Laughing all the way to the bank

Graef Crystal, who has been called America's leading expert on executive compensation, turns a gimlet eye toward Silicon Valley and doesn't like what he sees. With tech CEO pay packages heading off the charts, is this the prelude to disaster?

Margaret Kane Former Staff writer, CNET News
Margaret is a former news editor for CNET News, based in the Boston bureau.
Margaret Kane
7 min read
Tough times have fallen on the tech world, but you might think it's still 1999 judging by the size of the executive compensation packages being bestowed on top management.

Consider, for example, Qwest Communications International Chairman Joseph Nacchio, who pulled down more than $27 million, even as his company cut its growth outlook due to slow sales and a weak demand for data services. Motorola canceled Chairman Chris Galvin's bonus in 2001 and eliminated his raise, but still paid out $1.3 million in salary as he cashed in $2.73 million in options.

Even where boards reduced CEO salaries, they often made up the difference elsewhere. Intel froze pay and cut bonuses last year, but still bumped up option grants for its top executives. Over at Gateway, CEO Ted Waitt decided to forgo most of his 2001 salary after the computer maker turned in a poor year, but the company nonetheless awarded him 3 million additional options.

These figures are nothing new for Graef Crystal, who has been called America's leading expert on executive compensation. Crystal, who worked for 20 years as an executive compensation consultant with management consulting firm Towers Perrin, has also edited a newsletter on compensation issues and taught at the Haas School of Business of the University of California at Berkeley. CNET News.com recently spoke with Crystal about the trends in executive compensation for the tech-industry elite.

Q: How did compensation practices in Silicon Valley get to where they are now?
A: I think what has happened is that Silicon Valley started out with a pure compensation model consisting of very low salaries and little or no bonuses. Cash was very low, and you had substantial stock option grants. People at the top did not have any kind of employment (contracts), so if they were fired, it didn't matter.

But then what has happened here is that we've had a sort of morphing into Silicon Valley of all the best pieces of non-Silicon Valley excess. So we're now getting (the) worst of all possible worlds. You end up with large salaries, large bonuses, huge grants of restricted stock. Witness the grant that (Hewlett-Packard CEO) Carly Fiorina got. And (Compaq Computer CEO) Michael Capellas when he renewed his employment agreement.

The effect of having an employment agreement is that if someone is...thrown into (the) street, they now have a document that they can waive in front of the board and say, "Pay me."

But at the same time, we still have monster stock option grants--look at the shares (Oracle CEO Larry) Ellison got. Or (Apple Computer CEO Steve) Jobs. Also, we continue to retain in Silicon Valley another practice that was adopted here: option repricing. Company after company has repriced. They talk about how much faith they have in the market, and then the minute the market goes south they break their covenant with shareholders and reprice.

"We've had a sort of morphing into Silicon Valley of all the best pieces of non-Silicon Valley excess. So we're now getting (the) worst of all possible worlds."
What sort of impact does this have on shareholders, and on the company?
The nice thing about the original (compensation practice) was that if there was a downturn, costs went down as well. You didn't have a lot of salary, and if the stock (went) south you didn't have dilution. Now the market heads down and, sure, Carly's stock has gone down in value, but she still has 20 million shares...If you start firing, they say, "You can't just fire me--pay me $10 million." At the very time when a company needs to hoard its cash, we have to turn around and have hemorrhages of cash to all these execs. Shareholders get it both ways: a huge dilution and monstrous severance to executives.

What's the effect on the rank and file?
The impact on employees in the early days was...people made a devil's bargain. They said, "I know I can't get a 100K salary, but I'll take 50K and options." But...for many employees things have not worked out right and they're sitting on mountains of worthless options. In one sense, you can say employers don't have to do anything because these employees have nowhere to go. But there are lots of companies outside IT (that) are doing quite well and are willing to rehire them.

Also, because of the drop in faith that options are always going to produce a cornucopia, my guess is that lots of employees are now going to be pushing for cash. It's instructive to remember that between 1973 and 1982 the stock market tanked and took nine years to get back to where it was. Company after company lost total faith in stock options and started coming up with exotic new plans that insulated executives from the stock market. They (said) things like, "If we have 15 percent (earnings-per-share) growth, we'll give you a bonus."

But aren't things crazy all over? Is the high-tech world that out of sync with the rest of corporate America?
Tech is one of the big offenders. And it was tolerated when the markets were going up. Nobody blinked when Carly showed up with (options worth about) $66 million going in the door. She shattered the egalitarian position that the founders had instilled all those years. She was "Queen Carly." Walter Hewlett and David Packard were commoners, but we (had) a queen now. In one sense, you could say, "More power to her." She euchred the board into this huge contract. The board knowingly dumped this long-standing egalitarian community. But there's a lot of resentment (toward) her in the company.

I think the pay packages have been extremely high and have been tolerated because for so long Silicon Valley was this tremendous engine of wealth. They're out of line when you consider huge stock option grants. A lot of people say, "Don't worry, they're not going to grow so fast anymore." But a lot of the problem is the way options are valued. What you're seeing in a lot of cases is companies issuing far more shares than they ever did before because that equals the present value of what other companies gave when the stock market was high. But that creates even more dilution.

What do you think will be the end result?
What you'll see is rising potential dilution. Sooner or later I think shareholders will take vengeance on some of these companies.

"I think the pay packages have been extremely high and have been tolerated because for so long Silicon Valley was this tremendous engine of wealth."
I think there will be some sort of charges to earnings in the future. (U.S. accounting rules do not currently require companies to record a charge to earnings for stock options.) The (International Accounting Standards Board) is trying to instill best practices in various countries, and they're proposing a charge to earnings for options and probably will do that this year. If the United States doesn't follow suit, we will be branded as some sort of third-world nation in accounting. Pressures will be enormous on the (Financial Accounting Standards Board, the U.S. body that sets generally accepted accounting principles) to follow that.

How badly would companies be hurt by that rule change? What else would change?
I don't know if they would be hurt badly, but their earnings will be much lower. But almost every academic economist is of the belief that you charge earnings for options and analysts are already factoring into models. So stock values will not fall the way earnings fall.

There is an ancient dictum in accounting: "Never measured never managed." If we do start charging earnings, we will get the reverse: measured and now managed. We'll be looking at CEOs and saying, "If you want this 10 million share grant, we'll be charging to earnings for the next 5 years." I think it will stiffen spines of these boards.

Is there a historical precedent?
When I was a consultant you heard this dialogue: A chairman saying, "I just had lunch with the CEO, and he told me he wanted 4 million option shares." There would be a gasp around the table...But the chairman would say, "As I walked to the meeting, I began to think if the stock doesn't rise, Bill won't make a nickel. And if the stock goes up, Bill will make a pile but so will the shareholders. And on top of that, there's never going to be a charge to earnings--even if Bill makes a million, who cares?" So the CEO would get 8 million shares.

Boards have come almost to believe that these things are cost-free. This is like play money. If we do get charges to earnings, we'll see a lot more discipline. If Jobs' grant had a present value of $471 million, that would mean Apple would have had to charge $150 million a year for three years, and you would have noticed that. And maybe the board would have looked at it and said, "Let's be nice, but not that nice."