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Put managements' own capital at risk.

Put Managements' Own Capital at Risk

It was an astonishing statement! The chief executive of a multibillion dollar industrial company had just said his management was not trying to maximize the value of the company for shareholders. Over the past decade, this company averaged nearly a 20% return on equity, almost tripled its sales volume, and quadrupled its stock price. Why would the chief executive of such a high-performing company say such a thing?

His explanation was compelling. In the last few years, he had heard comments from top executives who had participated in leveraged buyouts or other restructuring efforts resulting in significant debt and far greater management ownership. The management teams - now substantial owners of the business - began to take actions that would have been unthinkable in the past. They sold off bad businesses, gutted bloated corporate staffs, and pressed for greater attention to customer satisfaction and productivity throughout their businesses. The results were startling: In most of these cases, the value of the companies increased enormously.

But, in this case, the chief executive was concerned that he and his management team were not substantial owners and, therefore, were not truly acting as owners would. In board rooms and executive offices throughout the country, corporate leaders and institutional investors increasingly are harboring similar concerns. The question often raised is: How can we increase the true sense of ownership that occurs when the management team faces both significant risks as well as outstanding reward opportunities? Short of actually undertaking an LBO, or some other massive restructuring that results in significant increase in debt, what can be done?

One answer is a move from the era of leveraged buyouts to a new period of executive "leveraged buy-ins." In a leveraged buy-in (LBI), executives put up their own money, usually by borrowing, to gain a significant ownership position in their companies. With this added ownership comes the risk of loss of their own assets but also the opportunity for financial gains greatly in excess of those of the average top executive.

Today, the vast majority of top U.S. executives have virtually no risk of losing money they have invested in their companies - even if company performance deteriorates dramatically or if the business fails to earn returns available on a Treasury bill. At the same time, these executives have far less gain opportunity than individuals of comparable talent who develop new ventures or spear-head LBOs. Thus, the interests of most top executives are not closely aligned with those of shareholders - who have both high reward opportunities and risk.

Corporate boards and senior executives now have a real opportunity to structure pay plans that require management to maintain a significant amount of their own capital at risk in the companies they manage. An LBI makes it possible to restructure executive pay programs to simulate - and produce the benefits of - management-led buyouts.

Typical executive compensation programs result in insufficient risk and reward for three major reasons: * Insufficient executive stock ownership. Executives in the 120 largest NYSE companies own just 0.04% of their companies' stock - down from 0.3% 50 years ago. The shares they do own have often been given to them in the form of stock options, restricted stock grants, and payout of annual or long-term incentives with shares rather than cash. In the last five years, a number of companies have attempted to put more stock in the hands of executives. Unfortunately, this has been accomplished primarily by means of "mega-grants" of options and/or restricted stock, which are pure "giveaways." * Too little variable vs. fixed pay. Base salaries constitute nearly 40% of a large-company CEO's total pay - sufficiently high to provide great comfort and little risk to executives. When the present value of pension and other retirement benefits, in-service medical and life insurance, and other perquisites are added to base salaries, the total fixed portion of executive pay packages, including base salary, increases from 40% to about 50% of total pay. * Questionable variability of supposedly variable pay programs. The variable portions of top executive pay are not typically very variable at all. Most annual bonus plans result in higher payments each year to most executives, unless the company experiences a financial debacle. One important reason for this limited variability is that incentive plan goals are often intentionally set at easily attainable levels. In effect, senior executives (and to some extent, boards of directors) view these plans as retention devices, rather than true incentives. When all is said and done, only about 20% of the average executive's total pay is truly variable.

Extensive research indicates that improvements in company performance are brought about by substantial increases in management ownership. But getting U.S. executives to think and act more like shareholders will require major restructuring of today's compensation programs. Great pressure will exist for such restructuring from two primary sources: Institutional shareholders represented by such powerful and effective groups as Institutional Shareholder Services are demanding a closer linkage between shareholder returns and executive pay; and larger, more formidable global competitors will force U.S. companies to improve company performance dramatically, if we hope to participate in the expanding global economy.

Faced with these pressures, boards can begin to work with senior management to restructure executive pay. The end result should be more variable vs. fixed pay, as well as executives willing to place a significant portion of their net worth at risk. There are several possible approaches for the CEO and other senior corporate executives.

1. Executive Purchases of Stock

Options With Their Own Money

Executives can be required to purchase stock options with their own money. A 10-year call on a company stock has significant value. This value can be calculated by investment bankers or by using an option pricing model, such as a modified version of the Black Scholes Model. In either case, a value of options is set at around 20% to 30% of the current market value of the stock. Executives are asked to purchase these options, rather than get them "free." In return for purchasing each option, executives might also be given one or two free options.

To increase the risk and potential reward, this "buy one/get one or two free" program could be substituted for all existing long-term incentives. Exhibit 1 (on page 47) shows an example of a company that previously gave its CEO 20,000 stock options at a stock price of $100 per share. Assuming an average S&P stock price growth in the past 10 years of about 10% per year, these options would have gains of $1.2 million at the end of a five-year period ($160 - $100 = $60 per share gain x 20,000 options).

At the same time, the CEO was promised 10,000 performance units worth $100 each (for a total of $1 million) at the end of five years if financial performance targets were met. Under the revised program, the CEO purchases 50,000 options at a cost of $20 per share and receives an additional 50,000 "free" options. As the exhibit shows, the range in executive gain or loss is significantly greater on the purchased options compared with the prior plan. Yet, the cost to the company on an aftertax cash flow-per-share basis is less for the revised program. General Mills Inc. introduced such a program in 1990.

Companies desiring an even stronger risk/reward orientation should consider freezing base salaries, significantly reducing nonvariable annual incentives, and eliminating such long-term incentives as cash performance units, restricted stocks, and stock appreciation rights. The "savings" to the company from these give-backs could be used by the executive to "purchase" significant amounts of additional stock options.

2. Stock Conversion Rights on

Convertible Debentures

A second proposal is for companies to sell executives' stock conversion rights on convertible debentures. This approach starts with the company issuing, say, $100 million in convertible debentures, on which it pays the market interest rate for convertible debt. Third-party investors may take $95 million of these debentures, leaving executives to buy the right to purchase the debentures for $5 million. Executives borrow the $5 million necessary and pay interest in a balloon payment at the time they exercise the right to convert the debentures. If the stock appreciates at 10% a year for the next five years, executives can convert the debentures to stock worth $161 million at that time, and pay off the $95 million principal on the debentures and their loan with interest (around $8 million). In the end, executives' gains would be $58 million. Exhibit 2 (on page 49) shows an example of this approach.

There is a caveat here. The conversion rights approach only makes sense for companies already financing through convertible debentures. Furthermore, the approach is also costly to the company, since it is likely to involve investment banker fees to place the third-party debt. If the company can do the financing directly, this fee would be eliminated.

3. Loans to Executives for Large

Share Purchase

The company may choose to loan executives 80% to 90% of the cost of a large share purchase. This would be a nonrecourse note secured by the stock. The 10% to 20% remainder of the purchase price would be put up by the executive out of his or her personal net worth, or borrowed independently. The loan from the company would accrue interest at the company's cost of capital. If the company's market value five years later is, say, lower than the face value of the loan, management would render the shares back to the company is payment of the loan. However, management would still be out of its 10% to 20% personal investment.

There is no single approach that is right for every company. But boards and senior executives can select from the wide variety of available devices to develop executive incentives that provide higher risk, as well as rewards, than current programs.

Requiring executives to risk their own capital to get large rewards makes great sense. For one thing, it aligns executive pay programs with a trend that is already well under way throughout U.S. companies - namely, the replacement of entitlements with a "piece of the action" for virtually all employee groups, executives included. But more importantly, new pay programs such as the leveraged buy-in help companies meet their obligation to shareholders to pay executives for performance.

Jude Rich is Chairman of Sibson & Co. Inc., a human resources management consulting firm based in Princeton, N.J.
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:Chairman's Agenda: Balancing Shareholder Interests
Author:Rich, Jude
Publication:Directors & Boards
Date:Mar 22, 1991
Previous Article:How to avoid negative votes on pay plans.
Next Article:Dealing with debtholders.

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