MEMORANDUM
To: Robert MacGregor, VP Product Engineering, Zoom Systems, Inc.
From: James Monaco, Design Center Manager – Austin Office
Date: 8 May2010
Subject: Maintaining Fair and Effective Compensation Practice at Zoom Systems
Zoom Systems, Inc. must strive to remain competitive, profitable, productive, and survive as an organization. To do so may require challenging corporate history and conventional wisdom with respect to executive compensation.
For the past ten years many United States businesses have been rocked by crises and scandals.
Some of the more well known individuals and companies involved include MCI, Enron, Tyco, Goldman Sachs, Martha Stewart, Bernie Madoff, and more. Pundits and commentators have referred the top executives involved as “Looters”. The accusers have wondered how those trusted with fiduciary responsibilities for their companies to permit the huge salaries, bonuses, and perks for non-performance. Who invented golden parachutes?
I believe a major contributing factor centers around power imbalance and the associated compensation inequality. CEO and top executive salaries at major US corporations exceed 300 times the salary of their average workers. In large successful companies in Australia, Germany, and Japan, where top executive salaries range from 10 to 25 times that of average workers’, there are far fewer scandals and greater confidence in corporations. Hundreds of scholarly and news articles have examined the issue of compensation – especially for top executives. Many arguments have been made and conflicting conclusions have been reached. In a time when stockholders, employees, customers, and the general population, no longer trust prominent companies, something must be done to prevent such circumstances at Zoom.
I believe after considering the arguments presented within this study “Maintaining Fair and Effective Compensation Practice at Zoom Systems”, you will agree to assist me by recommending its conclusions to our Stockholders, the Board of Directors, and all of our employees. When you are ready discuss this report, I can be contacted via phone at x6360 or e-mailed at jmonaco@zoominc.com.
Thank you for considering my proposal.
James Monaco
EXECUTIVE SUMMARY
Introduction
Will Zoom Systems, Inc. remain in existence 30, 50, or 100 years from today? It may not if executive compensation trends in our company continue on present course. Extreme inequality between pay for our top executives and our average workers will in likelihood lead to the company’s demise. This proposal examines where we’ve been and what forces are at work. It suggests a foundation for maintaining a fair and effective compensation system. This will improve our company’s long-term chances for survival.
In this report I will discuss:
– Background information about the identified concerns.
– Why a need exists to take action.
– What research the study examined.
– How the new system affects our annual budget.
– Conclusions and recommendations.
No system of compensation is perfect. The system we now have is similar to that of many organizations. Like others, our system is something of a “black art”. It directly and indirectly touches people within our company and outside: stockholders, the board, management, employees, customers, vendors, and even the general public.
By understanding the past and present, we can positively influence our future. It is a question of what kind of a company we will become.
I hope you will be provoked and enlightened by this research.
TABLE OF CONTENTS
MEMORANDUM i
EXECUTIVE SUMMARY ii
TABLE OF CONTENTS iii
I. BACKGROUND 1
I.1 History of Living Companies 1
I.2 Compensation Systems 1
I.3 Recent Trends and Events 2
II. THE NEED FOR CHANGE 2
III. CHANGING THE SYSTEM 3
III.1 The Study Objectives 3
III.2 What the Research Shows 3
III.3 Proposed Course of Action 5
IV. BUDGET IMPACT 6
V. CONCLUSION 6
REFERENCES 7
LIST OF FIGURES
Figure 1 - CEO PAY RATIOS vs. TIME 3
Figure 2 - CEO PAY vs AVG WORKER PAY 4
LIST OF TABLES
Table 1 – CEO PAY RATIOS BY COUNTRY 4
I. BACKGROUND
This study examines how executive compensation systems relate to a company’s performance and that company’s survivability. It describes how companies interact with their social, political, and economic contexts. Many disciplines were considered including compensation management, corporate management, corporate governance, stocks and stock options, and industrial management. Information involving direct research is covered from books and articles spanning 1997 through 2010 -- approximately thirteen years. The research behind the direct research covers more than three decades.
This background helps the reader understand three key concepts: the living company, a compensation system, and the recent history of compensation systems. It is good to begin by describing what comprises a living company. Next, elements of compensation systems are covered. Last, trends in corporate compensation systems as they pertain to executives are identified.
I.1 History of Living Companies
The best selling book on business, “The Living Company” (de Geus, 1997), considers the elements of a living organization. The author poses a primary question: “Why do so few companies survive even the lifespan of a typical human being?” What is different between a few years old company and a 500-year-old company? The author cites several characteristics that living companies have in common:
– The company is able to acquire knowledge and treat decision making as a learning experience.
– The company has an identity. That identity being the culture through which its people learn.
– The company has an ecology. Think of ecology as answering questions “like is the company tolerant”? “Does the company have a ‘corporate immune system’ to protect itself from internal and external threats”?
– The company evolves over time. The company succeeds in evolving through the nature its financing systems.
A key aspect of the company’s evolution counts on promoting power sharing. In a living company, an individual never holds too much power. This balance helps the organization survive.
I.2 Compensation Systems
Modern compensation is concerned with rewarding the company’s workers at all levels -- from it’s top executives to it’s clerks, and salesmen. These systems have been evolving over centuries. Some are simple. Some are complex. Factors such as risk taking, responsibility, and performance shape the compensation paid to a company’s employees (Chingos, 2002).
A modern company is class based. Not everyone is paid equally. It is common for executives and staff to receive greater compensation than those workers occupying lower levels of the organization – those who execute less complex tasks.
All reward systems involve base salaries and hourly wages. Sometimes health, dental care, or other benefits are provided. The extent of benefits depends partially on the company’s size, its revenue, and its profitability. In many cases formal employment agreements will specify employee compensation. These agreements can cover a variety of bonuses, the option to purchase company stock of various classes, or offer direct grants of company stock. Most executive rewards are specified by customized employment agreements.
Zoom Systems, Inc. offers these forms of reward as well as 401K retirement plans, discounted stock purchase plans, and profit sharing for all employees. Profit sharing, as its name suggests, is only paid when the company is profitable. This can be paid on a quarterly, semi-annual, or annual basis. When the company isn’t profitable these bonuses are not awarded.
I.3 Recent Trends and Events
In class societies, some simple questions invariably lurk below the surface of everyday events. Here are some of those questions: How much is compensation enough? What is a fair distribution of compensation? What constitutes excellent performance? In 2006, Bebchuk observed that the US stock market exploded in value beginning in the 1980’s.
Since then a divide has grown between the privileged and powerful and those who have considered themselves middle class. The rewards have not been shared in a pro-rata fashion. At the same time there have been numerous scandals as companies have failed financially. Some well-known companies’ have had top executives involved not just in unethical, but illegal activities. In some cases, top executives have been successfully prosecuted and jailed. Examples are the cases involving Enron and Anderson Consulting (Nakayama, 2002).
II. THE NEED FOR CHANGE
A cornerstone of American capitalism is the practice of rewarding the best performing executives and employees for helping the company gain market share, create imaginative products and services, and become more safe, secure, and successful.
Global economic turmoil has raised doubts about the wisdom of providing top executives with golden parachutes, extraordinary salaries, and benefits that seem at odds with the goals of shareholders and average employees. US taxpayers have become involved since the US government has bailed out many failing private companies in finance, banking, insurance, and automobile making. The shareholders lose wealth, the board seems oblivious, workers are laid off. Executives escape with incredible rewards whether they succeed or not. The office of “Pay Czar” was created to oversee executive compensation for these bailed-out industries (Solomon, 2009).
What is good for Zoom is good for our stockholders, middle managers, workers, and customers. A clear problem arises when a company is perceived as unfair. It leads to shareholder disappointment, falling morale, and eventually company decline (Hennigan, 2005).
III. CHANGING THE SYSTEM
A great deal of information is available to help us comprehend the emerging problems. How to find the right balance to improve our compensation system in the face of the problems?
III.1 The Study Objectives
The hypothesis under test is whether trends in executive compensation threaten our company’s long-term survivability? If so, what changes can be made to improve Zoom’s chances of survival?
III.2 What the Research Shows
Class struggle was prominent in the early 20th century. The struggle receded during the prosperous post 1945 era. Class warfare has been revived, though, because of eroding prosperity.
Between 1996 and 1997, US CEO total compentation increased by 35% (Hurtt, 2000). In 1997, the difference between CEO salaries and that of the a factory worker was 326 times. By 2003, that difference was more than still more than 300 times. These are estimates. The current levels may exceed 500 times (Bebchuk, 2004). Hennigan’s 2005 graphs and tables are included here to provide insight. Figure 1-1 displays a graph of CEO pay ratios between 1980 and 2003.
[pic]
CEO and Worker Pay: Average hourly worker to CEO pay ratios –
Source: AFL-CIO: Business Week and United for a Fair Economy
Figure 1 - CEO PAY RATIOS vs. TIME
Consider CEO pay in absolute dollars compared with an average worker. Figure 2 shows the trend in CEO compensation over time compared to average worker pay. It is easy to see the enormous gap between worker rewards. Average worker compensation stayed flat, while executive compensation vastly increased.
[pic]
Source: AFL-CIO - Emmanuel Saez, University of California, Berkeley, Department of Economics
Figure 2 - CEO PAY vs AVG WORKER PAY
Hennigan’s (2005) article explains that the US (300+) ratio is a larger discrepancy than many third world countries such as Malaysia (47) and Mexico (45). This is shown in Table 1. Among developed countries such as Australia (22), Germany (11), and Japan (10), wage ratios fall far below those estimated in the US.
Table 1 – CEO PAY RATIOS BY COUNTRY
|Country |CEO compensation as a multiple | |Country |CEO compensation as a multiple of|
| |of average employee | | |average employee compensation |
| |compensation | | | |
|Brazil |57 | |China (Shanghai) |21 |
|Venezuela |54 | |Belgium |19 |
|South Africa |51 | |Italy |19 |
|Argentina |48 | |Spain |18 |
|Malaysia |47 | |New Zealand |16 |
|Mexico |45 | |France |16 |
|Hong Kong |38 | |Taiwan |15 |
|Singapore |37 | |Sweden |14 |
|Thailand |23 | |Germany |11 |
|Britain |22 | |South Korea |11 |
|Australia |22 | |Switzerland |11 |
|Netherlands |22 | |Japan |10 |
|Canada |21 | |- |- |
The table estimates came from the firm Towers Perrin dated Apr. 1, 2000. For the purpose of calculations, an average employee was assumed to work in an industrial company that generated about $500 million in annual sales.
Regardless of the country, the inequalities in reward strongly correlated with a sense of distrust between the general population and business executives.
Hennigan’s article (2005) pointed to a 2002 study conducted by Australian researchers who concluded that optimum performance was found when the top executive versus average worker reward ratio ranged between 17 and 24. They claimed that worldwide, as executive pay increased, company performance decreased. The article concluded there is no relationship between enormous pay and company performance. French and German CEO’s are paid much less than their American counterparts yet their companies’ productivity is 20% higher. There is a belief that performance of US executives is as attributable to luck as much as competence (Hennigan, 2004).
Arguments have been made that Goldman Sachs’ executives deserve the large performance bonuses for their 2009 performance (Harper, 2010). The CEO himself received a $9M bonus and 2009 was the second most profitable year in Goldman’s history. Just the same, the CEO grudgingly accepted what he considered half of the pay he deserved. Why did he accept lesser compensation? It appears the company sought to pacify public outrage and resentment because Goldman took advantage of a bailout package that was arranged at taxpayer expense. A strong element of rationalization is in play.
III.3 Proposed Course of Action
Zoom Systems difference of pay ratio is about 30 times. Bonus compensation is about a three times difference between top and median salaries. Retirement benefits are not an issue at Zoom because the company matches all individual 401K contributions regardless of a worker’s function.
Therefore, the board should adopt a policy that neither modifies our profit sharing plan, nor our matching 401K contributions.
But this is the optimal time to limit base salary inequality across all pay grades. The difference between executive and average workers should never exceed 25 times. During the initial implementation period (2 years), executives should not receive salary increases until the other pay grades catch up.
Top executives affected by cost of living due to the proposed base salary changes could be provided with equivalent stock grants for 2 years to encourage them to stay with the company and think longer term.
Profit sharing bonuses should be based upon goals being met or exceeded using a combination of profit before taxes (PBT), return on investment (ROI), and earnings per share (EPS). The weighting of these metrics should be determined by the Finance Committee and approved by the Board of Directors. Profit sharing nor other bonuses should ever be paid while the company is not profitable. Profit sharing should only be paid semi-annually to strike a balance between the short and long term interests of the company.
IV. BUDGET IMPACT
There is relatively small budget impact for the company to implement the proposal.
The greatest short term risk is the loss a few executives. We are fortunate to have a large cadre of competent individuals who deserve inside promotions. The new plan should attract new executives who will be more aligned with long-term total company performance.
Legal fees may be incurred to adjust some of the existing executive employment agreements, but the estimated cost is less than $300K.
Additional HR and Accounting cost will be needed to cover initial administrative cost for implementation and tracking. The estimated cost will not to exceed $50K in the first two years. This cost will be recouped through salary freezes and improvement in company operating profitability.
Funds will be set aside to buy back stock to compensate current executives affected by the new plan. Given the current price of the stock, this should not exceed $2M.
The proposal does not reduce payment to anyone but freezes the top-executives’ base salary until re-balance has been achieved. The most affected individuals also happen to be significant stockholders. As the stock value and dividends grow, so will these executives wealth.
The proposal basically redirects future profits into three areas: stockholder dividends, company reinvestment, and a more fair distribution of base salary and profit sharing. More analysis will be performed and the results tracked so the system can be adjusted as needed.
V. CONCLUSION
Given what the research tells us, what the likely morale benefits are, how this should position the company for better profitability and valuation, and the improved likelihood that we will ultimately survive as a 500+ year old organization, some re-balancing is needed.
I urge everyone in Zoom Systems, Inc. to embrace this proposal and preserve our company as a great place to work.
REFERENCES
Bebchuk, L. & Fried, J (2004). Pay without Performance: The Unfulfilled Promise of Executive Compensation, Cambridge: Harvard University Press.
Chingos, P. (2002). Paying for Performance: A Guide to Compensation Management, New York: John Wiley & Sons, Inc.
de Geus, A. (2002). The Living Company, Cambridge: Harvard Review.
Harper, C. & Moore, M. (2010) Goldman Sachs’s Blankfein Receives $9 Million Bonus for 2009. Bloomberg Businessweek February 06, 2010. Retrieved May 16, 2010 from http://www.businessweek.com/news/2010-02-06/goldman-sachs-s-blankfein-receives-9-million-bonus-for-2009.html
Hennigan, M. (2004). The Gekko Doctrine-Fair Pay in an Age of Greed. Finfacts Ireland Business Review Portal – Commentary. Retrieved on May 6, 2010 from http://www.finfacts.com/comment/comment9.htm.
Hennigan, M. (2005), Executive Pay and Inequality in the Winner-take-all Society.
Finfacts Ireland Business Review Portal - Article. Retrieved May 8, 2010 from http://www.finfacts.com/irelandbusinessnews/publish/article_10002825.shtml.
Hurtt, D., Kreuze, J., & Langsam, S. (2000, Spring). CEO Compensation, Performance Variables, and Socially Responsible Investing, American Journal of Business, Ball State University (15, 1). Retrieved May 8, 2010 from http://www.bsu.edu/mcobwin/majb/?p=290.
McClure, B. (2010). Lifting the Lid On CEO Compensation. Retrieved May 9, 2010 from Investopedia. http://www.investopedia.com/articles/stocks/04/111704.asp.
Nakayama, A. (2002). Lessons from the Enron Scandal. Retrieved May10, 2010 from http://www.scu.edu/ethics/publications/ethicalperspectives/enronlessons.html.
Solomon, D. (2009, October 6). Pay Czar Targets Salary Cuts. Online Wall Street Journal. Retrieved May 12, 2010 from http://online.wsj.com/article/SB125478783753066235.html.
No comments:
Post a Comment