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Determining CEO Pay

|Includes:Andalay Solar, Inc. (WEST)

This article was first published on the 29th of March 2008 at Noise Free Investing

Jack’s first compensation committee meeting went smoother than he had thought it would. The night before he had spend countless hours reading the previous CEO’s compensation agreement, the agreement competitors had with their CEO’s, and recommendations of the consulting firm he had hired.

Jack feared that the other board members would notice that he didn’t have a clue when it came to setting compensation. He had been in a panic for the past week, his wife sensed what was going on and he confessed his insecurities about his new board position. She laughed, remarking “as if my Harvard MBA husband can’t set compensation for CEO.”

Arriving a few minutes late for the meeting, Jack took the only empty seat: the head of the table. As he sat all conversation in the room went silent. All eyes were on him. “I have reviewed the compensation agreement with the previous CEO, read the consulting report, and read the compensation agreements of all of  our competitors,” he started. “We need to offer something competitive in order to attract a good CEO. I recommend that we follow the advice of the consultant: pay the CEO in the top third of companies with similar revenues, offer significant fixed-priced stock options, and employ a bonus scheme that varies depending on profits.” A long silence overtook the room.

Jack wondered if he had been exposed for the fake he was. Harvard didn’t teach him how to set compensation; he hadn’t the first clue where to begin. After what seemed like eternity, a well dressed female remarked smartly “clearly we put the right man in charge, I second that recommendation.”
While characters above may be fictional, regretfully for shareholders, the story is too close to reality. Compensation is tricky. In order to accurately judge compensation you need to understand the business, retained capital, and people. In Corporate America, it’s rare to see companies that understand how to set compensation. When Bertrand Russell observed: “Most men would rather die than think. Many do.” He could have been contemplating compensation arrangements.
Before you can set any compensation you must understand how the position will be judged. In our view, CEO’s should not be judged on revenues, profits, customers, share-price, or total market capitalization. Unfortunately for shareholders, most are.
In simple businesses CEO’s should be judged by the results they achieve based on the assets employed. Any increase in profits needs to be compared with the incremental capital investment that produced it (as well as leverage employed, commodity prices, and other factors). Since retained earnings invested poorly can still lead to ever-increasing profits, CEO’s should be charged a high-rate for any incremental capital they employ. They should also be compensated for capital returned to owners (or, a corporate parent if the company is a subsidiary).
Let’s take a look at one recent employment agreement that we like from Western Sizzlin. Bob Moore, the CEO of Western Sizzlin Stores Inc. and Western Sizzlin Franchise Corporation, pays to retain earnings.
The Agreement provides Mr. Moore with a minimum base salary of $250,000 per year.  He is eligible for bonus compensation equal to twenty percent (20%) of Cash Flows (as defined in the Agreement) in excess of $2.3 million annually as adjusted by a charge of 20% of any incremental investment of capital during each year.  He also receives a monthly car allowance of $1,500 per month and a housing allowance of $1,500 per month.  He is eligible for such other benefits as are offered other employees from time to time and will be reimbursed for out-of-pocket expenses pursuant to the Company’s existing policies.
In this agreement Bob is compensated heavily (20%) for any growth in future cash flow. However, he’s also charged just as heavily for any retained earnings that he fails to return to Western Sizzlin. Thus, Bob’s earnings increase when earning on additional capital exceed a meaningful hurdle. (It would have been nice to see something about the base $2.3 million in cash flows being adjusted for inflation yearly.) However, Bob’s bonus is symmetrical: If he retains incremental capital that yields sub-standard returns, it quickly becomes costly. This agreement compensates Bob, to pass up money he can’t reinvest in the business at a high rate of return to his corporate parent (Western Sizzlin).
At the time of writing the author holds a long position in WEST. Visit Noise Free Investing for more articles. 
Stocks: WEST