Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) recently filed a document with the SEC disclosing the new compensation arrangement for Sundar Pichai. Pichai has been the CEO of Google since 2015 and was recently promoted to CEO of both Alphabet and Google. Earlier this month, the company's founders, Sergey Brin and Larry Page, stepped down from their roles as CEO and president, respectively.

The terms

Under the new pay plan, Pichai's salary is $2 million per year, a nice increase from the $650,000 he had been making. However, the vast majority of his total compensation is stock-based. On Dec. 19, he was granted two forms of stock-based awards. One is restricted stock units, which Alphabet calls "GSUs" or "time-based equity." The other is performance stock units, which the company calls "PSUs" or "performance-based equity." 

The GSU award was a whopping $120 million. One-twelfth of the underlying shares will vest -- essentially convert to unrestricted freely tradable shares -- on March 25, 2020, and another twelfth will vest quarterly thereafter, assuming continued employment with the company. Additionally, Pichai was granted a transitional award of $30 million in the form of additional GSUs.

However, the far more interesting piece is the PSU award. Pichai was granted two tranches of PSUs that each have a target value of $45 million. The first tranche will vest based on the total shareholder return ("TSR") of Alphabet relative to companies in the S&P 100 -- generally the 100 largest public companies in the United States -- during the 2020-2021 period. And the second tranche will vest the same way but will focus on the 2020-2022 period. Depending on how well Alphabet's stock performs relative to the S&P 100 over these periods, the number of PSUs that vest could be anywhere from 0% of the target all the way up to 200%.

Man in suit sitting in a chair with money raining down.

Image source: Getty Images.

So if Alphabet's stock performs well over these periods relative to the S&P 100, the total PSU award could have an initial value of up to $180 million. But initial value is less important than future value. If Pichai earns the maximum payout, it means the company's stock outperformed. Let's say GOOG appreciates by 15% per year for the next three years, and that earns him the max. That would mean the initial $180 million value of the PSUs would turn into about $274 million by then, and more over time, assuming the stock continues to do well.

Why this matters

I've looked through Alphabet's and Google's historical filings, and this appears to be a new compensation arrangement for the company and never before has the company so meaningfully and directly tied its CEO's pay to near-term total shareholder return. For example, founder and former CEO Larry Page received a $1 salary and did not receive stock-based awards. Eric Schmidt, the CEO before that, received options and GSUs largely based on "performance."

But what's especially striking is that Pichai's PSUs vest based on short-term stock price performance over the next two to three years. Alphabet is a company famous for its long-term perspective and for prioritizing long-term investments over near-term profits. That's why it is almost shocking to see the company so meaningfully incentivize its CEO to have the company's stock outperform other stocks over two- and three-year periods. By Alphabet's standards, that is exceedingly short-term.

This matters because Alphabet has never been a company accused of ruthless efficiency or maximizing profits. Its core search business has been such a cash machine that the company can afford to invest meaningfully in growth initiatives, new "moonshot" ideas in the other bets segment, employee perks, and other areas. However, given that Pichai is now meaningfully incentivized to have the stock outperform over the next two and three years, he may be thinking about sharpening his pencil as it relates to the company's profits. It's possible we see the company get a bit more choosy with its investments in certain other bets businesses. In addition, Pichai my increase investment in mature Google businesses like YouTube and Google Maps, hoping to squeeze out more profits. If that's the case, I'd expect the stock to outperform the S&P 100 and other large technology stocks.

Berkshire Hathway Vice Chairman Charlie Munger's quote is relevant here: "Show me the incentives and I'll show you the outcome."