Entrepreneurship and executive compensation: turning managers into owners.

Author:Rogers, John W., Jr.
 
FREE EXCERPT

Abstract

During the past fifteen years, compensation paid to senior executives has far outstripped the pay increases for other levels in the corporation and for other members of society. Most commentators justify higher compensation packages as the result of pay for performance. In fact, much thinking about executive compensation derives from Agency Theory, the contention of economists that there is a fundamental divergence between the interests of managers (agents) and owners (shareholders). The use of stock options and other ownership tools are designed to align the interests of the two parties to this economic transaction. An analysis of results and of current compensation practices suggests that the divergence may still persist. Moreover, the pay inequities resulting from this new compensation philosophy may be sowing the seeds of divisiveness within the corporation and within society.

When Michael Milken, junk bond king of the 1980s, was asked to justify the economic and ethical dimensions of the corporate restructuring that he engineered, he would often cite the experience of his father, an accountant and advisor to small businesses. Milken explained that, in his accounting practice, his father saw at first hand the difference in performance of businesses run by their owners and those run by hired professional managers. Because the owner treated business assets and investment choices as a personal financial decision, the motivation to optimize financial returns was clear and direct. With a professional manager, on the other hand, one could never be sure about motivation because the money came from someone else's pocket (Bruck, 1988).

Milken's simple insight is at the heart of a revolution that has transformed executive compensation in the United States and is now spreading to Europe and the rest of the world. The objective of the revolution is to make the employee managers of publicly held corporations think and act like business owners, in short, to recreate the spirit of entrepreneurship and to recognize it as a basic motivator of performance in all businesses. The results of the revolution have been impressive. In large U. S. firms, an average of 79% of CEO pay is now at risk through stock options and both short and long-term bonuses (Pearl Meyer & Partners, 2000). While bonuses and other incentives have been a standard component of executive compensation since the 1920s, the portion of compensation attributable to stock options has soared (Bok, 1993). This extension of the pay for performance philosophy, grounded in the granting of stock options in large quantities and combined with a raging bull market, has rewarded those senior executives who have successfully embraced this new approach to compensation.

While boards of directors and compensation consultants have acted forcefully and effectively on their belief in this new form of pay for performance, these developments have also raised some troubling issues of business ethics and social values. According to a recent survey, the average American chief executive now takes home 419 times the wage of the average factory worker. In 1980, a CEO made only 42 times as much (J.K. Galbraith, 1998). Injecting an entrepreneurial component into the executive compensation mix has been accompanied by a dramatic escalation in the total amount earned by executives in both absolute and comparative terms. So far, these questions of social justice and inequality have been drowned in the great sea of economic prosperity. But a debate is going on, not only among social scientists but also in boardrooms among experts concerned with issues of corporate governance. How much money is really needed to reward performance, and is the current widespread use of stock options necessarily the best guarantee that shareholder interests will be taken into account? These questions are at the heart of a growing debate over the fundamental principles of executive compensation.

**********

AGENCY THEORY: TURNING MANAGERS INTO ENTREPRENEURS

Michael Milken was an important participant, but by no means the principal architect or leader of this revolution in compensation. In fact, underlying these changes have been steady, inexorable trends in thinking about the role of the business enterprise and the people who manage it. The theory of the firm, the basic focus of microeconomics, has provided much of the background for changes in the way that shareholders, public officials, and academics view executive compensation. This development gives new meaning to the famous boutade of John Maynard Keynes that in finding solutions to practical problems in the real world, even the most hardheaded businessperson may inadvertently be a slave to the ideas of some past economist. The movement to build entrepreneurial values into mainstream executive compensation testifies to the surprising impact of ideas put forward by economists over five decades leading up to pay off time in the 1980s.

Beginning in the 1930s, economists noted the increasing importance of a split between ownership and management. Adolph Berle and Gardner Means, in The Modern Corporation and Private Property, described how the modern public firm, owned by a diverse and fragmented group of shareholders, delegates broad authority and responsibility to professional managers whom it hires to direct resources and make investment decisions in the interests of shareholders. To elucidate this phenomenon, Oliver...

To continue reading

FREE SIGN UP