How executive pay lost its way: two misguided notions are making it exceptionally difficult for directors to create strong incentives at reasonable cost to the shareholders.

• Author: O'Byrne, Stephen F.
• Position: EXECUTIVE PAY

THE EFFORT OF the investment banks to target compensation as a percentage of revenue is a rare, but misguided, effort to provide a comprehensive formula for executive pay. Few companies make any effort to define a comprehensive formula. But a share of revenue is more appropriate for movie stars than managers, and even movie stars don't get to raise their share when times are tough. Value-sharing formulas designed to protect the shareholders used to be common. Understanding why they've disappeared will help directors see what they need to do to re-assert the shareholders' interest.

In 1922, General Motors adopted a bonus plan that gave management 10% of profit in excess of a 7% return on capital. The formula was a comprehensive management-shareholder bargain, covering all incentive compensation, both cash and equity, and all bonus-eligible managers. Moreover, it lasted for 25 years without any change in the sharing percentage or threshold return. Similar formulas were quite common before World War II. A 1936 study by future Harvard Business School dean John Baker found that 18 of 22 companies analyzed gave management a share of economic profit or profit above a dollar threshold.

Comprehensive incentive formulas started to wane in the 1950s for two reasons. Special tax benefits led more companies to grant stock options, but few companies developed an option value formula so they could charge the option grant value against the bonus pool. Instead, they used a bonus pool formula to manage cash incentives and a stock option reserve to manage stock option grants. More importantly, changing management practice led to new focus on "job value" and "competitive pay" and less concern about management's contribution to shareholder value. The Hay Guide Chart for job evaluation was standardized in 1951 and the first American Management Association survey of executive compensation was conducted in 1950. The early compensation surveys used profit as a measure of company size, but soon switched to revenue--regardless of profit--as the key measure of company size.

Tracing the shift at IBM

IBM provides a good example of the transition to modern human resource practice. When Tom Watson joined Computer Tabulating Recording Co. as CEO in 1915 he had a salary and a 5% share of undistributed after-tax profits. As late as 1960, IBM had 90 executives with individual shares of corporate profit. In the mid-1960s, a major consulting study led to a new compensation...