Tuesday, August 28, 2007

Executive Compensation – How Do You Figure It?

In one of my classes, the subject of how much high-level executives are paid came up, and the professor asked if we could come up with an equation to define how an executive should be paid. I came up with the following equation:

XC = (N){(Xf [(3Sc(Fp-Pp)) + (0.5(T + (V*Ex)]))2R} – (CP*CE)


XC = Executive Compensation

Xf = Standard executive compensation for the industry stated as a multiplier

Sc = Scale of company

T = Duration of contract, including non-competition restrictions

V = Visibility

Ex = Expectations

R = Risk


CP = Contractual Penalties

CE = Critical Events (such as arrests, SEC investigations, bankruptcies, and the like)

N = a negating factor voiding the contract (N would equal either 0 or 1)

This equation is based on the assumption that I am attempting to describe executive compensation as it should be developed.

My initial equation was based on the fact that the modern executive compensation generally starts with the base salary, and adds bonuses and perks to it. In the exercise here, to leave the compensation one which attracts a good executive and which rewards superior performance, but also to deter dishonest, lazy or simply incompetent executives, we must add penalties for certain events. In my initial equation, I dumped those into CP or contract penalties, but given the habit of some committees to take short cuts, maybe that is too simple. So I would add the variable CE or Critical Events, such as Bankruptcies, SEC investigations, as a multiplier of CP. A CEO who likes to have expensive lunches is one thing, but one who hires spies to find out what board members are doing (as happened at HP) is of another degree entirely. I would also take a page from the professional sports leagues, and throw in a negation clause, I will call it N, value 0 or 1, which means that under certain circumstances the executive gets nothing at all, although I have to say it would be hard to get someone to sign such a deal, unless the conditions were very carefully defined and unlikely except for egregious conduct (did I mention Michael Vick?).

Anyone else like to play this game?

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