Director compensation: for wealth-building motivation, think LSOs.

• Author: Stewart, G. Bennet, III
• Position: Leverage Stock Option - Putting In Place the Right Board for the 21st Century

AMONG its many important responsibilities, a board of directors is most liable for representing the interests of the shareholders. While individual shareholders will care about many facets of the company's civic performance, culture, and other such intangibles, the maximization of the shareholders' wealth must be considered to be the overriding interest for the shareholders as a group. The reason is simple: Shareholders can convert an increase in their wealth for consumption, charity, or political purposes as they see fit. The question, then, becomes how to compensate directors so that they are motivated to maximize the wealth of the company's shareholders as the prime imperative.

Providing board members with cash compensation does not fit the bill. That gives them the interest of a creditor, not a shareholder -- a fixed claim against the company's assets and cash flow. Fixed claimants abhor risk-taking and change. They prefer diversification of risk, even if that means a lower stock price. They prefer size even at the expense of performance. They prefer tangible more than intangible values. Even if these are not the inherent attitudes of all board members, a cash compensation program will tend to encourage these attitudes.

A better strategy is to provide board members with a compensation plan that is highly aligned with the mission of maximizing shareholder wealth. Moreover, the incentive ought to be leveraged so that the magnitude of the potential payoff is meaningful as an incentive for board members who are likely to be well-off to begin with. In this respect, the leading LBO associations -- the KKRs and Forstmann Littles of the world are instructive. They receive a payoff that depends upon building value faster than interest accrues on the LBO debt. In other words, they receive a share of the "Economic Value Added" over time that is, of the return in excess of the cost of capital.

Stern Stewart has developed a special stock option to replicate the incentive payoff of an LBO. Dubbed an LSO, or Leveraged Stock Option, it may represent an ideal method for board compensation. Unlike ordinary stock options, LSOs are in-the-money instead of at-the-money when issued, are bought instead of granted, and project the exercise price to rise at a rate that sets aside the cost of capital for the shareholders before the board members participate.

For instance, consider a company with a $10 stock price. The initial exercise price is set at a 10%...