Back in 2018, Tesla appeared to be in trouble. Elon Musk was struggling to get production of the more affordable Model 3 up to projections. Investors speculated other heavyweights in the automobile industry would squash the company in a matter of years. But amidst all of this, Musk convinced Tesla’s board of directors to consider a new type of CEO compensation package for himself. He would agree to stay at the helm for another decade if they would provide performance pay for CEO leadership. No salary, simply stocks and options. In other words, if Tesla failed, then so would Musk.
Fast forward to 2022, the predictions of 2018 for Tesla seem almost laughable. In less than four years, the company’s worth has increased from $59 billion to nearly a trillion dollars. In the process, Musk’s net worth has exceeded $3 billion with CEO compensation earnings last year worth $6.7 billion. What Musk has accomplished was not believed to be possible. But by insisting on performance pay for CEO leadership, Musk had tremendous incentives to excel. This and his willingness to explore paths less traveled has led to great success. And as a result, many companies are following suit, hoping they can reduplicate what Tesla has been able to achieve.
“There’s a lot of companies out there that saw [Tesla’s] award and its structure. They think it’s a good way to incentivize performance.” – Brian Johnson, executive director with ISS Corporate Solutions
Recent Trends in CEO Compensation Plans
In recent surveys, it’s evident that Musk’s situation at Tesla has affected CEO compensation strategies. Year over year, CEOs earned 31% more than they did previously. looking back several years, earning figures for CEOs have effectively tripled for the top companies in the country. And it’s not simply for major firms like Amazon, Microsoft, and Alphabet. In 2021, Jeff Green of Trade Desk received $835 million in performance pay for CEO responsibilities. Peter Kern of Expedia received $296 million. And Sue Nobi, the only female CEO in the top 20 CEO earners, reported $284 million in income. These are sizable increased that highlight how CEO compensation trends are changing.
Among the top 10 companies in the U.S., the average CEO compensation exceeded $330 million. Musk has a lot to do with these trends. Because CEO earnings must be reported by public companies, other firms are well aware of the performance pay for CEO leadership that Musk has received. At the same time, they are also aware of the massive increase in valuation that has occurred simultaneously for Tesla. Seeing the win-win scenario as a means excel within their own markets, companies are embracing performance pay for CEO guidance. An incentive-based package consisting of stocks and options aligns CEO compensation with firm success. The concept is simply, but it took Musk to prove to them its value.
“When the market performs as well as it did in 2021—the S&P 500 rose 26.9 percent—and considering that CEO pay is incentive based, it’s not surprising. This year, if the S&P 500 continues to fall, you would expect to see CEO compensation come down.” – Michael Faulkender, Professor of Finance, University of Maryland’s School of Business
What Goes Up Can Also Come Down
Of course, not every company is going to follow in Tesla’s footsteps when it comes to company valuations. Not all companies will have an in-vogue product like electric cars. This will be especially true for many companies in 2022 with a drop in the market. As share prices decline for a firm, then stocks are less valuable. As a result, CEO compensation designed solely on stocks and options like Musk’s will take a hit. But this is the essence of performance pay for CEO packages. CEOs most willing to bet on themselves will be the ones who have the greatest potential to do well. But they are also the ones who will be taking the most risk. It might come as little surprise that Musk was willing to take this leap of faith. But the question is whether all CEOs will do the same.
Unlike Musk, few companies have CEO compensation packages that award solely stocks and options to its leadership. Instead, base salaries are usually guaranteed while stock incentives comprise the rest of the deal. Regardless, stocks and options are progressively making up larger portions of CEO’s earnings. Companies want results, and they want to link performance pay for CEO activities to company share values. By having more skin in the game, their level of commitment and dedication will certainly rise. And if it doesn’t, then they have as much to lose as the firm’s shareholders. It’s this simple concept that prevented most from pushing back against outlandish CEO compensation packages like Musk’s.
“As a percentage of the value of the company, CEO compensation hasn’t risen all that much although the absolute dollar amount has.” – Michael Faulkender
Additional Benefits for CEO Performance Pay
While performance pay for CEO leadership aligns company and executive incentives, there are other advantages. From the CEO’s perspective, compensation in stocks and options can significantly reduce tax burdens. Instead of a salary subject to income tax, stocks are only taxed when sold. And instead of selling stock and paying capital gains tax, stocks can be used as collateral for loans. This allows CEOs like Musk to pay debt interest in low single digits instead of double-digit taxes. This is yet another reason why many top leaders welcome these new trends in CEO compensation.
From the firm’s point of view, CEO compensation deals can also require that a number of objectives be met. Instead of simply targeting company valuation amounts, other requirements can be included in performance pay for CEO leadership. For example, Musk not only had to attain a company valuation of $650 billion for Tesla. He also had to meet sales objectives and operational profit targets. Thus, if done well, incentive-based compensation for CEO performance is quite attractive from everyone’s perspective. And interestingly, we have Musk to thank for it.