Why Executives Cost So Much

In my previous post, I explained why business spend a great deal of money on executive pay and why the rest of us should be glad they do. 

However, this raises the question: Why do we have to spend so much money to hire a small number of decisions makers? Even if the decisions they make determine the success or failure of entire businesses why does it cost millions to hire them? After all an executive doesn’t need the money to actually make decisions. In theory, an executive will make the same decision if you pay him $100,000 a year as he will make if you pay him $1,000,000.

So why do greedy capitalists pay millions to hire executives when in theory they could get the same decisions for less money?

The answer is deceptively  simple:You have to pay an executive more than he could make running his own private company.

Anyone capable of running a large corporation could also run his own business. Anyone capable of convincing a group of investors to let him run a publicly traded company could just as well convince a group of investors to fund a private venture. 

The first big executive paychecks came about in the late 1800s, when investors bought private companies but kept the original management in place since that management had made the decisions that made the company an attractive buy in the first place. The new owners had to cough up quite a lot to convince the original owners to stay around and work for someone else. The same basic pattern has driven up executive pay up to the present day. 

It costs a lot of money to hire the best people to work for others and not themselves. It costs a lot in assured pay such as stock options and “golden parachutes”. People who can make a lot of money working for themselves will ask for assured pay before they will take the risk of working for others. After all, few of us would work under a contract that specified we’d lose our pay if months or years down the road someone decided they didn’t like our work. 

Steve Jobs at Apple serves as a clear example of the cost of hiring good talent (as well of the value of good executive decisions). By the mid-’90s two disastrous CEOs had nearly wrecked the company. The third, Gil Amelio, made significant improvement but he couldn’t quite get a handle on the company. Steve Jobs at the time was (1) independently wealthy and (2) running the highly successful Pixar. To get Jobs back, the board agreed to make him the most highly paid corporate executive (relative to the size of the company) in history. 

Speaking as someone who worked for Apple and whose outlook depends heavily on the success of the company, I can’t say that the hundreds of millions that Apple paid for Jobs was wasted. Moreover, with expanding market share and 20 billion cash in hand, it’s hard to see how the investors, employees and customers of Apple computer would have been better off if they had not coughed up the money to hire Jobs. If they’d hired someone for a mere fraction of Job’s pay, they might not even have a company left.

Jobs serves as a rather extreme example of a general principle: In companies big and small, the people at the top matter and it costs a lot of money to get them to work for you. Elite executives earn a lot because it costs that much to hire them in the free market. 

People who want to cap executive pay for publicly traded companies will only succeed in creating powerful privately owned companies answerable only to the owners who manage them. The same people will still be hauling in tons of money, but the rest of us won’t be able to benefit by investing, nor will we get the say in the decisions such investment brings. 

Let the market decide. Let the enlightened interest of investors set salaries. If you want a say, buy stock.

20 thoughts on “Why Executives Cost So Much”

  1. In general, it seems that companies that pay very extreme amounts for executive talent (and also bind themselves contractually to very large termination benefits) are those who have not done a good job of developing internal talent, find themselves in trouble, and are looking for a savior/miracle worker from the outside.

  2. David Foster,

    I think your correct in that. Businesses in trouble do spend money to try and find critical talent regardless of the cost. It cost more, especially in termination benefits to hire someone to manage a company that might be irredeemable. It makes sense, because if they cannot find someone to make the right decisions, the company is doomed.

    Apple was in much the same circumstance when they hired Jobs. The company just barely survived a catastrophic quality collapse created by bad executive decisions. Getting the right talent paid off big.

  3. I think that there are instances where companies pay executives a lot of money and it is worth every penny. When you think of many successful CEO’s like Jobs who you mentioned or Gates or Dell they basically were entrepreneurs who built up their companies and ran it as if the $ was their own. Think of the stories of Gates flying coach class, or Bezos of amazon turning doors upside down to use for desks.

    Many, many other executives are essentially bureaucrats who are not putting any of their own capital at risk and are basically hedging their risks with golden parachutes on one hand, and options valuable if the stock goes up on the other hand. When they leave / change the company pretty much chugs along without a lot of noticeable impact.

    I would say that there is a third category of worthwhile CEO, is those who are not necessarily entrepreneurial but who have extremely thick skin and put up with torrents of abuse while keeping their company on an even keel. The head of Exxon for many years, Lee Raymond, ran a tight fiscal ship and took abuse from a million environmentalists, while running the company very well (for shareholders) through discipline. This is contrasted with many other CEO’s like Browne of BP who basically caved into environmentalists because it was a lot easier (personally) to give in than to try to do what is right for the company.

    But probably 80% of the CEO’s could be replaced for less $ and you wouldn’t really know the difference. You could replace them for more $ and wouldn’t know the difference. Bureaucrats are interchangable.

  4. Carl from Chicago,

    But probably 80% of the CEO’s could be replaced for less $ and you wouldn’t really know the difference.

    Yes, that would follow Prateo’s rule. However, the trick is knowing which individual CEO’s fall into the 80% replaceable and which fall into the 20% worth every penny. Given the highly experimental nature of business, often the only way to find out if someone is any good is to give them free reign.

    If you can come up with methodology from separating the managerial wheat from the chaff, you can certainly make your fortune.

  5. > The answer is deceptively simple:You have to pay an executive more than he could make running his own private company.

    That is remarkably astute. Hadn’t thought of it that way, but it’s sorta obvious once you say it.

  6. > By the mid-’90s two disastrous CEOs had nearly wrecked the company.

    Actually, the man who really, really copulated with the canine wasn’t even the CEO.

    They Coulda Been a Contender

    That assessment of Apple’s future has softened a bit (in no small part because of, as you note — Steve Jobs), but the idiot who nearly threw away the company was a French jackass who actually thought that what Apple created in a couple years time could not be replicated, for some bizarro reason.

    Count on the French to screw things up (US citizens decended from French don’t count. Your umpty-ump parents had brains enough to leave. The ones still in France are the ones who were too stupid or too chickensh**).

  7. A component of exec pay is base salary. This is determined by salary surveys of companies competing in the same business. Once the salaries of the competition are obtained and the range established, a company determines where they want their salaries to fall within that range. Since no company want to pay their executives an “average” rate, they usually decide on the 70th to 90th percentile level. You can see where this leads, since the same group of companies are surveying each other constantly. With no improvement in performance or any other justification (for most execs), salaries for these people automatically rise significantly. This same process occurs with executive bonus programs and benefits.

  8. Obloodyhell,

    The decision of whether or not to have licensed the operating system remains a controversial one and was even more hotly debated back in 97 when the article you link to was written. Apple did attempt to do so in the mid-90’s and the experiment proved disastrous. Personally, I don’t think that Apple could have duplicated Microsoft’s model. Certainly today, Apple succeeds nicely using a closed model.

    The history of Apple does bring home just how experimental and exploratory business leadership is and how uncertain an individuals reputation. In 1992, John Sculley was riding so high that he sat beside Hillary during Bill Clinton’s first State of the Union speech yet by then of ’93 he was kicked to curb.

    I’m not sure if Jean-Louis Gassée’s french (spit) heritage had much to do with his decisions. Michael Spindler, Sculley’s replacement, was a german born and trained engineer and yet he managed to utterly destroy the quality of Apple’s entire product line. Usually, “german engineer” and “terrible quality” do not go together in the same sentence.

  9. Mike Doughty,

    A component of exec pay is base salary.

    There are the perverse effects you describe in the salary setting processes of all employees, executive are not special in this regard. Everyone (except leftist intellectuals) has worked in a business unit wherein most of the people in the unit earn roughly the same salary yet show great differences in performances. It usually runs something like this: 20% of the people are stellar, 60% are okay at their jobs and 20% are absolutely hopeless.

    In the end, however, the range of executive compensation is set by the market competing with draw of private companies. You can see this in the high compensations paid to executives who leave their own private companies to work for others.

    Once a company has an executive, they do have to at least match the industry standard pay or they will lose him to a higher bidder. As I said in my previous post, the executives make the company. No matter how hard and skillful the people down the food chain work, if the companies navigator sets them on the wrong course, the company will fail.

  10. Thanks, Shannon for the thread,which is even more astute than usual. We have had a problem though, and that is with the costs of catastrophic errors being socialized. The compensation packages were such as to encourage imprudence.
    Of course Congress is now expecting those they aid to get management on the cheap. They will get what they pay for, or rather the really good ones will stay away.
    Reminds of generics at the supermarket-sometimes they are just as good as the brand names and sometimes-yuck!

  11. Renminbi,

    Of course Congress is now expecting those they aid to get management on the cheap.

    Yes and it will have the opposite effect that leftist expect. Just as Sarbanes-Oxley put publicly traded companies at a disadvantage compared to privately held ones, this legislation will reduce the caliber of talent at regulated companies putting them at a disadvantage compared to non-regulated ones.

    The end result of all the “oversight” will be the formation of large privately held companies that concentrate wealth and economic influence in very few hands. Exactly the opposite of the outcome leftist claim they want.

  12. Note also that many celebrities and athletes, and some trial lawyers, make more than many F500 CEOs. Few if any Democratic politicians seem bothered by the compensation paid to these people.

    Many years ago, Peter Drucker suggested that the management quality of a company can be judged in part by the *distribution* of executive salaries–if the CEO makes vastly more than the Vice Presidents, and they in turn make vastly more than the next level of execs, that is a bad sign. Makes sense, and I recently saw a study somewhere than tends to confirm this.

  13. David Foster,

    If the market is functioning, pay differentials indicate differences in talent. A firm that pays its top exec/execs out of proportion to its lower ranks may have cluster of talent at the top. If so, the firm may have trouble translating the execs ideas into action and they might have trouble replacing the execs from within the ranks.

    Of course, the market is an optimal solution overall, not a perfect mechanism in every instance. The market corrects mistakes such as overpaying hot incompetents by destroying the individual companies that make those mistakes. The negative feedback in the market place is just as significant as the positive feedback.

    As for pay for athletes, entertainers etc, I read a psychology study some years back in which people judged individuals compensation more justified if they saw the individual working. Athletes et al perform in public and people see them working. That triggers a inbuilt mechanism that makes us accept their pay as just. Business people by contrast work invisibly and it difficult to explain to lay people exactly what it is they do.

    Also, business people have to tell people no. They have to choose between options and someone always get stuck with some circumstance they did not want. People blame those who had to make the decision (while usually ignoring decision to their favor such as hiring someone in the first place).

  14. Taxes are important. I grew up when the top tax rate was 90% (incomes of $50,000 or more in those days). Top execs look at take home pay. To take home $100,000 per year, they needed $1,000,000. Today at 50% taxes, they need $500,000. etc etc etc. Of course, some supplemented take home with perqs that never showed up in their paychecks.

    Competition is important. Execs are like ball players. Those with great records get lots of calls from head hunters. A top exec knows the value of his company and his own value.

    When Obama hikes taxes, salaries will rise to compensate. If US companies can’t pay the salary, foreign companies will. It will be like losing to ball players to the Japanese leagues.

  15. Sol Vason,

    Yeah, back in the 70’s execs were often “paid” in untaxed corporate housing, cars, vacation houses, even the company yacht.

    If US companies can’t pay the salary, foreign companies will.

    It’s even worse. As technology progresses, information work will become increasingly delegalized. Expensive critical talent can simply relocate to countries or regions with lower taxes.

  16. Curious as to how much athletes would be paid if gov’ts didn’t subsidize the the construction of stadiums.

  17. Agreed on the 80/20 split.

    As far as how to tell, I don’t know how research has been conducted on effectiveness. It is very hard to break out what the CEO’s contribution is from the overall growth / decline in the market.

    My theory would be that performance would be correlated by some level of entrepreneurial stake in the business, and “acting” like they were entrepreneurs – not investing in HQ buildings, perks, and overhead.

    Of course, Bear Stearns had people very highly motivated in that their whole worth was tied up in company stock, and then they failed.

    I really am not plowing any new ground here, as you know, just trying to “glue” my personal experience and observations into a model that might have some predictive value.

    There also is the element that those that are great “builders” of companies or innovators often make lousy caretakers of the flame…

    A final element that makes this virtually impossible to analyze empirically is all the M&A activity. Many good companies get bought up, and bad ones die, and the ones we analyze are those that for one reason or another stand pat and have history behind them.

    The private equity guys, when they come in, focus on a big equity stake for the head guys and whack the smaller ones. They believe in the “big fish” model.

    We’ll see how their plans fare in the long run… a lot of their plans were based on easy access to debt financing and dumping companies back in the market 3-5 years later. Now both of those pillars are dead and we’ll see how their management methods work in isolation.

  18. Carl from Chicago,

    Judging the performance of executives is very difficult because every business is unique and the specific conditions of that business’ environment change from day to day. Ideas that work in one company fail in another. Last years brilliant plan is this years disaster.

    Neither is a way to perfectly align your interest with the interest of someone you hire to manage your interest. Its called the agent problem in economics.

    We just have experiment every damn day. This is the central reason why centralized planning and grand theories fail. There is simply to many variables changing to rapidly.

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