460 CHAPTER 12 Corporate Valuation, Value-Based Management, and Corporate Governance
GM, IBM, Mattel, Campbell Soup, and Xerox, to name just a few, have been removed.
This would have been unheard of 30 years ago.Using Compensation to Align Managerial
and Shareholder Interests
In the preceding section we discussed the stick side of corporate governance. Now we
turn to the carrot, managerial compensation. The typical CEO today receives a fixed
salary plus a bonus that is zero if the firm’s performance is poor but that rises as per-
formance becomes better and better. In 1997, salary for an average executive
amounted to about 21 percent of total compensation versus bonuses of about 79 per-
cent. So, performance certainly matters!^9
Executive bonuses are based on a number of criteria, some reflecting short-term,
or very recent, performance and others reflecting performance over a longer period.
Bonuses also reflect internal operating statistics as well as stock prices, which reflect
both internal operations and general stock market movements. On average, short-run
operating factors such as this year’s growth in earnings per share account for about 34
percent of the bonus, 20 percent is based on longer-term operating performance such
as earnings growth over the last three years, and the remaining 46 percent is linked to
the company’s stock price. Bonuses can be paid in cash, in stock, or in options to buy
stock. Moreover, they can be paid immediately after the relevant period (immediate
vesting) or be awarded in stages over a number of years (deferred vesting). To illustrate
deferred vesting, an executive might be awarded 10,000 shares of stock, but at the rate
of 2,000 per year for each of the next five years, provided he or she is still with the
company on each payment date.Stock Options The majority of stock-based compensation is in the form of options.
Chapter 17 discusses option valuation in detail, but we discuss here how a standard
stock option compensation plan works. Suppose IBM decides to grant an option to an
employee, allowing him or her to purchase a specified number of IBM shares at a fixed
price, called the exercise price, regardless of the actual price of the stock. The exercise
price is usually set equal to the current stock price at the time the option is granted.
Thus, if IBM’s current price were $100, then the option would have an exercise price of
$100. Options usually cannot be exercised until after some specified period (the vesting
period), which is usually one to five years. Moreover, they have an expiration date,
usually 10 years after issue. For our IBM example, assume that the vesting period is 3
years and the expiration date is 10 years. Thus, the employee can exercise the option 3
years after issue or wait as long as 10 years. Of course, the employee would not exercise
unless IBM’s stock is above the $100 exercise price, and if the price never rose above
$100, the option would expire unexercised. However, if the stock price were above $100
on the expiration date, the option would surely be exercised.
Suppose the stock price had grown to $134 after five years, at which point the em-
ployee decided to exercise the option. He or she would buy stock from IBM for $100, so
IBM would get only $100 for stock worth $134. The employee would (probably) sell the
stock the same day he or she exercised the option, hence would receive in cash the $34
difference between the $134 stock price and the $100 exercise price. People often time
the exercise of options to the purchase of a new home or some other large expenditure.
Let’s suppose the employee is actually a senior executive and the grant was for 1
million shares. In this case, the executive would receive $34 for each share, or a total
of $34 million. Keep in mind that this is in addition to an annual salary and other(^9) See Thomas A. Stewart, “CEO Pay: Mom Wouldn’t Approve,” Fortune, March 31, 1997, 119–120.