Elon Musk’s proposed pay bundle at Tesla retains making headlines and no marvel: its touted worth of $56 billion is a staggering quantity, even for the world’s most outstanding govt. How might that presumably be justified? The reply is that the majority informal observers, and even many media reviews, are failing to know the character of the bundle. Primarily based on our analysis as finance professors, our conclusion is that Musk was unlikely to earn wherever close to that a lot on the time of the grant, and, if he did, it will be well-deserved.
Earlier than explaining why that is the case, it’s useful to recall the context for the controversy. That features a resolution by a Delaware courtroom this January to reject the Tesla CEO’s proposed pay bundle on the grounds of poor course of and conflicts of curiosity. The ruling got here despite the fact that 73% of shareholders had accepted the bundle in 2018. By practically the identical precise margin, they voted to approve it once more this June—whereas Musk responded to the courtroom resolution by asserting he would reincorporate Tesla in Texas.
With a purpose to make a name on whether or not the bundle is truthful—as nearly all of Tesla’s presumably subtle traders did—it’s mandatory to know three points of any pay bundle: the rewards realized by the CEO, the fee to the agency, and the incentives for future efficiency.
First off, it’s necessary to notice the $56 billion determine represents the realized reward for the CEO and never the fee to the agency. The award consisted of 12 tranches of Tesla inventory choices, every equal to 1% of shares excellent on the time of the award. Every tranche of choices could be earned by the CEO solely on achievement of particular efficiency milestones. If these milestones aren’t met, no choices could be earned by the CEO and the realized reward may also be zero.
This award differs from typical time-vesting awards, that are routinely earned by the CEO so long as the CEO stays in workplace. Efficiency-based-vesting awards, such because the Tesla award, are given yearly to CEOs and aren’t unusual, however structuring them solely based mostly on inventory choices is uncommon. Over the 2007-2023 interval solely 4.2% of excellent awards to S&P 1500 CEOs have been performance-vesting possibility awards.
Tesla’s CEO stood to obtain the complete good thing about the 2018 pay plan provided that he have been to develop Tesla to a market capitalization of $650 billion, roughly 13x the market cap on the time of the grant, and develop income and adjusted EBITDA by 15x and 22x over the corresponding 2017 numbers. If Tesla have been to attain this inventory market capitalization goal of $650 billion, it will additionally develop into 13 instances the 2018 dimension of Ford and GM. From the vantage level of 2018, the probability that Tesla would carry out so properly as to clear all of the efficiency hurdles was considered as extremely unlikely. Certainly, a New York Instances article on the time cited specialists who stated growing the worth of Tesla to $650 billion was “laughably not possible.”
No person was anticipating Tesla to attain this. Information helps this: only one.2% of the observations within the 1950–2017 pattern of US corporations had achieved this fee of progress.
However Tesla did carry out properly, stunningly properly. Tesla achieved all of these milestones in six years, 4 years previous to the tip of the efficiency interval. The rise in Tesla shareholder worth over the identical interval was $ 523 billion. In stark distinction, GM and Ford inventory right this moment are valued at $53 billion and $43 billion, barely decrease than their 2018 ranges.
Because of this efficiency, Tesla’s CEO earned choices on 303,960,630 shares. If the CEO paid the $7.09 billion required to train the choices, he would personal the shares outright. The closing inventory worth was $182.47 on June 13, 2024 (the date the shareholders voted once more on the pay bundle). Multiplying these two figures offers $55.46 billion, which seems to be quite a bit just like the $56 billion reported within the press. Coincidentally, this $56 billion can also be the reward estimated by Tesla’s board of their 2018 proxy assertion on the time of the choice award.
The second factor to evaluate when contemplating the pay bundle is the fee to the agency. In response to Tesla’s 2019 proxy, per clearly-laid-out accounting requirements, the truthful worth of the award was $2.3B. Whereas that is no small determine, observe that the CEO had acquired no different pay since 2018. A superb approximation of “annual pay” for Tesla could be $230 million which is 1/tenth the quantity as a result of the CEO’s pay bundle was meant for 10 years.
It’s additionally price noting that the CEO is required to carry the shares for five years after train, a requirement to make sure his curiosity stays aligned with these of shareholders. Given this restriction, monetary assessors would low cost the awards worth by round 30%—so the award, on an annual foundation, could be price $158 million per 12 months fairly than the $230 million.
One other manner to think about the award is that Tesla granted its CEO a lottery ticket priced at $2.3 billion (the truthful worth underneath accounting guidelines) with a possible payoff of $56B—however that profitable the lottery trusted the CEO’s potential to rework an upstart automotive firm into a world large. One estimate of the chance that Tesla’s CEO might earn the $56 billion reward was 1.2% (as famous earlier). That low chance helps clarify why the fee to the agency was estimated at $2.3 billion.
The third facet of the pay bundle to notice is the embedded incentives meant to inspire future efficiency. Particularly, the contract was structured such that for each $1 enhance in shareholder wealth, the CEO’s wealth elevated by roughly $0.12. This “delta” (a measure of how intently aligned CEO wealth is to agency worth) of 0.12 is excessive, however not loopy excessive.
The Ninetieth-percentile “delta” for CEOs of huge US companies over 1996-2009 was 0.07, and this has solely gotten bigger lately. Within the case of Tesla, the excessive delta seems to have accomplished what it was meant to do—obtain “jaw-dropping” efficiency. We interpret the optimistic shareholder vote as indicating that shareholders are proud of that division of the acquire. And after the vote, traders continued to be optimistic as properly, with Tesla’s market cap peaking at $836B on July 9, 2024.
In conclusion, our evaluation of the Tesla CEO’s compensation bundle highlights the necessity for a nuanced understanding of govt pay. Govt compensation is inherently advanced, and a radical examination of its a number of aspects, fairly than fixating on a single sound-bite determine, is vital to judge whether or not the contract successfully aligns with shareholder pursuits. Ultimately, take into account a easy query: would you share 1% of the positive aspects each time an organization CEO doubles your cash? Tesla shareholders determined they might.
Jeffrey L. Coles, is a finance professor on the College of Utah whose analysis pertains to company finance, together with govt compensation. Naveen D. Daniel is a finance professor at Drexel College, who has revealed broadly on company governance. Lalitha Naveen is a finance professor at Temple College whose work on govt compensation has been broadly cited. The opinions expressed in Fortune.com commentary items are solely the views of their authors and don’t essentially mirror the opinions and beliefs of Fortune.