How to strengthen director incentives: want a board to make decisions that increase shareholder wealth? Then let's increase the directors' wealth leverage.

• Author: O'Byrne, Stephen F.
• Position: DIRECTOR COMPENSATION

GOVERNANCE experts are sharply divided about the impact of compensation on director decision making and effort. Some experts argue that directors serve on boards primarily to learn and that compensation has little impact on director performance. Others argue that the prospect of personal financial gain makes directors work harder and make better decisions. And both sides of the debate struggle to find a meaningful analytical framework for thinking about director pay. Some see more mystery than science, with directors in some industries getting much higher pay but putting in no more effort than directors in other industries. The NACD Blue Ribbon Commission on Director Compensation, for one, has lamented the lack of an "accepted philosophical framework" for director pay, particularly for director incentives.

I share the view that compensation affects director decision making and effort. I present an analytical framework for thinking about and measuring director incentives, and outline nine ways to strengthen director incentives to make decisions that increase shareholder wealth.

Director compensation, like management compensation, has three basic objectives: 1) provide strong incentives to increase shareholder value, 2) provide sufficient compensation to attract and retain qualified directors, and 3) limit shareholder cost to levels that maximize the wealth of current shareholders.

Director incentives to increase shareholder value have two components: 1) the incentive for effort, that is, motivating directors to invest sufficient time to fully understand issues, to participate in board deliberations, and to monitor company and management performance; and 2) the incentive to make value-maximizing decisions.

Managers and directors, like investors, seek to maximize their wealth, not their current year pay. A manager or director's wealth includes the present value of expected future compensation as well as stock and option holdings. A useful measure of incentive strength is "wealth leverage"--that is, the ratio of percent change in manager or director wealth to the percent change in shareholder wealth. A "pure entrepreneur," who has 100 percent of his wealth in company stock, has wealth leverage of 1.0 because any percent change in shareholder wealth results in an equal percent change in manager wealth. A manager who has 50 percent of his wealth in company stock and 50 percent in the present value of expected future salary has wealth leverage of...