Anne-Marie Fink is the author of “The Moneymakers: How Extraordinary Managers Win in a World Turned Upside Down” and runs the Money Makers site. Here’s an excerpt from the book:
Paying as many employees as possible in stock is an article of faith to both corporate leaders and people in the investing community. I risk being branded as a heretic, therefore, when I say:
Don’t pay employees in stock except those at the highest levels. Investors advocate paying in stock, because we want employees to share our pain when their stocks are not doing well. A shareholder revolt ousted CEO Bob Nardelli from The Home Depot in 2007 due to his indifference to the stock price, which had been stagnant for years. Those at the most senior levels of an organisation, the top five to 10 folks, certainly need to be responsive to shareholders, and receiving a large piece of their compensation in stock or options ensures that they will pay attention when the stock isn’t doing well.
However, to pay anyone else in the organisation in stock or options separates pay from performance. Over the long term, stock prices are determined by the earnings and returns that employees generate, but in the short and intermediate terms stocks can move for reasons entirely unrelated to a company’s performance. Nothing makes investors cringe more than when a CEO or CFO predicts how high a company’s stock price is going. As people paid to forecast where stocks are going to go, we know how inherently unpredictable the stock price for any one company is; too many exogenous factors influence prices.
These influences disconnect pay from performance. Throughout the 1990s, many CEOs and other option holders enjoyed huge increases in their compensation despite mediocre or poor performance. They benefited as the stock market rose more than fourfold over the course of the decade. As interest rates fell and risk tolerance rose, investors paid higher price/earnings multiples for stocks. This rising tide lifted all stock prices, even those of poor performers. In 2007–08 executives have seen the reverse impact as the global credit crisis has taken down all stock prices, even for those companies with no exposure to the subprime mortgage market meltdown that precipitated the crisis.
Changes in market conditions decouple the performance of stocks from underlying companies’ earnings and return results. For employees below the upper echelon, the disconnection between stock price and individual performance is even larger. These folks not only don’t impact the multiple of earnings that their stock trades at, they don’t impact the overall earnings. Just as rewarding employees on companywide metrics doesn’t work because most employees can’t impact the whole, so too rewarding employees with stock is in effective.
The United Airlines debacle with its employee stock ownership plan should serve as a warning to any corporate executive who thinks freely awarded options or ownership will align the interests of his or her employees. In 1994, UAL Corporation, the parent of United Airlines, signed a historic deal with its pilots’ and mechanics’ unions, giving them majority ownership in the company in exchange for wage and work- rule concessions. United represented the perfect test case of aligning employees’ and shareholders’ interests through stock ownership.
Instead, they proved to be woefully misaligned. The original deal had the pi lots, mechanics, and some nonunion employees taking an average 15 per cent cut in wages for six years in exchange for a 55 per cent stake in the holding company. The deal enabled UAL to stave off bankruptcy and expand at a time when other major carriers were saddled with higher costs. The deal worked reasonably well until the wage snapback approached. Then it became clear that as owners of the airline, pilots and mechanics felt they could set their pay as high as they wanted. They demonstrated little concern for other shareholders. The results were disastrous. When senior management didn’t immediately accede to their wage demands, the pi lots staged a disruptive, but effective, work slowdown in the summer of 2000. Management caved and the pi lots received significant pay increases just as the industry went into a cyclical downturn. With higher costs, customers annoyed by the job actions, and less revenue, UAL filed for bankruptcy protection in 2002. It was a tragedy not only for the in de pen dent shareholders but also for the pi lots and mechanics,
who saw the value of their stock wiped out.
There’s another flaw in employee stock ownership plans:
Reward people with stock, and you’ll hurt long- term productivity.
This may seem counterintuitive; after all, stock ownership would seem to give employees a reason to work harder and better than ever before, but it has other effects that negate this owner mentality. When employees have much of their net worth tied up in a company’s stock price, it’s often detrimental to the longterm interests of outside investors. Many option- heavy Silicon Valley firms see significant brain drains when their stocks do well; their employees can afford to retire. The problem becomes even worse when a company’s stock stops rising (as all stocks inevitably do, because eventually a company’s growth prospects get priced in). Intel, the premier semiconductor maker, experienced a 17 per cent increase in employee turnover in 2004, when its stock stagnated after almost doubling in 2003. It’s no coincidence that
after this brain drain the company struggled and two years later had to lay off 10 per cent of its employees as its results sagged.
I’m not arguing that you shouldn’t reward people for good performance, but you should:
Pay your people, whenever possible, with cash.
Though some professional investors talk a good game about stock being the best reward, most will admit that to really motivate people, cash is king. I remember speaking with a top equity analyst who told me that one of the most important things he looked for in potential investments was shareholdings by employees. Yet minutes later, he lauded the advantages of working for a hedge fund versus a bank- affiliated money manager because hedge funds pay bonuses in cash whereas banks pay in stock. On a personal level, he was acknowledging that he much preferred receiving cash rather than stock. Your employees will feel the same. A dollar is always worth a dollar (more or less), while a stock’s value can plummet through no fault of one’s own.
On a company level, too, I have seen greater long- term success in companies that pay their people with cash. Jefferies, a midsize brokerage firm, has succeeded in a field dominated by much larger players because it has tapped into the motivating effects of cash. Unlike other big brokerage houses, where much of employees’ compensation is in restricted stock or options paid out over three- year vesting periods, Jefferies pays its employees their commissions monthly and in cash. Traders and salespeople see a direct connection between their efforts and their spendable paychecks. This compensation system has worked for Jefferies; its stock price almost doubled from the end of 2003 to the end of 2006, and it avoided most of the problems other brokerages faced in 2007–08. Moreover, even though it does not lock employees in with restricted stock, the company’s turnover is lower than at other brokerage firms; Jefferies’ employees stay because they like working in an environment where they see concrete rewards for their efforts.
When awarding cash bonuses, you need to calibrate reward cycles based on the time required to judge success, given your employees’ tasks, as well as your business’s sales or product cycle. In brokerage firms, employees oversee dozens of profit generating transactions daily, so monthly rewards are appropriate. In longer- lead- time businesses, annual bonuses may be more appropriate.
The primary exception to the rule against paying in stock is start- ups; here, paying in stock makes more sense. Start- ups rarely have the cash to pay employees, so stock is often the only option. The firms are small, so interests are more readily aligned through personal contact. Plus, the upside is much greater if a company survives, so the motivational impact of the stock is more powerful. At the same time, paying in stock creates sanctions for failure. If a company doesn’t survive, the stock is worthless; naturally, stock compensation results in high turnover in start- ups. But this unfortunate repercussion is tolerable given the constraints. Leaders of start- ups also need to remain aware that they can’t stick with stock compensation for too long. As a company gets bigger and more established, the potential upside in the stock value will decline and the negative impact of stock’s inherent disconnect between pay and performance will overwhelm the benefits.
- Never forget that cash is king. Payments in stock and options divorce pay from performance.
- Pay rewards based on your business cycle. They should be frequent but still allow you enough time to assess the effectiveness of employees’ efforts.
- Use stock as compensation in a start- up, if necessary, but transition to cash rewards once your business gets on its feet.
Reprinted from The Moneymakers by Anne-Marie Fink. Copyright © 2009 Anne-Marie Fink. Published by Crown Business/Publishers, a division of Random House, Inc.