Musk’s $56bn is not the problem

Good morning. This morning’s jobs report will give us a better sense for whether the rather limp recent economic reports were (a) a welcome sign of gradual normalisation of the US economy and inflation’s incipient return to target, (b) indicative of rising recession risks as pandemic stimulus and savings are exhausted, or (c) just seasonal noise within a still very strong economy. When the numbers hit, tell me what you make of them: robert.armstrong@ft.com.

Elon Musk’s very stupid pay package is not that much stupider than everyone else’s

There has been a fair amount of huffing and puffing this spring about the incentive pay package that Tesla awarded to its CEO Elon Musk back in 2018. If it stands, it will pay Musk $56bn. A Delaware judge voided the package in January, on the grounds that the board was insufficiently independent at the time of approval. Tesla’s board wants shareholders to re-ratify it at the company’s annual meeting next week. Last month two proxy advisers recommended that investors vote against it.

One large Tesla shareholder, Baillie Gifford’s Scottish Mortgage Investment Trust, backs the plan:

“We agreed the remuneration package with Tesla back in 2018 because it introduced extremely stretching targets that would make a huge amount of money for shareholders if they were reached,” Tom Slater, manager of the £14.1bn trust, told the Financial Times. “Having agreed to that, we believe that it should be paid out.” 

That’s about right. The size of the award offends people, perhaps rightly. But it was agreed by the shareholders and the board. Without analysing the principles of board independence under Delaware law, taking the money back now feels like cheating. To invoke the rule of the playground: no takesies backsies.

What offends me is not the size of the award, but the structure. And, unfortunately, that structure has a lot in common with most public company pay packages. 

The package works, or worked, roughly as follows: It granted Musk the option to buy up to the equivalent of 12 per cent of Tesla’s outstanding shares as of January 2018, at the share price back then. The options vested in 12 equal tranches, the first when the market capitalisation of the company reached $100bn and sustained that level, on average, for six months. Each successive tranche vests when Tesla’s market cap adds and sustains an additional $50bn, up to $650bn. The market cap targets are contingent upon additional targets for revenue and profits.  

The problem is that pay package like this has the effect of making it the executives job to get the share price up. This absolutely should not be the executive’s job.

Before saying why it shouldn’t, it is important to point out that if getting the stock price up was Musk’s job, he has done that job unbelievably well. Yes, Tesla’s market cap, at $567bn, has now fallen below the top target in the pay package. But the stock price has compounded at 37 per cent a year since 2018. To the extent Mr Musk is in control of the stock price, he has done such a good job of driving it up that a lot of people don’t understand how it can be so high (a car company trading at 70 times earnings?). If his intention was to turn buying the shares into the entry fee for a cult, it seems to have worked.

On the other hand, to the extent that Mr Musk is not in control of the stock price, the pay package was very badly designed. We can all agree that there is a link between what chief executives do and the creation of economic value by the companies they lead. We can all also agree that there is a link between the creation of economic value at a company and the company’s share price. But we also know that those connections are loose rather than determinate, are only partly understood, and can be badly out of whack for a long time. 

This looseness is the first premise of an argument against paying executives on the basis of the share price. You should pay people for achieving outcomes they can understand and control. Defenders of share pay will quote some version of the claim, attributed to Ben Graham, that in the short term the stock market is a voting machine and in the long run it is a weighing machine. That is probably right in most cases, but the timeframe matters. 

Is six years enough for the voting to become weighing? That is not the only timing problem. When can we determine whether the investment projects initiated by a chief executive have added long-term value, rather than being a stunt or a flash in the plan? This is to say nothing of the fact that it is a bit odd to reward executives based on the fluctuations in value of the stock market overall. Can Musk also control the market’s valuation multiple, or whether tech stocks are in or out of style with investors? And then there is the much-discussed problem of the asymmetrical incentives embedded in stock awards. A high-risk corporate gambit stands to make the boss rich if it succeeds, but will not ruin her if it ultimately destroys the company. 

All of this makes a pretty clear case against pay packages like Tesla’s, in which executive awards are based directly on share price or market cap targets. But the very same arguments apply to pay packages that indirectly link pay to the stock price.

Stock options vesting over three to seven years are the bedrock of compensation plans at most public companies. These are mostly based on the company hitting financial targets, but they still put the executives in the business of getting the stock price up. The stock price determines how much the executive will be paid when the financial targets are hit. But this is not what the executives should be focused on; they should be focused on making the company better at doing whatever the company does.

Stock compensation is a bad idea. People like to talk about the alignment of shareholders and executives. But which shareholders? Over what timeframe?

Better to pay in cash, based on financial metrics (returns) and operational ones (production). There are many reasons companies don’t do this. One of them, I would speculate, is that deciding on such a pay package would require the board to commit to a clear and specific view of what the company’s goals are, how the achievement of those goals creates value, and exactly how much it is worth to the company’s owners if those goals are achieved. Tying executive pay levels to the stock price outsources those difficult decisions to the market, letting the board off the hook.

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The Michigan boom.