks, transformed the
company in many ways and achieved
remarkable success. (The Disney Touch
by Ron Grover provides a fascinating
chronicle of Eisner’s tenure.) By the end
of the original contract term, the price of
Disney stock had increased to $102 per
share, an increase of more than 600%.
Over that same period, Eisner’s
compensation (including unrealized
option gains) from his original contract
was $190 million, an increase of more
than 750% over the initial contract
value. The shareholder gain from
Eisner’s performance was enormous.
The wealth of Disney shareholders had
increased from $1.9 billion in 1984 to
more than $14 billion at the end of 1990,
a gain of $9.5 billion more than they
would have realized with an investment
in the S&P 500. The cost of Eisner’s
performance incentive was about 2% of
the excess return realized by Disney
shareholders.
In late 1988, Eisner signed a new
ten-year employment contract. The
contract extension presented Disney with
a difficult choice. Should the key terms
of the contract – a bonus of 2% of net
income in excess of 9% of equity and an
option on two million shares exercisable
at the current market price – be extended
even though they now had an expected
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value of more than $120 million, far in
excess of competitive pay levels? Or
should the bonus formula be changed
and the option grant reduced to bring the
contract value closer to competitive
levels even though doing so would be to
penalize Eisner for his own superior
performance? If Disney penalize Eisner
for superior performance, it would be
undermining the strong performance
incentive it originally sought to create
and that served it so well.
Disney
made
the
right
decisions. The company chose to
maintain the integrity of Eisner’s
performance incentive at the cost of
paying far above the market. Disney and
Eisner agreed to extend the original
contract terms (including the $750,000
salary) with three modest changes:
increasing the bonus threshold to 11%
beginning in 1991, paying the portion
of the bonus attributable to net income
in excess of 17.5% of equity in restricted
stock (also beginning in 1991) and
making a quarter of the two million
new option shares exercisable at $10
above the current market price of
$69. By the end of 1990, Eisner had
an unrealized gain of $60 million on the
new option grant, in addition to the
$190 million in compensation he
received under the terms of his original
contract.
Eisner’s contract is very
different from the typical CEO’s
compensation program. The typical
CEO has much more guaranteed pay.
Salary and pension on salary represent
38% of the typical CEO’s total
company-related wealth vs. 18% of
Eisner’s contract in 1984. The typical
CEO has a bonus plan that shows little
performance sensitivity over time
because targets are adjusted to the level
of recent performance. The typical CEO
receives annual long-term incentive
grants (often including restricted stock)
with “fixed value” grant guidelines that
penalize performance instead of the
front-loaded
options
that
Eisner
received. “Fixed value” grant guidelines
guarantee the same dollar grant
regardless of stock price performance.
Superior stock price performance is
effectively penalized by reducing the
number of shares granted and poor stock
price performance is rewarded by
increasing the number of shares granted.
“Fixed value” restricted stock grants are
particularly pernicious since they ensure
large gains for poor performance.
The net result is that the typical
CEO has a much weaker performance
incentive than Michael Eisner. A 200%
increase in shareholder wealth would
increase the typical CEO’s companyrelated wealth by only 91% – far less
than the 279% change in Eisner’s wealth
for the same performance. A 67%
decline in shareholder wealth would
decrease the typical CEO’s companyrelated wealth by only 30%, as
compared to the 71% decline in Eisner’s
wealth for the same performance.
One lesson of Michael Eisner is
that true pay for performance will – and
should – lead to very high pay levels. A
second lesson is that the average CEO’s
total compensation program needs a lot
more performance incentive to fully
align the CEO’s interests with those of
the shareholders.
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