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An informal, stream-of-consciousness reflection on business ideas, events and issues in modern business, modern life and with some specifics to the web-software industry by Paul Tomori, Internet Entrepreneur

Compensation for CEOs
By Paul Tomori
Monday, June 14, 2010 at 22:18:36 (EDT)

Freakonomics author Steven Levitt recently said the following in answer to the question

"Is there a better way to align CEOs' incentives with the interests of shareholders?" --Barbara Allen, Coralville, Iowa

Levitt's response:

"One thing that is not used as often as it should be used is benchmarking the relative performance of the company to other companies in that sector. The reason that we pay CEOs a lot of money is that we believe they have skills. But there are many factors influencing stock prices that have nothing to do with the skill of the CEO. If the stock market goes up 50% in a year, there's no particular reason the CEO should be compensated for general moves in the S&P 500. An oil company CEO shouldn't be compensated for the fact that the price of oil happens to be high. His compensation should be determined by how well his firm does relative to other energy stocks. It's sensible, and I don't know why it's not used more."

I think Mr. Levitt is wrong about this for several reasons:

  1. If benchmarking a CEO performance at a company based on that company's relative position to companies in that sector, then how do you calibrate? Do you wait for some company to arbitrarily set THEIR CEO pay, so that all other companies in that sector can set THEIRS? And if so, then looking at that first company, how did they make their determination? Was it arbitrary? Or was it objective based on some sort of criteria they established apart from just share price? And if so, why can't the other company's set their CEO pay similarly?
  2. Also, sometimes a company is competing against others who don't directly appear to be in the same sector. So, how do you pick which companies to benchmark against? For example, cinemas compete against nightclubs to get people's entertainment dollars.
  3. Why should the share price ever matter? Even "relative to other companies" in the same sector? The share price meanders up and down based on so many factors that are not directly tied to the CEO's actions. Perhaps a better measure would be "profitability" of the company... Or in cases where the company is not yet profitable, then the CEO compensation could be determined on how much less the company is losing this year compared to last. Of course, this can't be the sole criteria, because sometimes a company with a visionary (i.e. valuable) CEO may have to lose money for a few years as they embark on a new course of action. That company could be headed for the stratosphere of profits (in a few years). So, sheer profitability (or a reduction of losses) cannot serve as the only yardstick.

It is doubtful I would ever subject myself (or be invited to subject myself) to being CEO of a publicly traded company, but it's food for thought to understand the underlying philosophy.

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