Risks taken by leaders to build up corporate equity (along with their compensation packages) has been tied to the financial industry's house of cards that came crashing down in 2008. The time may have come, according to a Knowledge@Wharton (K@W) article, to reconsider adjusting those packages, not based on how much a company appears to be worth on paper but how solvent it is in real terms.
In a new paper, Inside Debt, written by Wharton finance professor Alex Edmans and doctoral student Qi Liu, to be published in the Review of Finance, the authors contend that in companies run by executives with packages based largely on equity, there is a natural inclination to take risks.
The rationale for tying executive compensation to a company's equity has been the defacto standard for three decades. The idea is that shareholders and execs share a common purpose -- increasing the value of a company's stock. The issue is that the pursuit of that goal (as well as other factors) does not always lead to an ever upward path for share values.
"If the risk pays off, the value of the equity shoots up," said Prof. Edmans. "If the risk doesn't pay off, the worst their (executives') equity can be is zero." Bondholders and other creditors, however, are not as fortunate.
Prof. Edmans pointed to Bear Stearns, Enron and Lehman Brothers as three companies that took the "gamble for resurrection" and failed.
In the case of Enron, Prof. Edmans told K@W, the company should have been upfront about what it was facing. "Instead, they tried to conceal the problems, hoping that one of their gambles would pay off before the problems became noticed. But they only became worse."
AIG, another poster child for the financial industry's collapse, might offer a picture of compensation packages that balance equity and debt. Executives at the company are now paid bonuses based on "long-term performance units." Roughly 20 percent of these units are tied to the company's common stock while 80 percent is based on AIG's junior debt.
Discussion Questions: Is it time for a lower percentage of executive compensation to be tied to share prices? Does tying more executive compensation to performance of a company's bondholders work for successful companies as well as those in a turnaround mode?