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Saturday, July 4, 2009

The Myth of $1 CEO Pay

A lot of times, I hear the following story on the Communism Channel. A CEO of a struggling corporation agrees to work for a salary of $1. Isn't he such an awesome guy!

What the story neglects to mention is that the CEO is getting paid in the form of options and restricted stock (usually options).

A pro-State troll says "So what? Options are only valuable if the corporation's stock price increases!" The fallacy is that, due to inflation, all stocks rise over time.

Suppose that the CEO does a bad job, but the overall stock market doubles in 2 years. Suppose that corporation's stock price rises by "only" 80%. The CEO still gets a huge windfall when he cashes out his options, even though his corporation's stock underperformed the rest of the market.

Recently, CEO option grants are charged as an expense, according to the Black-Scholes price. The fallacy is that the true value of the option is greater than the Black-Scholes price, because the expected gain in the stock market is much greater than the risk-free interest rate. The cost of option grants are paid by other shareholders, as their ownership is diluted.

Another fallacy of option-based CEO compensation is that the CEO is not really taking any risk at all. If the share price rises, then the CEO gets a windfall. This is true even if the increase in share price is due to inflation and overall market movement, rather than anything the CEO does. If the share price falls, then the CEO gets his options repriced with a lower strike. As long as the stock price changes, the CEO benefits.

Sometimes, a profitable corporation will spend money repurchasing shares. If the CEO grants himself 1M shares of options, the corporation may repurchase 1.5M shares. The fallacy is that the money spent on share repurchases is otherwise unavailable for dividends or reinvesting for future growth. The corporation may decide to repurchase shares at the same time that the CEO is cashing out his options!

When the CEO is paid via equity grants, the other shareholders pay for it. The ownership interests of other shareholders are diluted. Just like your slave points lose their value when new money is printed, shares of stock lose their value when the CEO prints new shares and gives them to himself. This is one big reason why the stock market underperforms true inflation over time.

The "CEO working for $1!" story is a common evil fnord. It makes the CEO seem like a swell guy working for free, rather than someone lining his pockets at the expense of shareholders. Even though the CEO is working for only $1 cash, the CEO is still getting paid via option and equity grants.

1 comment:

CEO said...

I'm glad that I got to read this article. It was very enlightening and captivating.

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