CHAPTER 7 CEO COMPENSATION MELDAH ANGIR & NANCY VISAVILWA

MANAGEMENT COMPENSATION The board is usually faced with the task of wanting to attract and retaining the right people to manage the enterprise in line with share holders interests in both the short term and long term The underlying challenge is the justification of an expansive CEO package to the general public vis- à-vis the threat of losing an impressive CEO to another competing firm.

MANAGEMENT COMPENSATION Ideally Management compensation must reward strong current performance and simultaneously provide incentives for similar future results It should be structured in manner such as to avoid premiums for average or poor performance

MANAGEMENT COMPENSATION In recent years there has been increased publicity on CEO compensation both in the print and electronic media. The resultant effect is the general public questioning the expansive pay packages. This is because the topic is so complicated and hence it is not easy to relate the amount of compensation to performance. and thus to the average person CEO salaries are far much in excess in relation to their performance

GOAL OF EXECUTIVE COMPENSATION The goal of executive compensation is to find equilibrium level that provides share holders with the greatest return consistent with their risk tolerance, net of the cost of compensation The challenge therefore for the board in how to find the best deal for the share holders

FACTORS TO CONSIDER IN FORMING COMPENSATION STRATEGIES The basic philosophical issues to consider in forming the foundation of compensation strategies include. 1.What constitutes good perfomance 2.Does management make a difference in performance

FACTORS TO CONSIDER IN FORMING COMPENSATION STRATEGIES 3.Does compensation make a difference in getting good management How much, if any, of management compensation should be at risk.

WHAT CONSITUTES GOOD PERFOMANCE A board usually wants to pay for good performance but question then arises how to define good performance. What constitutes good performance is circumscribed by a company’s current circumstances, its goals, and the execution of its strategies

WHAT CONSITUTES GOOD PERFOMANCE A good compensation strategy should have time dimension just like goals which are both short and long term. Compensation plans should thus include both short and long term components. The board must search for a balance between the two perspectives. Some times, good short term performance may be masking deteriorating long term out-look

COMPENSATION AND STRATEGY Financial incentives can be used to implement growth strategies of a firm whereby staff fell better motivated and ripple effect is increased productivity. The case is given of General Dynamics(GD) where provision of financial incentives for all levels in the organization eventual paid off. The entire workforce become change agents rather thant resisters to change and this saw the complete reversal in the company’s performance

MANAGEMENT EFFECT IN PERFORMANCE Virtually all studies as well as most intuitive observations support a conclusion that management generally does make a difference in a firm’s performance. Getting and keeping the right people is the foundation of success in every business.

MANAGEMENT EFFECT IN PERFORMANCE A number of factors should however be considered in attracting and retaining qualified managment. Among these pay plays a defacto role in attracting and retaining talent in the competitive market place for labor, and it stands to reason that those who pay well will tend to to better in that market place than those who do not

MANAGEMENT EFFECT IN PERFORMANCE Accepting the principle that an organization reaps a return on its investment in human resources is important if one is to accept pay-for-performance packages. Boars must therefore recognise this as an important area of governance while resisting the temptation to place too much emphasis on the issue of compensation at the expense of other significant matters

MANAGEMENT EFFECT IN PERFORMANCE Among the issues related to CEO compensation is the philosophical question of how much of management compensation should be at risk, at is based on performance and how much should be guaranteed. Many boards embrace the notion that plans improve as they motivate members of management to think act as if they were owners, meaning having compensation at risk along with owners capital. Currently stock ownership is seen as the best way to bring this out.

BUILDING COMPENSATION PLAN The boards of most public companies approach the delicate issue of CEO compensation with caution. In order to avoid being perceived as out of line with the compensation schemes of similar or comparable companies many boards make use of public data about CEO Compensation or engage services of consulting firms that specialize in compensation matters.

BUILDING COMPENSATION PLAN The goals is to ascertain and then establish external parity in CEO compensation. The use of consultants is intended to provide both expertise and objectivity that might enhance the board credibility with shareholders and other constuencies.

THE COMPENSATION MIX COMPONENTS OF CEO COMPENSATION CURRENT Base salary Fringe benefits Perquisites Cash bonuses LONG TERM Cash bonuses Stock options Stock grants Stock ownership plans

COMPONENTS OF CEO COMPENSATION Base salary : The base salary is the starting point for the compensation package. The board has to decide to what degree it wants to compare itself to the external market in establishing the CEO’s salary A policy many boards use is that if their company wants outstanding people to attain outstanding performance it must offer compensation packages that provide the potential for high end- rewards

COMPONENTS OF CEO COMPENSATION Fringe benefits The value of fringe benefits to the recipient typically range from 30 to 50 percent of base salaries. Firms normally include standard employee taxes, medical and life insurance premiums, the costs of holidays and vacation time, and retirement costs among other

COMPONENTS OF CEO COMPENSATION Perquisites (Privileges) The perquisites of a job can be significant in companies. Clubs and expense accounts are justified as business expense reimbursements for entertaining customers, or the executive’s salary may be grossed up to cover these costs. Automobiles and airplanes are justified on the grounds that they increase efficiency of the executives. When the perquites are used properly these are valid explanations

COMPONENTS OF CEO COMPENSATION Bonus Short term bonuses are usually some combination of individual performance and corporate performance Long term bonuses accrue as result of achieving certain long term objectives of paramount importance to the future of the firm

COMPONENTS OF CEO COMPENSATION Stock options Stock options have been available and have been used as facets of management incentive plans for many years. This are rights to purchase a specified number of shares of the firm’s stock at stipulated price during some forward time period. Stock grants Grants are taxable when granted and are more expensive per share to the company than stock options however the do provide some down side risk to the recipients assuming they hold rather the sell the shares Stock purchase plans In such cases the company may offer loans to the executives to purchase a stipulated number of shares and recover the funds through means of bonuses earned for superior performance

EMPLOYMENT CONTRACTS AND SEVERANCE ARRANGEMENTS Boards and their CEO enter into employment contracts for a variety of reasons CEO’s may seek to preserve some independence as result would want specificity as to the term of employment, the level of compensation and other supplemental perquisites On other hand the board may seek to protect the firms competitive position by creating employment contracts that take the oblique approach of forbidding the CEO to work for competitors' for similar businesses during the period of contract

EMPLOYMENT CONTRACTS AND SEVERANCE ARRANGEMENTS Most CEO employment contracts include a clause stipulating the situations under which the CEO is considered to in breach of contract. Such terms as rule relate to character dishonorable acts, evidence of dishonesty and other acts that are detrimental to the reputation of the company. The CEO can be removed for violation of these terms but otherwise, the board and company are required to fulfill the terms of the agreement often including handsome severance payments if they decide to remove the CEO for reasons other than for cause

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