stanord closer look series 2
What Is CEO talEnt WOrth?
companies (such as revenue growth, prot margin,and return on invested capital) or specic measuresthat are relevant to a particular industry or line o business (such as research and development pipe-line productivity or on-time delivery rates). Simi-larly, they might be readily quantiable (such asproduct deect rates) or more qualitative in natureand thereore require proprietary methods o mea-surement (such as customer and employee satisac-tion). It is the responsibility o management andthe board o directors to identiy the value driversthat are most critical to the success o the corporatestrategy. Tis process is best accomplished throughrigorous statistical testing that demonstrates a proven correlation between the relevant metric andchanges in corporate value.
Te valid perormanceindicators o the company then serve as the basis ormeasuring management perormance and awarding compensation.Te challenge or the board is to determine whatlevel o compensation to ofer to chie executive o-cers or the achievement o specic perormanceobjectives. Tis can be an extremely dicult task,not least o which because it is not always easy to de-termine how much corporate value creation shouldbe attributable to the eforts o a single individual.
Although a considerable number o theorists andpractitioners have argued that CEOs play a criti-cal role afecting rm perormance, the empiricalresearch on this issue is mixed. Tomas (1988)nds that CEOs are responsible or only 3.9 per-cent o the variance in perormance among com-panies, while Mackey (2005) nds that the impactis much greater: as high as 29.2 percent.
Te view that board members have on this issue will have a substantial impact on what they view as reasonableCEO compensation (see Exhibit 2).Finally, the board must determine the percent-age o value creation to award in compensation. Although there are no agreed upon standards, ob-servation o compensation practices among othertalent pools might serve as a guide. For example,the CEOs that manage private-equity owned com-panies receive on average 5.4 percent o the equity upside (in the orm o stock and options).
A-listactors in Hollywood receive $10 to $30 million perlm, plus 10 to 20 percent o gross prots.
Musicartists receive 8 to 25 percent o the suggested re-tail price o an album, a $0.08 perormance royalty when a song is played live or broadcast, plus a per-centage o the gross prot generated on tour (seeExhibit 3).
Similarly, in setting compensation orCEO talent, the board should target a payout inrelation to perormance or value creation. In thisregard, the structure o the compensation contract will be as important as its overall size.
Why thIs matters
1. Executive compensation is a topic that is lled with much rhetoric (“nobody is worth $20 mil-lion per year”) but somewhat less critical analysis(“maybe some CEOs are worth $20 million peryear while many others are not”). Why isn’t moreo the discussion ocused on the actual observ-able impact that a CEO has on value creationand the percentage o value that should be o-ered or these eforts?2. Why don’t we commonly see
calculationso actual value creation by the CEO in proxy statements? Is it not possible or boards to per-orm this calculation? I not, how does the boardmake rational decisions regarding pay levels?
Although precise gures vary depending on the sample and meth-odology employed, one recent estimate pegs this ratio at 343 among a sample companies in the S&P 500. See AFL-CIO Executive Pay- watch, available at:http://www.alcio.org/corporatewatch/pay- watch/.
Xavier Gabaix and Augustin Landier, “Why Has CEO Pay IncreasedSo Much?”
Quarterly Journal of Economics
Steven N. Kaplan and Joshua Rauh, “Wall Street and Main Street: What Contributes to the Rise in the Highest Incomes?”
Review of Financial Studies
Further complicating the matter is the act that reported compensa-tion gures in the proxy do not reect what an executive has
but instead combine cash compensation received plus a air value es-timate o the expected value o equity compensation granted. I per-ormance does not meet expected results, the actual value o equity grants will be considerably lower than their original air value. For a ull discussion o this issue, see: David F. Larcker, Allan McCall, andBrian ayan, “What Does It Mean or an Executive to ‘Make’ $1Million?” CGRP-22, Dec. 14, 2011.
For a detailed review o this process, see: David F. Larcker and Brianayan,
Corporate Governance Matters: A Closer Look at Organiza-tional Choices and Teir Consequences
, Chapter 6: OrganizationalStrategy, Business Models, and Risk Management (New York, NY:F Press, 2011); and Christopher D. Ittner and David F. Larcker,“Coming Up Short on Nonnancial Perormance Measurement,”
Harvard Business Review
Sometimes it is even dicult to compute the value created by a rm.For example, does a one-year change in market capitalization validly reect the change in value creation over the period?