It wasn't quite the happy ending the top five executives at Borders Group Inc. had hoped for. Starting in 1997, full of faith in their company and optimism about the future, they decided to take stock options in lieu of their salaries, figuring that the market would make them rich if they improved the bookstore chain's performance. Then came Amazon. Even record sales and profits last year failed to revive Borders' flagging stock. With his options under water, Vice-Chairman Bruce A. Quinnell had to borrow to pay his living expenses. This year, four of the five have elected to take their salary in cash. Says Chairman Robert F. DiRomualdo with a sigh: "We believe over time we'll be valued fairly in the marketplace." But Borders may not have that long. Recently, the company hired Merrill Lynch & Co. to help it evaluate options including a sale or a leveraged buyout.
The Borders team may be extreme, but they're hardly alone. In a world where the only adjective that counts is "new," companies branded "old" just can't catch a break. "Old Economy companies are screaming like stuck pigs," says Frederic W. Cook, head of compensation outfit Frederic W. Cook & Co.
Of course, for most CEOs, who have plenty of cash, bonuses, and other pick-me-ups at the ready, the pain is more theoretical than real. Robert D. Glynn Jr., CEO of PG&E Corp., is typical. His San Francisco energy company's operating earnings grew 15% last year, but the stock badly lagged the market, putting Glynn's last grant of 300,000 stock options well under water. He still took home $2.2 million in total pay in 1999. That's nothing to sneeze at--unless you compare it with his neighbors in Silicon Valley. David S. Pottruck, for example, co-CEO of Charles Schwab Corp., took home $127.9 million last year, while John T. Chambers, CEO of Cisco Systems Inc., pocketed a cool $121.7 million.
At first glance, these disparities would seem to represent exactly the type of cruel justice the executive compensation system is supposed to mete out. By linking pay to stock performance, executives do well only when their investors do and feel the pain when the stock drops. No guts, no glory. But during the early years of the bull market, there was a disconnect. A lot of mediocre executives effortlessly reaped millions from their stock options as the market soared. Recently, there's been another kind of disconnect: Even stellar results do not always send the value of stock--and thus stock options--skyrocketing. "We had the second-best year ever in terms of net income last year," says John N. Lauer, CEO of industrial chemicals company Oglebay Norton Co., who sank a million bucks of his own money into company stock when it traded at 37 1/2, only to see shares slide to a current 20 3/4. "None of that is being reflected in the price-earnings ratio."
Old Economy corporate leaders can take some comfort in the fact that suddenly, a dot-com pedigree is no longer a guarantee of a pay bonanza, either. Although stories of billion-dollar option gains in high-flying Net stocks abound, the market is beginning to slap around some of the New Economy companies. Episodes such as March's stock collapse at Drkoop.com Inc. may have been just the beginning. With the Nasdaq falling sharply in early April, yesterday's breathtaking dot-com paper profits are vanishing as quickly as they appeared.
Indeed, for all of the whimpering of old-company chieftains, market gyrations are beginning to level the playing field. Despite nearly doubling last year, the Nasdaq is up just 2% this year, while the Dow Jones industrial average is down 3%. As of Apr. 3, a full 42% of all 1999 initial public offerings of at least $100 million were trading below their offering price, according to a study by SCA Consulting. Shares in TheStreet.com, for example are trading at 7.84, 59% below the May IPO price of $19. Once wildly wealthy executives are now holding a lot of worthless paper.
For now, however, the suffering is relative. Overall, pay continues to explode, according to the results of Business Week's 50th annual Executive Pay Scoreboard, compiled with Standard & Poor's Institutional Market Services, a division of The McGraw-Hill Cos. In 1999, the average total pay garnered by CEOs at 362 of the largest U.S. companies again shattered the record, rising 17% from 1998's $10.6 million to an average of $12.4 million. That compares with a 19.5% rise in the Standard & Poor's 500-stock index and a 32.8% boost in earnings for 1999. That $12.4 million is more than six times the average CEO paycheck in 1990. The raise was smaller than the 36% boost in 1998--perhaps because CEOs in some underperforming sectors chose not to exercise their options, the biggest component of a top paycheck these days.
For out-of-favor folks, the frustration is palpable. "We had a very, very, very good 1999," says Paul J. Liska, executive vice-president and chief financial officer at The St. Paul Cos., "and our stock went down." The insurer's operating earnings, for example, rose 31% in 1999. Given that performance, you have to ask: Is there anything an overlooked company such as St. Paul can do to gain the market's attention? "For now," says James A. Reda, senior manager at Arthur Andersen, "all they can do is ride it out." Frantic to make up for the uncooperative market--and deal with the specter of a talent outflow--many lagging companies are simply granting more options. "Every one of those companies wants to do a mega-grant right now," says Ira T. Kay, co-practice director for executive compensation at Watson Wyatt Worldwide. "I've strongly urged them not to do that. This is not the bottom."
And of course, stories of instant fortunes are driving pay ever higher. At the high points following their IPOs, Richard S. Braddock of priceline.com Inc. and Glen T. Meakem of business-to-business startup FreeMarkets Inc. were worth $1 billion and $2.7 billion, respectively, on option gains alone. In Silicon Valley, where fortunes increasingly are measured in billions instead of millions, the perceived scarcity of qualified players has desperate boards ponying up sums that would make a potentate blush. In doing so, they're continuing to lift expectations and diluting their other shareholders at record levels. They're also setting themselves up for very expensive cash outlays to make up for some of the missed option profits should the stock price not pay the piper for them.
EXPLOITING FEARS. Certainly, some of the executives who are taking home large sacks of dough are being rewarded for stock performance that consistently beat their peers and the market. Others at the top of the pay pile have successfully exploited the fears of boards that they will leave for brighter horizons (read: companies whose stock might go up) and demanded more options, cash, bonuses, and extras as a retention incentive. After all, the only thing worse than being an out-of-favor company is being one without a firm hand at the wheel. "There's a tremendous outflow of talent from these industries," says Alan M. Johnson, president of compensation firm Johnson Associates. "In my lifetime, you haven't seen that."
Maybe that's why you won't find all of the biggest executive paychecks confined to Silicon Valley. If you look at Business Week's scoreboard, companies offering the most lavish pay packages aren't the upstarts but rather the big, established companies--some tech, some not. In the top slot? Not a Valley-based IPO leader but rather Charles B. Wang, the longtime CEO and founder of Computer Associates International Inc. in Islandia, N.Y., who received a fiscal 1999 payout of $655.4 million, almost entirely in restricted stock. Unlike options, which carry no charge to earnings, the payout caused the company to take a $675 million charge to pay for the award to Wang and two other executives. The payout has been challenged in court, and Wang announced on Mar. 31 that he plans to give some of it back as a settlement. "If you're going to pay someone hundreds of millions, you better be sure there is a real sustainable value," says Johnson. "[Computer Associates' board] should be horsewhipped."
The top five executives on Business Week's list together earned $1.2 billion, and the top 20 CEOs averaged $112.9 million apiece. The current portraits of wealth don't all belong to young whippersnappers at dot-coms with soaring stock prices and not much else. Seven of the top 10 best-paid CEOs have appeared on Business Week's best-paid list before--some, such as Citigroup's Sanford I. Weill, for several years running. While America Online's Stephen M. Case and Cisco Systems' John Chambers are founding members of the New Economy, others, such as Colgate-Palmolive's Reuben Mark or Tyco International's L. Dennis Kozlowski, have deep roots in the old one.
That could change fast, however. Dominating Business Week's list of those with the most valuable option profits to come are tech companies big and small. FreeMarkets' Meakem was worth more in unexercised stock options at the end of 1999 than General Electric Co.'s John F. Welch. And the three leaders--Yahoo!'s Timothy Koogle, AOL's Case, and USA Networks' Barry Diller--were each worth more than $1 billion in potential option profits alone at the end of 1999, the first time option-only billionaires have appeared on our list, though these stocks have come down some since.
Most of the folks who hauled in the biggest paychecks in 1999 had a soaring stock price--and plenty of options to exercise at will. According to a study by SCA Consulting of how CEOs would have fared if they had to beat the S&P in order to exercise their options, such members of the Top 20 list as Cisco's Chambers and IBM's Louis V. Gerstner Jr. would have handily beaten the mark. Others, such as Walt Disney's Michael D. Eisner and Enron's Kenneth L. Lay, would have had to leave a chunk of options untouched, since their companies' shares were performing at or below the S&P index over the period of their most recently exercised option grant.
L. Dennis Kozlowski, CEO of Tyco, defends his $170 million in total 1999 pay as just reward for a great performance. "Most of my compensation [for 1999] was the exercise of some stock options that were granted in 1997," he says. "But the way I calculate it, while I gained $139 million [in options], I created about $37 billion in wealth for our shareholders" over the same period. Indeed, Tyco's stock has risen 259% since early 1997, beating the Dow and a lot of New Economy companies. Since the end of fiscal 1999, however, the stock has fluctuated because of questions about the company's accounting and the disclosure of an SEC inquiry. After plunging as much as 40% since the questions were raised last fall, Tyco's stock has since recovered to around 47 1/4.
The dramatic numbers show that despite the teeth-gnashing from the Old Economy folks, many of them are hanging in there so far--thanks to a pay system that not only piles on the options but also adds a heavy dollop of cash compensation, restricted stock, and other delectable extras. Continuing a trend, long-term compensation--primarily exercised options--made up 81% of the average CEO pay package in 1999, up from 80% in 1998. But for the first time in three years, the average salary and bonus moved up as well--from $2.1 million to $2.3 million. It looks as if executives, frustrated by their stock prices, are developing a new appetite for cash. Indeed, 78% of CEOs got an increase in their salary and bonus, up from 71% in 1998.
While a 17% pay hike is closer to the 3.5% raise for white-collar workers and the 3.4% boost for blue-collar workers in private industry than last year's 36%, according to the Bureau of Labor Statistics' Employment Cost Index, it isn't doing much to compress the chasm between the top and the bottom of the food chain. In 1999, the average CEO earned an astonishing 475 times the average wage of a blue-collar worker. And, perhaps because of the scramble to retain good executives, those in the No. 2 spot got the biggest raise in recent history--up 37%, to an average $7.6 million. "We have a significant gap that has been growing between the top and the bottom for 25 years," says Representative Martin Olav Sabo (D-Minn.), who every year since 1991 has sponsored a bill that would get rid of corporate tax deductions for any company whose CEO's salary is more than 25 times that of the lowest-paid worker at the company. Sabo isn't sanguine about the bill's chances but hopes it will "tweak some consciences."
Yet when such high-profile defections as that of Andersen Consulting chief George T. Shaheen--to dot-com Webvan Group Inc.--lead the news, compensation committees don't feel they can think much about consciences. They're frantically piling on more options and scrambling to make sure their execs come out on top--no matter what happens to their share prices. This is backwards thinking, says Matt Ward, CEO of WestWard Pay Strategies. "Keeping people is the wrong objective," he says. "You retain people by having the coolest products and a good business proposition."
The simplest way to fix a broken option, of course, has been to exchange them for new ones at the lower price, commonly called repricing. Shareholders hate the practice because it separates the interests of top execs from their own. But repricings are not so easy to pull off anymore, thanks to the Financial Accounting Standards Board. On Mar. 31, the group formalized its long-debated ruling that any company that cancels underwater options and reissues them at a new lower price must take a potentially substantial charge against earnings. And since the ruling had a retroactive date of Dec. 15, 1998, the mere threat of it going through, plus pressure from institutional investors, was enough to make most repricing plans go the way of the stegosaurus.
RETIREE REPRICING. Of the 1999 proxies filed so far, just a handful of companies undertook repricings. One of those, however, was Metro-Goldwyn-Mayer Inc., which repriced options for its former--not current--CEO, Frank G. Mancuso, from $24 to $14.90 per share, as well as giving him a $2 million annual consulting contract that is not even exclusive. Given that repricing is usually rationalized as a retention maneuver, the move is highly unusual. A spokesman for the company said MGM felt the perk was fair since it had repriced options for other executives the previous year.
Other companies worried about retaining execs as their stocks slump have turned to restricted stock, which makes a comeback whenever options fall out of favor. It's being used more for retention because it holds at least some value when options don't. It does require a charge to earnings, however. "Restricted stock is a problem. It's like a computer virus," says Ward. At Bank of America, CEO Hugh L. McColl Jr. was given a $45 million treasure chest of restricted stock even as the stock fell 17% last year.
At Philip Morris Cos., in addition to giving a group of top execs special "retention bonuses," the company is now paying dividends on its option grants. So even if the options are under water (the stock is currently at 22 3/16, down from 58 1/2 in late 1998), executives can look forward to a quarterly check. Other companies are simply changing the rules when their performance plans don't pan out. At Sears, Roebuck & Co., the company has extended the time frame for top executives to meet the performance requirements of some of its option and restricted stock grants by one year. "The compensation committee believed these dates were a more realistic time frame," said a spokeswoman.
The perceived need to keep inflating top paychecks isn't limited to old-style companies. Even dot-coms are finding that the option strategy just isn't as effective as it once was. According to a study by Harvard business school associate professor Brian J. Hall, half of all options granted from 1997 to 1999 at non-S&P-500 companies are currently under water. Case in point: the poster child of defections from old to new, Webvan's Shaheen. At the high point of the first day of Webvan's November, 1999, IPO, Shaheen's 15 million stock options were worth $390 million. Along with the 1.25 million shares he was granted, he was worth some $815 million. Yet just six months later, the stock has fallen to 7, making those options worthless and his shares worth some $8.8 million--substantial, of course, but not the windfall that has allowed CEOs everywhere to hold their hands out for much, much more.
And while options have proven wildly successful in luring employees to new, riskier startups, the accelerated vesting periods and greater willingness of companies to make their new hires "whole" have made it relatively easy to leave should the IPO not perform as expected. And boy, do the executives know it. "We have to redefine retention," says Susan K. Bishop, president of internet recruiter Bishop Partners. "One-and-a-half years would be considered a success."
This volatility is leading Net companies to offer pay packages that are looking increasingly like those at traditional companies. "There's a convergence between Old and New Economy pay packages," says James A. Hatch, executive vice-president at Compensation Resource Group Inc. That means more cash, long-term incentive plans, restricted stock, and other perks are beginning to head west. "Eventually," says Pearl Meyer, head of Pearl Meyer & Partners, "dot-coms will all turn to the traditional pay format." That idea is angrily resisted by many longtime venture capitalists and pay experts, who credit these pure pay-for-performance option-only packages with creating the spirit of the New Economy.
Still, the seasoned managers being recruited by Net companies are demanding buckets of cash. At Amazon, No. 2 Joseph Galli, hired from Black & Decker Corp., collected a $7.9 million cash bonus payable over three years in addition to 3.9 million stock options, which are being granted over 20 years instead of 10 in an effort to keep him tied to the company. And he is guaranteed $20 million in cash should his stock not rise at least that much in value by 2003. At AOL, restricted stock was used for the first time as a retention tool for some top executives.
In an environment like this, do companies have any choice but to give away more and more of the store in order to satisfy the appetites of a ravenous executive class? And how will they keep up if the ubiquitous option doesn't work anymore? Expectations remain high--as do the numbers. "In the past 20 months, people have become more and more demanding" about compensation, says Venetia Kontogouris, managing director of venture firm Trident Capital Management. "When I ask, `How can you have this kind of expectation?' they look at me like I'm a strange object," she says. It is this sense of entitlement that may cause an executive-pay system that some credit with stimulating innovation to choke on its own excesses.