Leadership Mistakes

In Defense of the CEO W-2

Anthony F. Smith asked:

Over the past few months, amid the release of corporate proxies and income tax filing deadlines, national newspapers of note ran their annual “special reports” on executive pay.

Besides examining the annual compensation packages of CEOs of many high-profile public companies, the articles, for the most part, defined the new SEC-mandated compensation reporting and disclosure requirements, and gently took the position that it will take more than another decade for executive entitlement to regain balance.

In my more than twenty years as a leadership researcher, I’ve served as sounding board, bartender, and confessioner to many of these high-profile figures. Almost all have struggled with the perceptions and ethics surrounding their seemingly-obscene annual compensation packages. And almost all, after carefully weighing every aspect of their 24/7/365 jobs — which are carried out in isolation and can destroy health, families, and personal privacy — come to the conclusion that said packages are justified.

I’ve had these entitlement debates with the CEOs with whom I’ve counseled on all the leadership decisions they face. Over time, I’ve come to agree with them that many (not all) of these compensation packages are warranted. Here’s why.

The current outrage over executive compensation is largely a perception vs. reality issue. The perception is that a $5-10 million compensation package is out of balance because it’s either too large of a multiplier of an average employee’s salary or it’s greater than shareholders’ perceived rate of return on investment. Or both. This perception was a key factor in passage of an April House of Representatives bill requiring public companies to put executive pay packages up for an advisory vote by shareholders. Unfortunately, many of those “outraged” have failed to consider several important points.

Consideration #1: The reality is that the free market is alive and well, and is the true dictator of CEO pay. While what one’s peers are making is still a legitimate barometer, critics should look at the macro economics of “stars” in all fields (after all, CEOs are the “stars” of the business world), and not just the micro economics of CEO pay, if they are serious about understanding the calculus in determining compensation. Such valuation analysis must factor in the track record of the CEO; his or her potential; competing job offers; personal enticements; what he or she is leaving behind; their reputation on the “street”; and the team of other executives he or she is likely to bring or attract.

Consideration #2: few people can perform like Bono, write like Harry Potter’s J.K. Rowling, or golf like Tiger Woods. They have unique talents the free market has decided are worth millions of dollars each year, even though Woods doesn’t win every Major and every album of U2’s isn’t double platinum. Yes, they drive product sales and ad revenue, and in many cases, spearhead major philanthropic initiatives. Yet, like CEO’s, their compensation is usually established long before the success (or failure) is obvious — Nike signed Woods years before he donned a green jacket.

Likewise, only a handful of people are capable of leading major multinational corporations with 100,000+ employees and $50+ billion in annual revenue. Bottom line: true stars are in short supply and high demand. It’s pure Economics 101.

Consideration #3: these unique people create more than just entertainment value. They create thousands of jobs, deliver a lifetime of wealth for legions of investors, and drive life-changing innovation. IBM’s Lou Gerstner saved an American institution. Harvey Golub at American Express increased shareholder value by record numbers. Herb Kelleher defied industry logic by consistently delivering profits in the toughest of times. Many of us became rich as lifetime investors in GE, or were saved by GE medical products — and yes, Jack Welch did have something to do with it.

(I make this point because I was recently asked during a television interview if GE’s success was solely driven by Welch. My answer was, Jack would be the first to say that it was a collective effort of great executives and talented employees. But let’s not forget who created a culture that attracted, developed, inspired, and retained those folks.)

Consideration #4: Unlike an artist with a distinctive talent, a CEO’s craft and contribution is highly subjective. Often, the fruits of their labors don’t show up in the short term — as Wall Street demands — and are apparent only long after they take the helm. Carly Fiorina’s leadership, for example, likely had something to do with Hewlett-Packard’s current success.

While most chief executives are in fact compensated at a far lower rate than the Rowlings and Woods, the criticisms lobbed at them are far more frequent and severe. To understand the blatant mistakes of the past, we need to find an objective means, in this highly subjective universe, of separating a CEO’s overall performance from the number attached to his or her compensation.

Why? Because historically, compensation was negotiated before one’s tenure, based on potential and probability (not unlike the aforementioned musicians and sports stars). In the future, however, we must move closer to a merit-based “pay for performance” model that will indeed drive greater differentiation. When this is established, however, shareholders must be prepared to award perhaps even larger payouts than we have seen thus far — unless, of course, those shareholders just want a ceiling and no floor.

Consideration #5: in large multinational corporations, $5-10 million is likely a budget line item amount for office supplies such as Post-It TM Notes and paper clips. Executive pay shouldn’t just be weighed against aggregate employee salaries or benchmarked with similarly-sized companies. It should be compared with, and judged against, all of a company’s expenditures and the rate of return they generate. Who creates more value in the company, the CEO or a bunch of paper clips? Institutional shareholders understand this dynamic. Individual investors, and the media, often do not.

To conclude, CEOs can’t lose sight of the major climate shift that has come to hover over the corner office. Since Sarbanes-Oxley passed in 2002, transparency and disclosure are the climatic bywords of our time — and shareholders will continue to demand (justifiably) even more openness, and a greater correlation between pay and performance, each passing fiscal year.

Copyright © 2007 Anthony F. Smith

Anthony Smith is Co-Founder and a Managing Director of Leadership Research Institute and author of The Taboos of Leadership: 10 Secrets No One Will Tell You about Leaders and What They Really Think (Jossey-Bass, May 2007).

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