If Elon Musk can do it, I can too. Right?
That's apparently the newest mantra of corporate CEOs hoping to get their boards of directors and shareholders to approve a potentially enormous payday. What I'm talking about is companies modeling compensation packages after Tesla's (TSLA -3.55%) performance award package for Elon Musk that may pay him $78 billion over the next 10 years. Now, Axon Enterprise's (AXON -0.74%) CEO, Rick Smith, is following with his own massive performance package that may misalign his interests and those of long-term shareholders.
What multibillion-dollar pay packages look like
Tesla's performance package for Elon Musk gives him 12 stock option tranches equal to 1% of shares outstanding as of Jan. 21, 2018. Each tranche would vest if Tesla hits both a market cap goal and any one of the revenue or adjusted EBITDA goals, both of which you can see below.
Image source: Tesla.
Rick Smith's award follows a similar blueprint, scaled for Axon's much-smaller size. But if the plan fully vests, he would get 6.46 million shares of Axon Enterprise stock that could be worth over $1 billion.
Image source: Axon Enterprise.
You might say that you'll be happy with these incentive plans if the CEOs meet their respective goals. Both plans would require the companies' market caps (note: this is not the same as a stock price requirement) to grow about 10 times to meet all targets, and if they do that, why should shareholders care if the CEOs make billions of dollars? But that reasoning overlooks the fact that these plans create incentives for the CEOs to take more risk than they otherwise might.
Misaligned incentive
If your objective as a CEO is to grow a business tenfold over 10 years, you have a big incentive to make bets that give you a chance to hit those targets. And those bets may be riskier than a CEO would take under normal circumstances. In Axon's case, the company has to increase revenue at a compound rate of 19.2% to hit the $2 billion revenue goal. That's not impossible in theory, but you can see below that the company's growth in the last 10 years hasn't been anywhere near that level. Based on the company's performance, the CEO would have hit only one or two of the tranche targets.
AAXN Revenue (TTM) data by YCharts.
But over this 10-year span, Axon's stock more than doubled the performance of the S&P 500. So shareholders did well even if Smith would have missed most of his targets had this compensation plan been in place 10 years ago.
Would Smith, or any other CEO, have made different bets if they could have made hundreds of millions, or billions, of dollars more by hitting more tranches?
The casino analogy
Let's use gambling odds as an example of how CEOs may think about investments under these compensation plans. Let's say a casino is offering two different potential bets with different payouts and odds for a $100 bet. And you can only bet once.
In one scenario, you have a 98% chance of winning $10 for a total payout of $110 on your $100 bet. In the other, you have a 0.1% (1 out of 1,000) chance of winning, but the total payout on a $100 bet is $50,000.
| Potential Bet | Chance of Winning | Potential Total Payout | Expected Profit for Gambler on Each Bet |
| Low-risk | 98% | $110 | $7.80 |
| High-risk | 0.1% | $50,000 | ($49.90) |
Calculations by author.
As you can see above in the last column (expected profit to the gambler), the casino is actually losing money on the low-risk bet because you're expected to make $7.80 in profit on an average bet. But the upside for you is very low. The high-risk bet, on the other hand, has a very high payout if you win, but is very profitable for the casino. Which one would you choose?
Now, if you tie compensation to the potential payout, the picture gets even more skewed. Let's say I gave you $100 to go to the casino, and I agree to split my winnings with you, no matter how much you make, plus I will absorb any losses. Under that scenario, it's a no-brainer that you're going to make the high-risk bet, because your potential upside is $24,950. If you take the low-risk bet, I'm only going to share $5 with you.
Encouraging CEOs to make high-risk bets
If you were the CEO of a company, choosing between a low-risk and a high-risk bet should be a no-brainer. You want to invest in projects that have a positive expected return, so you'd choose the low-risk bet if everything else was equal. But if your compensation package is heavily skewed to high growth and a high market cap, you may choose the high-risk bet because you get a large payout, even if the company's expected value on the investment is negative. And remember that the downside for you would be the same as if you'd generated positive returns but not high enough to hit the first tranche.
Under these compensation packages, the personal interest of the CEO and shareholders' underlying expectation from their investment are greatly misaligned. I think that's very problematic in that it gives company leaders an incentive to take boom-or-bust bets in their businesses. That incentive for risk may not be what long-term investors think they're signing up for.
