The Salary Sage

Tangible Equity vs. Synthetic Equity In Privately Held Companies

It's commonplace for newly hired executives to expect (or request) equity when joining a company. This is true regardless of whether the company is privately held or publicly traded. At one time, such equity was reserved for unique circumstances such as turn-around situations or when attempting to attract a uniquely talented individual who could add special value to the business (e.g., an inventor with a special patent or an executive from a key competitor with unusually valuable contacts or relationships). In such instances, it was easy to see why the new executive should join as a "partner." Over the years, these practices have become commonplace and in all but the smallest businesses it is customary for executive compensation plans to include some form of equity.

In general, I am opposed to granting equity to new executives because I see no need for the owners to give away hard-earned value to someone whose future contribution is uncertain. Remember, on their first day every new employee is considered a star (or they wouldn't have been hired), yet three years later half of them are gone. Others would argue that granting equity to executives ensures that they will have the best interest of owners in mind (since equity makes them an owner themselves). The advisability (or lack thereof) of granting any form of equity to employees is a worthy topic for a future posting, but for now I am going to assume that you have already decided to grant equity and are considering what type of equity to grant.

WHAT'S THE DIFFERENCE?

In general you have two types of equity to consider -- Tangible Equity and Synthetic Equity. Within each are specfic sub-categories.

Tangible Equity (also referred to as Incentive Stock Options ISO or Stock Grants) is actual legal ownership of some portion of the business.

Synthetic Equity (also referred to as Phantom Equity or Stock Appreciation Rights SARs) simulates the cash value of tangible equity but entitles the holder to none of the rights of legal ownership.

When considering which ownership vehicle is right for you, it is helpful to view them separately from the viewpoint of the employee and the employer.

LET'S SIMPLIFY MATTERS

Any Internet search involving tangible equity will reveal a labyrinth of arcane tax treatments and legal considerations. At the end of the day, they are all designed to ensure that the employee and the employer pay their fair share of taxes. This generates an elaborate dance with each party trying to outsmart the others. If half as much energy and intelligence went into trying to increase the value of the business as goes into trying to minimize taxes, so much money would be made that paying taxes would not be inconsequential.

Which brings us to the key issue. With Synthetic Equity all payouts will be taxed as ordinary income (this is not always true, but let's take it as a given since it is true in the vast majority of cases). From the point of view of the employee, this can be viewed as a non-starter. From the point of view of the company, Synthetic Equity payments must be paid out of cash flow and/or retained earnings. Neither of which seem particularly desirable. Let's look at an example.

Consider an executive who has been granted SARs (stock appreciate rights) worth 5% of the business' increase in value over three years. Let's assume the company was valued by an independent appraiser at $20 million on day one. Fast forward ahead three years, and let's say that appraisal values the company at $28 million. The three-year increase in value amounted to $8 million of which the executive holding SARs worth 5% would be due $400,000 (5% of $8 million = $400k). That $400k would be taxable as ordinary income. So the good news is the executive would get around $250k of that after taxes. The bad news from the point of view of the employee is that Uncle Same would get the other $150k. The bad news from the point of view of the company is that they will have to cought up $400k in cash at that point (unless they have negotiated payout terms which is often the case).

Now if this same executive is granted 5% tangible equity in the business, in the scenario described above, there are only three points in time when the executive will ever see any money:

1. When the company is sold.
2. When the executive leaves
3. When the majority owners choose to buy him out.

Unlike Synthetic Equity where the executive usually has access to cash within a specified timeframe, with Tangible Equity the executive cannot count on ever seeing any cash. This is usually considered as desirable from the vantage point of the company since they don't have to come up with any real dollars unless they choose to do so.

Most companies and executives seem to be enamored with the idea of tangible equity. Executive like the idea of "owning something" and companies like the idea of not having to pay anything until it suits them. I look at it differently. I am a huge fan of synthetic equity. From the point of view of the executive, it means real cash in a reasonable timeframe. From the point of view of the employer is it is much simpler to set up, easier to administer, and less costly in the long run considering the legal and accounting fees associated with tangible equity.

THE PERFECT PAY PLAN

In addition to your well designed base salary and annual incentive plans, consider adding SARs to your executive pay plans. They are an excellent tool for simulating ownership and improving focus on increasing the value of the business.

The ESOP I Love and the ESOP I Hate (Part 3)

And now, for something completely different. . .

The last two blog entries have dealt exclusively with one type of ESOP, the Employee Stock Option Plan. If you have read those entries, you know that I am not a big fan of such plans. In this third and last installment of the three-part series on ESOPs, we are going to look at an entirely different type of ESOP, the Employee Stock Ownership Plan. What a difference a word can make. This type of ESOP, while not appropriate for every company, can be an enormous benefit when all the right pieces fall into place.

A TRUE WIN/WIN

The term win/win is thrown around rather blithely, but in the case of an ESOP it is really quite accurate. An ESOP simultaneously does all of the following:

1. It provides an exit strategy to owners of privately held businesses by using company profits to fund the sale of the business to the employees.
2. It enables employees to acquire ownership in their company without having to invest their own money.
3. It creates a beneficial relationship between the company and federal and state governments by allowing the Company to use pretax profits to fund the buy-out of the owners.
4. It provides significant tax and retirement benefits to the employees after they become owners.
5. It provides continuing tax advantages for the company after the original owners have sold the business to the employees.

That is the essence of an ESOP. Of course, the devil is in the details and ESOPs are usually highly complex to set up and administer. But beyond the near term financial benefits already mentioned, there are a host of other benefits:

1. Because ESOPs are wholly or partially employee-owned, they tend to have a very unique corporate culture that is built around openness, fairness, and egalitarianism.
2. ESOP companies tend to enjoy unusually high productivity that stems from high levels of employee involvement.
3. ESOP companies tend to place high importance on employee education, participatory decision-making, and open communication.

In general, this makes them a lot of fun to work for.

THERE ARE SOME DISADVANTAGES

As I mentioned earlier, ESOPs are not for everyone, and it is important to consider the downside before taking the plunge. Here are a few things to keep in mind:

1. Availability of Financing -- Fortunate are those companies that are able to finance the sale of the company to employees through cash-flow and associated tax benefits. But most often some form of financing is required. If the transaction is financed with a bank loan, the company must have the ability to qualify for this loan. Otherwise the seller may have to give a personal guarantee and/or self-finance the sale.
2. Disclosure -- ESOPs are required by law to produce a considerable amount of paperwork for the government and the employees.
3. Valuation -- ESOPs must secure an independent valuation each year to establish the value of the stock.
4. Liquidity -- In order to fund transactions as employees leave and/or retire, an appropriate amount of cash must be kept on hand to repurchase their stock. This is not normally a problem for the first few years, but it must be carefully managed after that.
5. Fiduciary Liability -- The plan committee members who administer the plan are deemed to be fiduciaries and can be held liable if they knowingly participate in improper transactions.
6. Stock Performance -- If the value of the business does not increase over time, the employees may feel that they would rather have a cash incentive rather than the deferred benefit provided by an ESOP. In the extreme case, if the company goes out of business, employees stand to lose everything in their ESOP account.

THE BOTTOM LINE

Clearly, the brief and simple description of both types of ESOPs reveals the complex nature of these types of pay plans. To sum it up, I would steer clear of Employee Stock Option Plans in favor of annual cash incentives (provided the cash incentives are self funding and the company can afford them). I encourage owners of privately held businesses who seek an exit strategy to look into Employee Stock Ownership Plans as they provide intriguing possibilities

MORE INFORMATION

Check these links for more information on Employee Stock Ownership Plans:

Menke & Associates -- Consulting firm specializing in setting up and administering ESOPs

National Center for Employee Ownership -- National association made up primarily of ESOP organizations

Great Game of Business -- Organization dedicated to disseminating the principles of employee ownership

The ESOP I Love and the ESOP I Hate (Part 2)

In Part 1 of this three-part series on ESOPS, I expressed concern that the combination of economic uncertainty, cost-cutting measures, and unwarranted vilification of cash incentives might result in an upsurge in Employee Stock Option Plans (ESOPS). In that posting, I described my concern in terms of the following objections:

• The volatility of share price
• Minimal employee impact or control over this price
• The artificial illusion of extreme value fostered by granting large numbers of low-value shares
• Managers creating unrealistic expectation of the future value of options
• Excessive complexity and administrative expense
• The huge distraction (even obsession) caused by such programs
• The tendency for options to create more selfishness (and jealousy) than teamwork

But this is only the tip of the ice-berg. The effectiveness of any compensation program is directly related to how well employees understand it. Since stock options are among the most complex compensation vehicles around, a major communication and education effort is essential in order to avoid confusion and dissatisfaction. This is particularly important with options because unlike other forms of compensation, there is a long list of gotchas than can creep up to bite employees in the backside and shatter their expectations. Below is a list of some of these things:

VESTING SCHEDULES

Stock options are rarely owned by employees when they are granted. Instead, the employee "vests" or qualifies for their options over time based on some schedule. These schedules often require employees to wait 4 or 5 years before they actually own the options granted to them when they join the company.

DILUTION

Dilution occurs when investors put money into the company and receive stock in return. This has the immediate effect of reducing the value (not the number) of everyone else's shares.

REVERSE SPLITS

When companies go public, it is not uncommon for them to declare a reverse split. This is an instantaneous reduction in the number of shares owned by all employees. One of my clients had been telling employees for months that their stock would be valued around $12 per share when it went public. They neglected, however, to mention that this was after a 10:1 reverse split (they argued that such information would demotivate the employees so they conveniently suppressed it). So while it is true that the stock did come out around $12 per share, every employee lost 90% of their shares, effectively making their stock worth $1.20 per share, not the $12 they were promised.

BUY-OUT CLAUSES

Some stock plans involve buy-out clauses that enable management to buy-back employee shares at any time at the fair market value that exists when the buy-back occurs. I once owned a 5% share in a Company that was rapidly increasing in value. When management saw that the company would be worth a fortune in a few years, they activated the buy-out clause, paying me a small amount for shares that three years later were worth a fortune.

PREFERRED STOCK

Stock options are granted as common stock. But some companies also issue preferred stock (usually to investors) with considerably greater privileges and hence value. Since preferred stock gets paid out first, there are many instances where the holders of common stock (i.e., the employees) end up with nothing.

EXPIRATION

Stock options normally have expiration dates. It is possible for employees to wait 5 years for shares to fully vest then have them expire before they are worth anything.

LITIGATION

Not surprisingly, with such complexity, uncertainty, confusion, and greed, stock options are ripe for litigation. This is a great boon to lawyers, but a source of enormous frustration, delays and ultimately disappointment for employees.

VALUATION

Before a company is publicly-traded, the value of stock options must be determined through an independent valuation. This amounts to a complex financial analysis followed by a judgment call on the part of a valuation professional. Such professionals value companies based on a number of different variables, but the most important one is profitability. Unfortunately, profitability can be easily manipulated by those with a controlling interest. I have one client whose company profit is severely impacted by the owner's lifestyle, much of which is charged to the business (corporate jet, country retreat, expensive meetings in exotic places). By the time all this is over, there isn't much profit and the value of the business is adversely impacted.

THE BOTTOM LINE

Whenever I am advising business owners about whether or not to create a stock option plan, I usually suggest they keep their equity and find other ways to motivate employees. Whenever I am advising employees about whether or not to accept a job involving a significant cut in pay in return for stock options, I usually suggest that they negotiate for more cash or look for another job. At the end of the day, stock options don't do the company or its employees any favors. Both are better off making effective use of incentives which are far better at driving results. They also pay employees in something they can count on, cash.

In the next entry of this three part series, I will take a look at the type of ESOP I really like, the Employee Stock Ownership Plan.

The ESOP I Love and the ESOP I Hate (Part 1)

Unless I miss my guess, ESOPs are going to make a comeback soon. Just as toadstools sprout from the mud after a steady rain, ESOPs surge after economic slowdowns. What are ESOPs? That depends on whom you ask. There are actually two distinct types, a fact that leads to considerable confusion. This confusion is enhanced by the fact that both types are very complicated. And now we know, if we know nothing else, that complicated financial instruments can lead to big problems. Fortunately, with ESOPs, these two types are radically different, one in my view to be avoided at all cost, and the other extremely beneficial (although not overly common).

THE TOADSTOOL

The toadstool that I referred two is one of the two types of ESOPs -- namely, the Employee Stock Option Plan. These are the programs whereby employees are granted the option to purchase shares in their company at a discounted price ("strike price") and can redeem them later for a payout if the value increases.  As a rule, employees pay nothing for these shares when they are granted, then after some period of time when the value of the shares have increased, the employee sells them and realizes the gain associated with the difference between the strike price and the market value at the time of the sale. The intent is to align employee interests with those of the shareholders by providing employees with motivation the behave in ways that will boost the company's stock price.

The reasons that I consider this type of ESOP to be a toadstool are almost too numerous to list, but I will attempt to do so, beginning with the one that relates to their popularity in financial downturns. ESOPs are viewed by companies as a way to compensate employees without spending real cash. And real cash is something companies don't have much of right now. This is why I am anticipatinga surge in ESOPs. I suspect employees may start to hear their leaders say "we can't pay you back the money you lost in recent salary cuts, so we are going to issue options." If this happens, a lot of people are going to experience the downside of options. So what are those downsides?

• First of all, let's face it, the value of a share of stock has about as much connection to the value of a business as a bet at the crap table has with a passbook savings account. So the inference that employees who own stock will be better employees is about as sensible as saying that gambling helps you save money. Sensible action on the part of employees rarely has any connection whatsoever to share price. So rather than encouraging right action, stock options create an intense fixation on something completely outside employees' control.
• In addition, by their nature, stock options create the illusion of extreme value. Sensible people who would never expect their salaries to double over-night, naturally assume their shares will. Ask anyone who owns a pile of stock options valued at $1 per share what those shares will be worth in three years and you will be shocked at what you hear. For every person who says 50 cents, there will be 100 who will say $20. And where do they get this idea? Often not from themselves. They get it from management.
• Stock options are the perfect vehicle for managers to create (consciously or unconsciously) the illusion of future wealth for their employees. This illusion can be used to great advantage to secure increased loyalty and extra effort. If employees can be convinced that their options will make them wealthy, they will attempt to move mountains.
• To encourage this perception, companies grant huge sums of stock. They do this in order to make the grants appear more valuable than they actually are. Case in point -- rather than giving an employee 1 share of stock valued at $5,000, they will grant 50,000 shares wort 10 cents. By doing this, they are manipulating human nature. They know that a person can more easily be imagine a 10 cent investment becoming worth $10 than they can imagining a single $5,000 share suddenly being worth a half million dollars. But the ratios are the same.
• What happens when reality settles in (as it always does) and stock options fail to live up to employees' expectations? Disappointment, resentment and betrayal are sure to follow.
• The reality of options is that real wealth, as in so many other things, if it is to be had at all, falls into the hands of a select few (usually high level executives and investors) not the larger employee group.

All of this, coupled with the fact that administering a company-wide ESOP program is breathtakingly expensive and complicated makes it, in my view, one of the most flawed forms of compensation ever conceived. In fact, of all the companies and people I have known involved in ESOPs (and there have been hundreds), the only person I know who consistently sings their praises has spent his entire career at Exxon. Over the last 30 years his stock has steadily increased in value and has made him a wealthy man. But for every person like that, there are thousands who worked for companies like Enron and AIG who have a very different story to tell.

THE BOTTOM LINE

If you find yourself talking to a company about a new job, and management starts discussing stock in lieu of cash, beware. Your pocket is about to be picked.

In the next entry of this three part series, I will provide additional details on more pitfalls and problems with Employee Stock Option Plans.

Bonuses Continue to Get Hammered in the News

A couple of months ago I described why all the hysteria about management bonuses was a smokescreen and a red-herring (pick your annoying anachronistic metaphor). Now, I am compelled to weigh in again in light of recent developments.

This time, the spotlight of shame has shifted from the ex-Merrill Lynch CEO (John Thain) to the villains at AIG. Their decision to pay $165 million in bonuses, most if not all of which will come out of TARP funds, has cast them in a very poor light. And as often happens when hysteria permeates public opinion, people aren't interested in being confused with facts when it is so much more fun to vilify and accuse. After many months of being blamed for all the problems, Congress is thrilled to have someone else to blame. Listening to them pontificate about waste and excessive spending is as comical as it is pathetic. Policymakers can always, it seems, be counted on for meaningless posturing when serious action is needed. And the public will respond in kind, fixating on inconsequential and superfluous details

How best to summarize this mess? Well, consider this. Incentives are not extra pay, they are merely another part of pay. And they happen to be the part that a person actually has to earn. Unlike base salaries which are paid merely because a person is able to fog a mirror, you actually have to do something to earn an incentive.

Now if you believe that AIG's incentives were paid to individuals who did nothing to deserve them, then your beef is with the people who designed the incentives, not the people who received them. Conversely, if you believe the recipients of the incentives did something worthwhile, then your beef should be with all the other people who did nothing to deserve a bonus and got paid anyway. Get the point?

So rather than vilify incentives, we should be begging for them. Incentives are contracts that only pay out when the recipients deserve them. Rather than guaranteeing 80% to 100% of a person's pay in the form of a base salary and paying it out for nothing, shouldn't we be guaranteeing far less and demanding performance for far more? Imagine a world where executives and managers received 20% of their pay in the form of a guaranteed base salary, and had to deliver specific measurable results to earn the remaining 80%. I am willing to bet that the same AIG employees who earned $165 million in incentives, earned close to a billion in base salary over the same period. They had to do something to earn the $165 million. They did nothing to earn the billion.

So now congress, in its infinite wisdom, is capping salaries at $500,000 and taxing incentives at 90%. Consider what this means. The executives that the taxpayer is counting on to dig us out of this mess show up to work every day guaranteed to earn $500,000 whether they perform or not. Wonderful. And if someone actually wants to link their pay to actual results, there is no way to do it. Not even the circus would make such a foolish mistake -- at least the lion tamer has a little bag of treats he can give to the animals to keep them from chewing his head off.

My great fear is that incentives will take such a PR hit from all this bad press, that boards and CEOs will shy away from them in the future. This would be a grave mistake.

So, as I said back in February:

...while government regulators clamor for caps on executive earnings and the abolition of incentives, don't get caught up in the hysteria. If the people who are saying these things knew what they were doing, they would never have let this mess happen in the first place. Instead, remember that well designed incentives are a key part of the solution, not part of the problem. They provide clarity and transparency by revealing what a person is expected to do, and what they will earn when they do it. They protect against windfalls and focus on outcomes that are controlled and influenced by each individual. So, when you hear that incentives are being abused and misused, blame the leadership teams and Board Compensation Committees who created the incentives, not the incentive plan itself. After all, if someone walks up to your car and smashes your windshield with a hammer, do you blame the hammer?

The Adulation Advantage -- Singing Their Praise In Place of a Raise

In recent years, considerable controversy has swirled around the issue of executive pay. With top executives of large companies getting 400 times more pay than the average employee, it's no wonder -- especially since top executives in Japan and Germany receive only 20-40 times average pay. Is anyone really worth this much?

Defenders of this system, including the CEOs themselves, point to the free market and tell us that's what it takes to attract and retain these exceptional people. Athletes earn even more, they point out. Of course, no one can really spend the huge fortunes these CEOs accumulate, but that isn't the point. Money, we are told is a measure of their worth; a way of keeping score. CEOs can hardly accept a paltry few million a year when their peers make so much more.

There is a solution to all this. I take the CEOs at their word that it isn't about having more money, but about prestige and competitive pride. On the other hand, I am sympathetic to the argument that if a CEO makes 400 times the pay of an average employee, the company could hire 380 more people by reducing that ratio to 20:1. And since these high ratios often apply to other top executives, a large company could hire hundreds more people by ratcheting all executive pay down.

To make both sides happy, we should first reduce top CEO pay to 50 times the compensation of top employees. Other executives should be limited to 15-20 times pay. The free cash flow that results could then be applied to the cost-effective replacement of their damaged self-esteem through the employment of Adulation Specialists. These professional adulators would include portrait artists, dramatists, poets, song writers, musicians, comedians, biographers, tapestry weavers, and other artists and artisans who would devote themselves to celebrating the achievements of our illustrious executives. In so doing, we would create thousands of new jobs, and might even be able to abolish the National Endowment for the Arts because so much money would be flowing to the arts community.

Today, we revere the artistic accomplishments of the Renaissance. But let's remember how this was created. It was professional adulators, of course, who supplied the very rich with much needed self esteem in return for a meager share of their earnings. Think about it, we can create our own Renaissance. Our grandchildren will thank us. I an certain this solution will work. My adulators tell me so.

GUEST BLOGGER -- Corey Rosen is executive director and co-founder of the National Center for Employee Ownership (www.nceo.org), a private, nonprofit membership, information, and research organization focused on broad-based employee ownership plans. He is the author or co-author of over 100 articles and numerous books on employee ownership. He has appeared frequently on CNN, PBS, NPR, MSNBC, and is regularly quoted in The Wall Street Journal, The New York Times, and Business Week.

Bonuses Getting Ill-Deserved Bad Rap

In the panic and chaos surrounding the financial melt-down, common sense and reason have been unceremoniously dumped in favor of a carpet-bombing of accusation and blame. As everyone from executives to regulators to investment managers to government officials emits fusillades of covering fire in hopes of deflecting in-coming criticism and responsibility, the real culprits get obscured while effective business practices get trashed as collateral damage.

The latest victim is the "management bonus" and even President Obama himself is getting in on the public ridicule and scorn. Obama wants to talk to Wall Street executives about a report indicating payments of over $18 billion in bonuses as the economy was in virtual free fall. "It is shameful," Obama said from the Oval Office Thursday calling these bonuses "the height of irresponsibility," Vice President Joe Biden spoke even more bluntly, saying "I'd like to throw these guys in the brig," in an interview with CNBC.

While I have written extensively on my disgust with excessive executive pay (See, Note to Congress -- Convert Executive Pay to Loans, I Admire His Pluck -- But His Timing is Deplorable, and John Thain, Poster Child of Excess), I want to be careful to point out that it is not the practice of paying bonuses or incentives per se that is the culprit, but rather their abuse. It would be foolhardy and narrow- minded to assume that because the same culprits who trashed our economy were paid with incentives, that all incentives are therefore evil, ill-conceived, risky, dangerous, and unsavory. Nothing could be further from the truth. This would be like saying we should do away with mortgages because they were the financial vehicles that created this mess. We still need mortgages just like we still need incentives. The difference is they need to be properly designed, properly administered, and properly managed.

I have personally seen the effect this kind of hysteria and paranoia can have on a business. One of my clients (who shall go unnamed for obvious reasons), until recently, had a Board Chairman who earlier in her career personally observed the wreckage that an ill-conceived incentive plan had on an organization she worked for. From that moment on, she vowed that no company she ever controlled would use incentives or bonuses again. And she adhered to this rigid doctrine for the next 30 years. Her myopic edict did not, however, release her from the realities of the pay market. So in order to compete for talent and retain top executives, she was forced to rely strictly on base salaries. As a result, while all of her competitors had 30% to 50% of pay at risk and could flex their cost based on company performance, she was compelled to guarantee all pay in the form of base salaries. These salaries got paid every year regardless of performance. As performance began to slip, she continued to pay top dollar. Eventually all her best executives departed, seeking positions where they were rewarded for their personal contribution to organizational success. Ultimately, she was left with an expensive leadership team comprised of people who were risk averse, timid, and overly conservative. That organization is now teetering on the brink of failure. Of course, there is much more to their collapse than the absence of incentives, but it definitely played an important role.

So, while government regulators clamor for caps on executive earnings and the abolition of incentives, don't get caught up in the hysteria. If the people who are saying these things knew what they were doing, they would never have let this mess happen in the first place. Instead, remember that well designed incentives are a key part of the solution, not part of the problem. They provide clarity and transparency by revealing what a person is expected to do, and what they will earn when they do it. They protect against windfalls and focus on outcomes that are controlled and influenced by each individual. If you doubt that I am right, ask yourself this simple question -- would you rather the head of your favorite corporation earn all his money as a guaranteed base salary and receive it regardless of what he does or how well he does it, or would you prefer he was guaranteed only a small amount and had to earn the rest by actually performing. I think the answer is clear. The challenge is to properly define "performance" and establish reasonable and appropriate payouts when the performance is achieved.

So, when you hear that incentives are being abused and misused, blame the leadership teams and Board Compensation Committees who created the incentives, not the incentive plan itself. After all, if someone walks up to your car and smashes your windshield with a hammer, do you blame the hammer?

John Thain -- Poster Child of Excess

Less than two months ago (Dec 10, 2008), I excoriated Merrill Lynch CEO, John Thain, for having the temerity to go before his Board of Directors requesting (demanding?) a $10 million bonus for successfully negotiating an 11th hour merger with Bank of America (see, "I Admire His Pluck But His Timing is Deplorable"). Prior to the inexplicable act, Thain was roundly praised throughout the industry and from within his own company for grasping a life-ring while other companies were foundering. What followed was a fire storm of negative criticism that resulted in the Board denying his request. Everyone agreed that while his actions might have been heroic, his judgment was breathtakingly bad.

It has now been revealed that two weeks after his own bonus was denied, Thain paid Merrill Lynch staff $1.4 Billion in bonuses. And he did this three days before the deal with B of A was official. Experts speculate that Thain, anticipating that the conservative leaders at B of A would deny such payouts, took it upon himself to rush them through on December 27th when normally they wouldn't have been paid until late January. By then, he surmised, B of A would be firmly in control and such payouts would be impossible.

When Thain approved these payouts, Bank of America had already received $10 billion in federal bailout money ear-marked specifically for the Merrill Lynch deal. So, in one sweeping act, Thain personally appropriated more than 10% of the taxpayer dollars expected to fund loans and stimulate the economy and paid it out in employee bonuses.

As if this news wasn't bad enough, it was also revealed yesterday that Thain spent well over $1 million dollars of Company money earlier in the year to redecorate his office. Click here to see what he bought.

What is truly fascinating about all this is what emerges when you attempt to read between the lines. Consider the fact that thousands of Merrill Lynch's employees receive most of their annual pay in the form of incentives. Had Thain not pushed to pay them, they would have taken a much deeper pay cut than the 10 or 15 percent that so many others have suffered. Consider also that by the time these bonuses were paid, many top ML employees had already abandoned ship to join other firms. To Thain, those that remained had demonstrated loyalty and resolve to see it through. And lastly, Thain knew that the vastly different corporate culture at B of A would deal a crushing blow to his loyal staff.

Thain must have known that B of A would ultimately discover his bold act, yet he did it anyway. Is it possible that Thain is not merely a corporate villain, but also something of a hero?  As always, such judgments depend on which side you are on. To B of A, Thain is the poster child of the failed economy. He is also the ideal person to deflect any blame that B of A executives might have for entering into a bad deal that ultimately led to them losing 80% of their stock value. To many ML employees, Thain is a selfless leader who ultimately sacrificed himself for the good of his staff (although even they acknowledge his many flaws).

It is no coincidence that the revelation about Thain's office shopping spree was exposed on the same day he was fired. With the sharks circling, B of A new a little blood in the water would speed up the attack. It worked so well that the whole sordid mess ended up as a feature story on the august and respected Jim Lehrer News Hour on PBS. Such is life in the cut-throat world of high-stakes corporate America where the name of the game is draw first and shoot straight.

People it seems, especially under duress, can be counted on to exhibit predictable frailties, lapses in judgment and false heroism. Twenty five hundred years ago, the Greeks had already assigned this tendancy a name -- they called it hubris; excessive pride, unfounded self-confidence, and arrogance. It has always led to a fall, then, as it does now.

What Do Board Compensation Committees Actually Do?

With executive compensation so much in the news these days, I thought it might be a good idea to take a look at the rolls and responsibilities of the people trying to reign in this madness. Euphemistically called the Board of Director's Compensation Committee, this small group works quietly behind the scenes assembling pay packages for many of the most powerful and influential persons on the planet. Here's what they do.

(The following is a compilation of, and excerpts from, the by-laws of several major public companies.)

 

PURPOSE:
The Committee is responsible for reviewing and approving, on behalf of the Board of Directors, the amounts and types of compensation to be paid to the Company's executive officers and the non-employee directors; reviewing and approving, on behalf of the Board of Directors, all salary, bonus, perquisites and equity compensation to be paid to other Company employees; and administering the Company's stock-based compensation plans.

MEMBERSHIP:
The Committee normally consists of a between two and five members of the Board of Directors. The members of are normally recommended by the Governance and Nominating Committee and are appointed by and serve at the discretion of the Board of Directors.

RESPONSIBILITIES:

1. Reviewing and approving the compensation policy for executive officers and directors of the Company, and other managers as directed by the Board.
2. Reviewing and approving all forms of compensation to be provided to each executive officer and non-employee director of the Company.
3. Acting as administrator of the Company's compensation plans, including granting awards to each executive officer and director, reviewing aggregate awards for other eligible individuals and determining the terms and conditions of such awards. The Committee also makes recommendations to the Board of Directors on amendments to the plans and changes in the number of shares available.
4. Reviewing and approving the information to be included in the Company’s annual proxy statement and/or Annual Report.
5. Reviewing and discussing the Company’s management succession plan at least annually, as well as the Company’s leadership development strategies and executive retention and diversity strategies.
6. Evaluating the performance of the Chairman and the Chief Executive Officer (and such other executive officers as the Committee deems appropriate) in light of the Company's current business environment and the Company's strategic objectives.
7. Reviewing and approving recommendations regarding the overall salary and bonus budget and guidelines for all Company employees.
8. Evaluating the need for, and provisions of, employment contracts or severance arrangements for executive officers.
9. Monitoring data on the Company's employee population (e.g., total compensation costs, compensation benchmark data, employee diversity, turnover levels, etc.).

In carrying out these responsibilities, the Committee has the power and authority to retain compensation consultants, outside counsel and other advisors and has the authority to approve the fees and other terms of these engagements.

AVAILABLE RESOURCES:
The Committee is granted access to whatever resources are required to discharge its responsibilities.

MEETINGS & REPORTS:
The Committee usually meets at least four times a year, generally in conjunction with the regularly scheduled meetings of the Board of Directors. The Committee maintains written minutes of its meetings, which are filed with the minutes of the meetings of the Board of Directors.

DIRECTOR COMPENSATION:
In return for their service on the Board, Directors normally receive some or all of the following forms of compensation: Travel reimbursement, Cash Stipends, Stock Options, and Errors & Omissions Insurance. The specific amount varies based on company size, maturity, and industry. In large, publically-traded companies, the stock options alone can be worth millions.

I Admire His Pluck -- But His Timing is Deplorable

A while back I wrote a blog entry titled Characteristics of Ineffective Leaders. In it, I marveled at the bumper crop of bad leadership examples that have been served up lately for us all to feast on. Well, pull up your chair, because it's feeding time again.

When Merrill Lynch's former CEO Stan O’Neal, left the company last year, he was widely disparaged—and continues to be disparaged-- for not properly overseeing Merrill's balance sheet. During his tenure as CFO, then later CEO, he nearly ran the company right out of business. He finally left in shame and disgrace, and with an additional $250 million in his pocket -- his reward for helping the gargantuan firm lose $8.4 billion.

Now, his successor, John Thain, the former CEO of the NY Stock Exchange, has requested a $10 million bonus for his role in saving the company.  To his credit, Mr. Thain did broker a deal with B of A that preserved the Company's illustrious name and quite a few of its current jobs (at least for now). But does he deserve a $10 million bonus for that? Apparently, he thinks so.

This request has caused a fair bit of controversy. Take a look at what recently appeared in DJ Market Talk under the heading "At Least One Wall St Exec Earned His Bonus:"

John Thain might be one of the few executives in corporate America who earned a bonus this year, James Surowiecki writes at the New Yorker’s Balance Sheet blog.  NY Attorney General Andrew Cumo says Thain’s bonus appears to be unjustified, but Surowiecki notes that unlike Lehman and Bear Stearns executives, Thain recognized that Merrill wouldn’t be able to last as an independent firm.  “It’s obviously bad form at this point to say anything good about Wall Street executives,” Surowiecki says, “But if preserving shareholder value is still a criterion for evaluating executive performance, there’s little doubt that Thain did a bonus worthy job.”

I'll leave the matter of whether Mr. Thain deserves a bonus to the wisdom and judgment of his Board's Compensation Committee. But what I don't understand at all is him REQUESTING or SUGGESTING such a bonus (both words appeared in various accounts of the situation). Since when does an executive, or any employee for that matter, request or suggest the amount of their bonus? This tells me that Merrill Lynch does not have a proper executive incentive program. If they did, there would have been explicit goals established when Mr. Thain joined and he would have clearly understood what he needed to do in order to receive a payout. And he would have agreed to these terms PRIOR TO accepting the job with the Company. Then, there would be no need for grand-standing or negative publicity -- two things that beleaguered financial institutions hardly need right now. And if such a plan was in place, Mr. Thain's actions in publicizing it were at best colossal bad judgment or at worst a major breach of trust.

So, even if you are not a Wall Street fat cat and your only shot at a $10 million payout involves a lucky Lotto pick, there are several things to be learned from this poorly handled incident:

1. Creating proper executive incentives can save a lot of heartache at the end of the year by aligning everyone's expectations from the outset.
2. Timing is everything, and asking for the right thing at the wrong time is worse than not asking at all.
3. Nothing is gained by appearing greedy.
4. A little trust and humility goes a long way.

Apparently Mr. Thain failed to read my description of the new type of CEO America craves. Perhaps I will forward it to him.