Reward real growth, not
By Roger Martin
Published: August 2 2010 22:03 | Last updated: August 2 2010 22:03
Answer the following question quickly: what
incentive effect does stock-based compensation generate? The chances are
that your answer will mirror the accepted wisdom: it causes executives to
work harder to make their company perform better, whether that means growing
faster, increasing profitability or increasing market share.
If that is your answer, however, you would be wrong. A stock price is
simply the consensus of investor expectations about the future performance
of the company, and linking compensation to it is an incentive for
executives to focus more on raising investor expectations than improving
While we might imagine that real performance drives expectations of
future performance, the link is exceedingly tenuous.
Just ask the executives of
Microsoft. Last month, it reported a
blow-out fourth quarter with sales
up 22 per cent and profits
up 45 per cent. The stock? It jumped a mere 2.9 per cent on the
announcement. And that wasn’t because there had been a recent big run-up on
the stock in expectation of a strong quarter. With a few brief exceptions,
Microsoft has traded (adjusted for splits) in a narrow range between $20 and
$30 per share for the past 10 years. During that decade, revenue and profit
nearly tripled but the stock has remained flat. Had a dutiful executive been
given a generous grant of 100,000 options on January 2 2001 at $21.69 and
held on to them to today, the executive would be able to exercise those for
a profit of a mere $440,000 (at the current price of about $26 per share) –
after 10 years of hard slog to triple the company’s real performance.
Of course, this is one example and there are examples all over the map –
including those in which expectations track real performance exactly. But
that is precisely the point: the relationship between real performance and
expectations is all over the map.
The only way an executive can be sure to realise a return from the
incentive compensation provided is to work first, foremost and directly on
raising expectations from the current level – the only thing that makes a
stock price rise – often at the expense of improving the actual underlying
value and performance of the company. There are much easier ways to
accomplish that objective than working for a decade to triple the revenue
and bottom line. It is much easier to go to the City and hype your stock. Or
change your accounting treatment to appear to produce a jump in performance.
Or make stupid acquisitions to appear like a fast-growing company.
Stock-based compensation was originally conceived as a way to align the
interests of senior executives with those of the shareholders.
Interestingly, it has created a wonderful alignment between segments of
each: bloody-minded executives and hedge fund investors. Both profit most
from expectations volatility. A bloody-minded executive bent on doing
whatever is necessary to maximise stock-based compensation earnings will
happily drive down expectations in order to get more low-priced stock
compensation (whether options, stock or phantom stock) and then drive
expectations back up to realise huge gains, then repeat the process until
fired. Hedge funds, meanwhile, make all their money from volatility – the
rise and fall of expectations – so they are totally aligned with and
actually help out the bloody-minded executives in producing and profiting
One might ask, what is the harm in all of this: a little hyping, some
accounting hanky-panky, a few acquisitions that might not have been needed,
executive compensation going through the roof, hedge funds making
extraordinary profits. The problem is that this is a short-term game.
Expectations cannot be made to rise forever – Jack Welch was the last chief
executive to master that ancient art form – so executives need to raise
expectations as precipitously as possible, and then simultaneously get out
and cash out.
More than anything else, stock-based incentive compensation is
responsible for short-termism in the modern corporation and the shrinking
average tenure of today’s chief executives. It is an incentive for
manipulating expectations rather improving real performance.
The solution is to replace stock-based compensation with incentives that
affect underlying value – whether that is increasing revenues,
profitability, market share, customer service or, optimally, a combination
of all of these. And for longer-term incentives based on the actual market
not the expectations market, use royalties on real results, as are given to
designers, inventors and musicians. The bottom line is that if you want to
skew reality, use stock-based compensation. But if you want to build the
real company, use incentive compensation anchored in reality-based measures.
Roger Martin is dean of the Rotman School of Management and author of
a forthcoming book on the dangers of stock-based compensation, to be
published by Harvard Business School Press