Executive Compensation-Class Slides

Formal criteria for defining Executive status
- KEY EMPLOYEES AND HIGHLY COMPENSATED EMPLOYEES

Executive compensation is heavily biased toward rewards
for actual results.
Executive pay is structured to reward company

performance and align executive pay with shareholder
value. If executives and the company perform well, they
along with the company's shareholders stand to gain much
more from superior performance.
The pay packages given to the senior executives of corporations often consist
of six components:
• Base salary
• Performance based annual incentive (bonus)
• Performance based long term incentive
• Benefits
• Executive perquisites
• Contingent Payments
Pertaining to CEO compensation, under classic economic theory, we have
A) The price is obtained through negotiations that are at arm's length.
B) The CEO names his/her price.
C) Compensation is based on a market survey and job evaluation.
D) The board of directors set CEO compensation.

E) The CEO hires the consultant to perform an objective analysis of the company's executive
pay package and to make whatever recommendations the consultant feels are appropriate
(This relationship has the potential to promote a conflict of interest)
AGENCY COMPENSATION THEORY
The shareholders use this theory to negotiate the compensation contracts with the executive in
hopes of aligning the executive's interests with theirs.
Shareholders' interests are represented by a Board of Directors, who
weigh the pros and cons of top executives' decisions.
Base Salary
• The base salary for executive pay is normally stated as an annual salary, although it is typically
paid monthly, similar to other salaried staff.
• The pay for the Chief Executives for big companies range widely, depending on the company, the
industry and the tenure of the executive.
• When companies hire new CEOs from other companies, how do they compensate them?
Option 1: approximately the same as individuals who are promoted to CEO from within the
company
Option 2: substantially more than individuals who are promoted to CEO from within the
company
Option 3: substantially less than individuals who are promoted to CEO from within the company
Option: at least 50 times the average median employee salary within the company
Short-Term Incentives
Purpose of the annual incentive is to compensate executives for achieving the company’s short-term
business strategy. Thus, it is based on achieving a number of goals specified for the company by the
company's Board of Directors. The nature of these goals varies depending on the business, company
strategy and other conditions.
Annual objectives can include such items as:
• increasing revenue or market share

• improving profit margins
• implementing a new corporate strategy
• development of new products
• expanding to a new market, and completion of a critical project
Short-Term Incentives
• Typically, the annual incentive is paid in cash and is expressed as a

percentage of the CEs annual salary.
• Most annual incentives include a two-tier structure:
a "target" level, which is the executive’s normal expected performance,
and a "stretch" component, meaning that the company would have to
obtain extraordinary results for the maximum incentive to be paid.
This is done to encourage executives to achieve superior results.
DISCRETIONARY BONUSES are awarded to executives by boards of

directors on an elective basis
Long-Term Incentives: the largest potential component of
executive pay
Purpose: Rewarding executives for achievement of the

company’s strategic objectives that will maximize shareholder
value.
Provided- in the form of stock-based compensation or Equity Plans
such as:
• stock
• stock options
• restricted stock options/Units
• performance-vested stock, options, or similar devices
EQUITY PLANS
Plans that provide an executive with ownership stakes in the company through a
variety of mechanisms, including stock option plans and stock purchase plans.
Stock Grant
The term used when a company offers stock to its employees
Stock disposition
This refers to the sale of stock by the stockholder
Capital Gains
This is the difference between the stock price at the time of purchase and the lower stock price at the time an executive
receives the stock option
COMPANY STOCK SHARES ARE THE MAIN FORM OF EXECUTIVES'

DEFERRED COMPENSATION
The performance period for a long-term incentive typically runs
between three and five years, with the executive not receiving any pay
from the incentive until the end of the performance period.
Long-term incentive goals vary by company but the most

prevalent are focused on
total return to shareholders
earnings per share and
other return measures, such as return on assets.
• Stock options: These rights provide employees with an opportunity to
purchase stock shares at a designated price or whenever the stock price
increases, usually, within a specified period of time.
• Restricted Stock Units: The shares of company stock that are awarded
to executives at the end of the mandatory stipulation period
• Phantom Stock: A stock plan arrangement where executives receive a

bonus that is equivalent to either the value of company shares or the
increase in that value over time.
• Stock Appreciation Rights: Stock options that do not require the
stockholder to exercise them to receive income.
Benefits
• Benefit programs run the normal range familiar to salaried employees.

Include:
• Statutory benefits such as Social Security, Medicare, Workers
Compensation, and Unemployment Insurance.
• Executives also participate in other company benefits such as vacation,
holidays, sick days, severance pay, life insurance, and medical insurance.
• In addition to the benefits provided salaried employees, executives are
often eligible to participate in special retirement plans. These plans,
unlike those that apply to all employees, are not protected by federal
tax and pension rules and are not typically secured by a trust. Instead,
the amounts in these plans are at risk, and if the company is unable to
pay them, such as in insolvency or bankruptcy, the executive would be
at risk to lose such benefits.
• Non-qualified deferred compensation plans which allow executives
to voluntarily defer salary and bonus amounts until a date certain,
death or retirement (much like a non-tax-favored plan).
• Supplemental Employee Retirement Plans (SERPs) which are meant
to supplement traditional pension plans, but are at risk.
These plans are "restoration plans" designed to allow executives

to save the same percentage of income as other employees may save
in tax-favored plans
PERQUISITES OR PERKS
• Not available to other salaried employees.
• These “extra benefits” are normally structured to recognize the value of the
executive to the company, extraordinary demands on his or her time and other
unique conditions.
Some perks are structured to maximize executive work time including:
• drivers to and from work,
• convenient parking,
• installation of home communications systems,
• financial planning, and even the use of airplanes for personal travel.
• Others recognize the unique positions of executives, especially CEOs, by providing
security both at home and when traveling.
Typically, executive perks constitute a modest component of executive.

Example
The recently appointed CEO of XYZ Inc. uses a luxury

summerhouse owned by the company for rest and relaxation
with his family as well as a place to invite important clients
before a lucrative business deal. XYZ Inc. also provides a
membership to an exclusive club to its CEO.
These kinds of benefits offered to CEOs are known as

PERQUISITES
Performance Contingent pay
• Covered by severance which provide for payments to executives in

the case of involuntary termination except in the event of
termination for cause.
• They are often included in agreements for executives hired from
outside the company to encourage him or her to leave a prior
employer in case the new arrangement sours.
The actions of executives on behalf of their own self-interest are known as the
AGENCY PROBLEM
Golden Parachute
Agreement that provides pay and benefits to executives after a
termination that results from a change in ownership or merger
Severance package- “change-in-control” benefits
Discourage unwanted takeover attempts
Poison pills or anti-takeover measures
They are structured to provide additional protection to executives in
the event of a change-in-control thereby allowing executives to focus on
sale or merger opportunities that are in the best interests of
shareholders without being overly concerned as to the potential impact
on their career
After the recent merger of ABC and XYZ Airlines, the former CFO of XYZ Airlines,
John, lost his employment in the newly merged airline.
Which executive compensation agreement is customary in such circumstances
Theory
SPECIAL CASES
XYZ Pharmaceuticals recently announced that the clinical trials for a cancer drug
failed to cure the illness. This announcement led to a dramatic decrease in the
stock value of the company. The company hired a new CEO two years ago when
the clinical trials for this drug had already initiated.
Which one of the following is true about the compensation of the CEO of XYZ
Pharmaceuticals?
The CEO should receive lower compensation since shareholder returns have been
declining.
The CEO was not involved in the decision of the failed initiative; therefore he/she
should not receive lower compensation.
Each company handles this situation differently.
The compensation of this CEO depends only on pretax profit margins.

Transparency
• The SARBANES OXLY ACT OF 2002 brought a number of reforms

to enhance corporate responsibility, enhance financial disclosures,
and combat accounting fraud due to dishonesty in companies such
as Enron and Tyco.
• Legally required document that reveals detailed information about
the compensation of the CEO and named executive officers
(NEOs)- definitive proxy statement (DEF 14(A))
The XYZ Co. took back performance-based compensation of
$1.2 million from their CEO because of his decision of the
buyout of another firm that eventually lowered the overall
value of the XYZ Co.
The compensation agreement that allows the board of directors

to take back this $1.2 million is called
CLAWBACK PROVISIONS.
• In the end, Yolanda beat Tristen and Michel in a series of
competitions among top-level managers to become CEO of
National LemGlass. Which compensation theory did the
company probably use? Tournament Theory
• The concept that individuals evaluate their accomplishments
by comparing themselves to similar individuals is based on
Social Comparison Theory
What is?
• Platinum parachutes?
• 401(k) plan?

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Formal criteria for defining Executive status

- KEY EMPLOYEES AND HIGHLY COMPENSATED EMPLOYEES

Executive pay is structured to reward company

A) The price is obtained through negotiations that are at arm's length.

B) The CEO names his/her price.

C) Compensation is based on a market survey and job evaluation.

D) The board of directors set CEO compensation.

Annual objectives can include such items as:

• increasing revenue or market share

• Typically, the annual incentive is paid in cash and is expressed as a

DISCRETIONARY BONUSES are awarded to executives by boards of

Purpose: Rewarding executives for achievement of the

COMPANY STOCK SHARES ARE THE MAIN FORM OF EXECUTIVES'

Long-term incentive goals vary by company but the most

• Phantom Stock: A stock plan arrangement where executives receive a

• Benefit programs run the normal range familiar to salaried employees.

These plans are "restoration plans" designed to allow executives

Typically, executive perks constitute a modest component of executive.

The recently appointed CEO of XYZ Inc. uses a luxury

These kinds of benefits offered to CEOs are known as

• Covered by severance which provide for payments to executives in

The compensation of this CEO depends only on pretax profit margins.

• The SARBANES OXLY ACT OF 2002 brought a number of reforms

The compensation agreement that allows the board of directors

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