Keyword: stock options

Apple Logo

There has been more than a little noise about executive compensation in general, and stock option backdating in particular.  I have been quite vocal about the ridiculous level of CEO pay, it is just silly that people should be getting 9-digit pay — for anything including professional sports.  I have witnessed some of the ugliest side of this, with supposedly mature executives arguing to me that, in some way in their mind, their mid-8-digit net worth was inadequate.  Little in this realm shocks me any more.

So when the charismatic do-no-wrong CEO of Apple, Steve Jobs, got caught up in the whirlwind of backdated stock options, I was not really surprised.  Only just a little disappointed.  But in some way, it proves little more than that Steve is, in fact, a mere mortal.

Now, time for a disclaimer.  I’m both a huge Apple fan and a shareholder.  I’m writing this on a MacBook Pro, am very close to swapping out my Windows desktop for a new MacPro, and have at least eight iPods in the family.  I love the simplicity, the way things just seem to work, and the passion for nice design.  And the stock has been a winner for us as well.  I am as excited as the rest of the planet about the future of the company, especially with the new iPhone in the works.  So I am admittedly biased to see the Apple glass more than a little half-full.

Recently it was revealed that Apple issued stock option grants that don’t meet with the standards of scrutiny that should be expected.  Specifically, grants were issued with dates that were the most favorable to the grantees, and this news forced the resignation from the board of the CFO at the time of the grants.  To Apple’s credit, they admitted the issue, although some complain not quickly enough.

What impressed me the most is that the release disclosed quite frankly that Steve was aware of the issue.  Most companies would first deny that anything like this happened, and their CEOs would almost certainly distance themselves from the fallout as quickly as possible.  It is refreshing to see at least one company and the CEO admit the issue.

Steve Jobs

But to be clear, Steve is no saint in the realm of money.  He is famous for his $1 a year compensation, but this belies his huge stock and option stake in Apple that has made him extremely wealthy.  Combined with his Pixar (now Disney) stake, Steve is well off with an estimated $4.9b net worth, placing him at number 49 in the Forbes 400 list.  In sum, he ceratinly hasn’t been short-changed with respect to compensation.

In Steve’s defense, however, is the fact that he made his money on the stock of his companies.  He doesn’t hold the companies hostage for some huge pay package, he simply owns stock, makes the company and stock grow, and both he and the other shareholders benefit.  In short: he earned it.

As a CEO compensation critic, this is just fine with me.  As a purchaser of technical products, I love the fact that he has advanced the state of the art and am happy to let him get his just reward.  And as a stockholder, I’m ecstatic.  The stock is up 10-fold in the last three years.  And if that works for Steve too, that’s great.

I have written more than a little about Home Depot and its CEO Bob Nardelli.  From their top-heavy “Culture Change Offensive” (which I found offensive here), and the silly army mentality Nardelli tried to force down everyone’s throat (and got stuck in my craw here), to Bob’s stunning pay package (which rubbed me raw here), and even his autocratic shareholders meeting (which I recounted here) Nardelli has provided plenty of fodder for these pages.  Well, it seems that the company and the board have finally come to their senses.

ATLANTA, Jan 03, 2007 — The Board of Directors of The Home Depot and Bob Nardelli announced today that they have mutually agreed that Nardelli would leave his position as The Home Depot’s chairman, president & CEO and as a Director effective January 2, 2007.

In other words: “get out…  like yesterday”.  Clearly the company simply tired of all the bluster and noise that went along with Bob’s “Army Mentality”, and the corporate results have been lackluster since he arrived.  And as I said in this piece, the mood in the stores is rancid.  It is a wonderful sign that the company saw the insidious effect Nardelli had, and chose to put an end to it.

But, the company didn’t completely come to their senses.  They continued to give Nardelli completely ridiculous payouts even as he exits in disgrace:

Nardelli and the Company have agreed in principle to the terms of a separation agreement which would provide for payment of the amounts he is entitled to receive under his pre-existing employment contract entered into in 2000.  Under this agreement, Nardelli will receive consideration currently valued at approximately $210 million (including amounts which have previously been earned or vested).

Holy Cow!  Even in the face of amazingly generous pay packages to CEOs, this one is a stunner.  This means that Nardelli has received, since becoming CEO of Home Depot, a whopping $400+ million in compensation!  During the same time, HD (the stock) has gone from a high of around $70 to the mid-30s.

And worse, much of this is clearly a golden handshake, or simply “go away” money.  It is optional, the board didn’t have to agree to it, but just wanted him out so badly they were willing to pay almost anything to have him go away:

This consideration will include a cash severance payment of $20 million, the acceleration of unvested deferred stock awards currently valued at approximately $77 million and unvested options with an intrinsic value of approximately $7 million, the payment of earned bonuses and long-term incentive awards of approximately $9 million, the payment of account balances under the Company’s 401(k) plan and other benefit programs currently valued at approximately $2 million, the payment of previously earned and vested deferred shares with an approximate value of $44 million, the payment of the present value of retirement benefits currently valued at approximately $32 million and the payment of $18 million for other entitlements under his contract which will be paid over a four year period and will be forfeited if he does not honor his contractual obligations.

The bulk of this is sickening…  I’m sure there were clauses in his contract that would have allowed the company to fight most of this.  I haven’t seen it, but I’d be shocked if it was all carved in stone.  I’m betting they didn’t have to accelerate his unvested and/or deferred options, they didn’t have to buy out his retirement plans, they just did it to get rid of him.

While I applaud Home Depot for ridding themselves of this jerk, I wish they had the backbone not only to fire him, but to not pay his blackmail too.  But I’m sure the company is better off without him.  The markets surely agree, the stock is up over 3% today alone on the news.

There has been quite a bit of hubbub lately over the end-of-year bonuses paid by Goldman Sachs.  It even provoked an op-ed piece in the venerable New York Times.  Totaling some $16.5 billion, and averaging $623,000 per employee, the payouts have set off a firestorm of shock, awe, envy, and more than a few cries of “That’s obscene!”  It’s really funny to see how people react when things not only work as intended, but work perhaps too well.

The more serious people question whether the pay was justified, or was prudent for the company.  With the average employee getting more than $200 an hour, and some reaching into the tens of thousands an hour, it seems inevitable that there would be sour grapes but the real question should be: is it right?

In a word: yes.  It’s fine, and even exemplary.  I think there are three key measures by which to judge a compensation system:

• Is it based on, and does it reinforce, the organization’s goals and objectives?
• Is it applied according to some reasonable, and preferably transparent, methodology?
• Is it fiscally prudent for the organization?

That’s it.  Forget about providing a living wage, or some sense of social fairness, or even public perceptions of the system.  If it meets these three measures, I think it is great.  Let’s look at each of these measurements, and reflect on Goldman’s application of them.

Reinforcing goals and objectives

This is number one for a reason: it is by far the most important.  I’ve said it here on these pages a hundred times, but the key to success in an organization is defining a clear vision followed by consistent daily application of that vision.  There are many ways to apply the vision, but few are more effective than to base compensation on it.  I have built compensation systems that are directly based on the company vision, and the results are astounding. [ed: more on this later]

Does the system at Goldman Sachs meet this test?  Well, from a distance it’s hard to tell.  But I can say that, from what I know of the company, the goal is to make deals and trades that benefit the buyers, the sellers, and Goldman Sachs.  And by all reasonable measures, they hit a home run there.  Pre-tax profit (that’s net, not gross) even with these salaries included was over a half-million per head.  That’s twice the Wall Street average, and 5 times what we so proudly got when I was at Microsoft.

So, even without knowledge of the specific goals and objectives that Goldman set for itself, it’s clear that from a strictly financial perspective, they scored big.  And the compensation system should reward those who exceeded those objectives so dramatically.

Reasonable and transparent methodology

This is the point that catches up so many companies.  Many firms have their compensation set extremely top-heavy, with those who control the purse strings, taking the most out of the purse.  I like to see a compensation system that is based on some simple, clear, and preferably public, metrics.  Typically it’s something like gross sales, or gross profit, or even something like regularly measured customer satisfaction.  Whatever it is, it should be simple, directly correlated to things people actual have some influence over, and difficult to “game”.

Another key component of this is that the compensation system should be very broadly based.  Not just a perk for those at the top, but dipping deep down into the organization, so that all people who have a part in creating the success can share in it.  When I was at Microsoft, virtually all full-time employees were eligible for stock options.  That’s the kind of example I’m stressing here.

From what I can see, Goldman’s scheme meets these objectives.  There are stories of most employees seeing twice to three times their peers at other firms, and this is in line with their company performance against their competition.  Yes there are reports of some secretaries complaining they only got $120k when others saw millions, but that melts when you point out that’s 2x the going rate.  So what this all means is that the system is implicitly broad-based and relatively effective.

Fiscally prudent

This is where Goldman has me completely won over.  You see, they pay compensation in arrears.  They wait until the end of the year, and then, once all the numbers are in, they divvy up the spoils.  This has many great effects, a key one being that they never have to worry about paying for performance they might achieve.  They know both how well the person has performed, and how much they can afford to reward them.  How clean is that?

In addition, they have the benefit of drawing the bonuses not from pending revenue, but from cash on hand.  And they’ve had the better part of a year to invest that money wisely, before they have to pay it out.  I think every small firm that has had to scrape to make bonus payments would do well to consider a scheme like this.

So, in summary, I think Goldman has it just about right.  They pay people from their profits, they do it in a manner that rewards for definitive past performance, and in line with their corporate objectives.  The fact that the company was enormously profitable isn’t something people should resent.  Envy, maybe.  Emulate, probably.

Numerous news reports and blog postings have been aghast at the fact that some execs were setting the price of their option grants at the lowest price in the period.  They are simply stunned that these execs would take advantage of the system. “How could they?”

Oh, grow up.  As the guy responsible for this system at one of the leaders of the whole “options as pay” phenomenon, let me tell you that nothing, literally nothing, could surprise me in the realm of pay.  I’ve seen senior executives complain about pay that would be the GNP for a small country.  I’ve seen people who normally show incredible judgement and morals become slimey at the drop of a paycheck.  And I’ve seen amazingly smart people put sincere time and effort into figuring out ways to game any system that involves their pay.  I’ll tell some of these stories over time here, but, nothing in this realm surprises me any more.

Let’s be clear, you’re giving people options [money] and you need to decide when to give it to them [cost], and the choice is up to them.  Hmmm, let me see…  I’ve got it, how about when they cost me the least?  Why does this shock anyone?  Why does this even make news?  How else would it be done?

At Microsoft, and other companies, the kind of backdating described in these reports was systemized in their ESOP (Employee Stock Ownership Plans).  The plan defined as a rule the price to be paid for the shares as the lower of the stock price at the beginning or the end of the purchase period.  Yes this is outright stock purchase, not options.  Yes, this was defined as part of the ESOP plans, not some hidden understanding between the purchaser and the issuer.  And Yes, it is legal under the ESOP rules.  But it should not surprise anyone that a similar rule/system would be put in place for exec option grants.

The thing that seems to shock people is that this behavior resulted in people making obscene amounts of money.  This is where they begin to get to the point.  Executive pay is absurd these days.  All you have to do is look at mediocre performers getting 9-digit pay packages and you see that it’s not how they get the money, but why they get it that is the problem.  I have lots more to say on that [ed: stay tuned].  But come on, you give children the keys to the candy store, you have to expect them to binge on a sugar high.

Well Bob, it worked.  This great PR offensive (see these posts about it here and here) worked wonders, the board bought all this stuff, and they rewarded you handsomely.  In the last five years, you’ve received some $200 million in salary, bonus, stock, stock options, and other perks.  In 2005 alone, you got a stunning $38.1 million in total compensation.  Nicely done.

But in case you missed it, the Home Depot board has guaranteed Bob Nardelli a “bonus” of $3million.  Read about it in BusinessWeek online.

one lucrative element of the package is not as well-known: Nardelli’s guaranteed minimum annual bonus.  Of course, many CEOs are eligible for a bonus each year, usually if they hit certain financial and operating targets.  Others have more limited guarantees, such as an assured payout in the first year of service.  But Nardelli’s employment contract shows that $3 million of his annual bonus, defined as the “target amount,” is a sure thing. “For each year during the period of employment,” says the agreement, “the executive will receive an annual bonus of no less than the full target amount.”  Last year, Nardelli earned a total bonus of $7 million.

Guaranteed bonus?  Isn’t that an oxymoron?  Aren’t bonuses supposed to be a reward for good work you did, not compensation for work you are going to do?

And as writer Brian Grow notes in that article, it’s not like he’s returned anything to shareholders.

To the ire of many investors, however, Home Depot’s total return to shareholders, a key benchmark of corporate performance, is down 13%, according to Institutional Shareholder Services (ISS).

Gee, Bob, hope you share some of it with the PR team.