Many believe that Elon Musk already has revolutionized automotive technology, rocketry, and solar energy. He now may have done the same to U.S. executive compensation with shareholder approval of his new incentive compensation arrangement at Tesla’s annual shareholder meeting on March 21st. The shares held by Musk and his brother did not count in the vote, so the outcome cannot be attributed to ownership control.
The new incentive compensation arrangement is essentially 12 tranches of performance stock options, each vesting when Tesla’s market-capitalization value grows in $50 billion increments starting from $100 billion for the first option tranche and ending at $650 billion over 10 years. Market-cap was about $53 billion on the date of shareholder approval, making the goals aspirational. But if achieved, the earned compensation value delivered from the award is estimated to be $55.8 billion. This is a value-sharing ratio of 8.5% for Musk ($55 billion ÷ $650 billion).
Our comments are not a critique of the arrangement’s structure or rigor of the goals. It is on three potential high-level implications that we see as follows:
Redefinition of high-quantum CEO pay. Right or wrong, for purposes of annual proxy disclosure and market-value comparisons, public-company CEO pay is defined as the sum of annual cash compensation plus the “grant date fair value” of equity awards as prescribed by accounting rules. The accounting grant date fair value of Musk’s award is an estimated $2.6 billion. To date, the closest runner-up is arguably Apple’s Tim Cook who received a grant of $378 million in 2011; or Snap’s Evan Spiegel, whose 2017 grant value was $692 million, although at least partially attributable to IPO conversions. Regardless, the gap remains monumental even if annualized over the 10-year life of the agreement to recognize that the Company does not intend to provide Musk additional compensation until it is complete (Tim Cook’s grant also was intended for 10 years).
In approving the grant value, shareholders hopefully were focused on the relationship between the potential real level of pay delivery and the shareholder value creation, rather than the theoretical Monte Carlo grant-value opportunity reported in the proxy Summary Compensation Table. This would be an encouraging change, if true, since the proxy advisors and proxy reporting rules focus on the grant value. However, Musk’s 8.5% value-sharing ratio, from the performance option award that reflects 12% of the Company, far surpasses the total potential dilution from aggregate outstanding equity grants to all employees at most public companies, which is controlled through shareholder-approved stock plan authorizations.
Growth in market-cap value is a new way to measure long-term performance. It is common for companies to use total shareholder return (TSR) as a measure for performance-based long-term incentives, and to pay-out based on relative performance compared to peers or broader market indices. Though directionally similar, growth in market-cap value is not the same as the common TSR measure used for compensation purposes.
The reason that TSR and growth in market-cap value are different is that TSR is a per-share measure and market-cap is not. Said another way, market-cap can grow even if stock price remains flat due to issuance of new shares for financing, M&A, and option exercises. This is relevant for Tesla because the Company is likely to raise additional cash over the next several years, and it is conceivable that there will be share dilution from equity financing issuances that increase its market-cap without increasing stock price. Look at Tesla’s own history from 12/31/12 through 12/31/17 as an illustration. Cumulative average annualized TSR growth was 56%, while market-cap increased at a 68% compound average annualized rate during the same period (12 percentage points faster than TSR). TSR was excellent. But all else equal, the earnout of an equity award set to reward market-cap performance would have been higher than the amount earned by Tesla’s shareholders.
Board’s pass-off of the tough calls on CEO pay directly to shareholders. A major responsibility of public-company boards is to appoint the CEO and set his or her compensation. For the past seven years, boards’ executive-pay decisions have been subject to shareholder approval through the advisory Say-on-Pay vote that occurs annually in most cases. During that time, a body of rules and best-practices have been developed by proxy advisors and big investment funds. Boards are generally well-informed of these rules and practices that include both CEO pay quantum and structure. When they go outside accepted norms that may draw opposition, they approve the action and engage with shareholders after-the-fact to explain their rationale to campaign for Say-on-Pay support. The boards then take responsibility if the opposition is significant, which is commonly regarded as less than 70% approval.
When boards pass-off their responsibility for approving controversial CEO pay decisions directly to shareholders, there are two potential consequences. If the action is approved, the shareholders who approved the action are accountable to those who were opposed, taking the board “off the hook.” If the action is not approved, the board can take credit for aggressively pursuing its rationale. We expect other boards to consider the success of Tesla’s Board in similar future situations.
Michael Reznick has over 20 years of experience designing total compensation strategies, including short- and long-term incentives. He has consulted for a wide variety of industries and companies in all stages of growth and ownership structures. This includes life sciences, technology, consumer products, healthcare, manufacturing, oil and gas, distribution, professional and industrial services, airlines, mining, and hospitality. Michael’s experience includes all business phases, from early stage start-ups and IPO/spin-offs to mid-level growth companies and mature Fortune 50 clients, as well as extensive transaction and spin-off work.