Elon Musk's new Tesla pay package could make him $55.8 billion — and it's a case study in what's wrong with executive compensation (TSLA)

Elon Musk

Tesla shareholders this week approved a new pay package for CEO Elon Musk that will award him up to 20 million stock options if the company hits certain milestones.
Although the company valued the options at a hefty $2.6 billion, they actually could be worth as much as $55.8 billion if Musk hits the top range of his goals.
While Tesla's directors argued that the pay package was needed to spur Musk to drive the company forward, Musk already had a big incentive in the form of the 37 million shares and options he already held — a stake that would appreciate by $106 billion if Tesla hits his top valuation target.
The gigantic pay package is emblematic of what's wrong with executive compensation practices and helps explain why inequality keeps getting worse.

Maybe it's just me, but $106 billion seems like a lot of money.

Heck, for me, $106 million is a good chunk of change. I could be motivated to do a whole lot of stuff for a mere $106 million. I bet you could too.

The board of directors at Tesla, however, don't think like you and me — and neither, it turns out, do the company's shareholders.

You might have missed it amid all the uproar over the Facebook-Cambridge Analytica scandal, but Tesla shareholders this week approved a new pay package for CEO Elon Musk. Even if you did hear about it, you probably didn't realize just how massive or outrageous the pay package is.

Long story short: Tesla's shareholders agreed with the company's board that $106 billion wasn't enough money to encourage Musk to take the company's valuation to new heights. They figured he needed another $55.8 billion, an amount that is itself equivalent to the annual gross domestic product of Bulgaria.

Musk's payday is emblematic of just how broken executive compensation is this country. But it also offers a window into how inequality in this country has gotten so bad and why it keeps getting worse.

Tesla set lofty goals for Musk — but promised even loftier compensation

The payday Tesla shareholders approved for Musk on Wednesday consists of 20.3 million stock options that are subject to certain performance targets. Using a complex formula, the company estimated the value of the options, which have a 10-year lifespan, at $2.6 billion. That amount would be generous enough — it amounts to $260 million a year, after all, a heady salary for most CEOs — but it vastly understates the potential value of the options.

The way Musk's pay package is structured, his windfall will increase exponentially with each milestone the company hits.

Tesla divided the options into 12 different tranches of equal numbers of shares. Each tranche only vests if the company meets certain operating results and its market capitalization reaches certain levels. Each market capitalization milestone is separated by $50 billion. The first tranche of options can vest when Tesla's market capitalization reaches $100 billion, the second at $150 billion, the third at $200 billion, and so on.

Those targets will be tough to meet, no doubt. But the way Musk's pay package is structured, his windfall will increase exponentially with each market capitalization milestone the company hits.

Tesla estimated that if only two of Musk's group of options vest, and he doesn't sell them until after both of them do, he'll realize about $1.4 billion in value from them. If four of his tranches vest — and, again, he doesn't sell until all of his options are vested — Tesla estimated he'll see $6.3 billion in value from them. If all 12 tranches vest — and he doesn't sell before they do — the total value of his options would be $55.8 billion, according to the company.

Even dividing that by the 10-year life of the options, that would still amount to a jaw-dropping payday of $5.6 billion a year.

Musk's potential windfall amounts to a steep commission

Here's another way of looking at Musk's potential windfall. For his first two groups of options to vest, Tesla's valuation will have to hit $150 billion, up from about $51 billion today. His own windfall from that gain would amount to about 1% of that rise in valuation. But his share of the increase would go up with Tesla's market capitalization.

For all 12 tranches to vest, the company's market capitalization would have to hit $650 billion. Tesla investors, of course, would be ecstatic if it got that high. But Musk's windfall would amount to 9% of the total increase in Tesla's valuation. That's a pretty steep commission in my book — no matter how much of a gain investors would have seen.

Now, you can argue that if Musk is able to drive Tesla to the operating and valuation targets laid out in his pay package, it will be worth it to give him such an outsized portion of the company's stock gains. After all, it's a huge mountain that the company would have had to climb.

Tesla Model 3 Tesla has struggled for years with with profitability and production. It's currently producing only a small fraction of the number of its Model 3 car — the vehicle on which Musk has basically bet the company — than it expected. So its chances of achieving even half of the goals set out for Musk seem unlikely at best.

In a letter to shareholders explaining the award, Tesla's directors said they intentionally gave him a tough challenge.

"Our aspirations may appear ambitious to some, and impossible to others, and that is by design," the board members said in the letter. "We like setting challenging, hard-to-achieve goals for ourselves, and then focusing our efforts to make them happen. This is why we based this new award on stretch goals and why we gave Elon the ability to share in the upside in a way that is commensurate with the difficulty of achieving them."

The directors designed Musk's award to ensure his interests are aligned with shareholders, they said. After Musk received a similar structured grant in 2012, Tesla's market capitalization increased 17 times, they noted.

"We believe [Musk's] prior award was instrumental in helping Tesla achieve the objectives laid out in the original Tesla Master Plan and the tremendous stockholder value that was created as a result," they said.

The rationale for Musk's new pay package doesn't make sense

Let's set aside the question of whether the goals in Musk's new pay package are achievable — or whether they're even appropriate for him to focus on. The idea that Musk needs a $55.8 billion incentive to achieve all of them is laughable on its face.

The theory behind giving executives stock awards is to allow them to benefit from the company's success, and thereby align their interests with those of shareholders. The assumption is that the executives generally don't hold much in the way of the company's shares, so they wouldn't otherwise benefit from a rising stock price. We can argue about how well that theory holds up in practice, and the incentives it creates for executives, but that's the basic idea.

But that theory just doesn't apply to Musk. He already holds a huge stake in Tesla. As of the end of last year, he owned 33.6 million shares of the company's stock, and held another 4.2 million options that could be exercised within 60 days. All told, that amounted to nearly 22% of the company's outstanding shares.

Because of that stake, Musk was already going to benefit if Tesla's valuation went up. And not in a small way.

Musk was already going to benefit if Tesla's valuation went up. And not in a small way.

In fact, the value of that stake alone will go up by an $17.5 billion if Tesla's market capitalization hits $150 billion — the second milepost in his new pay package — taking into account the dilution the company expects. If Tesla's market capitalization goes all the way up to $650 billion, that stake would appreciate by $106 billion, again taking expected dilution into account.

In other words, Musk already had a $106 billion incentive to hit the top valuation target in his new pay package — even before being granted the new shares. Sure, he'd have to hold on to his current shares, but to see that $106 billion windfall he wouldn't even have to hit any of the operating targets set out in his new package. Maybe I'm naive, but I would think that $106 billion is more than enough of a reason to get him to drive Tesla to that valuation.

If it's not, then maybe Musk isn't the right guy to be running Tesla. I admire Musk and what he's trying to build with Tesla and SpaceX and all of his other projects. But I'm sure there are plenty of capable CEOs out there who would be more than willing to take on the challenge of leading Tesla to that kind of valuation for a lot less than $106 billion — much less the $161.8 billion, which is the total Musk stands to gain between his existing stake and his new pay package. For goodness sakes, it's a CEO's job to be driving longterm shareholder interest anyway — no matter how much the CEO is paid.

Musk's potential gain would come at the company's expense

In crafting this new pay package, Tesla board members said they actually did take into account Musk's current stake in the company. But they didn't explain why the expected appreciation of that stake alone wasn't enough to encourage him to achieve the goals they set out for him.

Investors have the most to lose from Musk's new pay package. If and as Tesla's stock appreciates, their share of the gains will get smaller and smaller.

But they'll lose out in other ways that are often not appreciated, especially since options and other stock awards are often treated as a trivial, non-cash expense that's more than accounted for by dilution.

Each share awarded to Musk represents an opportunity cost for the company. It's a share that the company itself could have sold to the public to raise money for its own treasury. That's not a small consideration for Tesla, given that it has has repeatedly had to raise money to fund its operations.

What's more, assuming Tesla is around long enough, it will almost certainly do what nearly every other company that hands out stock awards does — buy back those shares to soak up dilution and shore up its stock price. To do that, it will have to use actual cash that could have gone to other other, arguably better uses, whether that's paying other employees, expanding its operations, or paying out dividends.

One would have hoped that given such costs — and the ridiculous size of this award — Tesla investors would have put their collective foot down. But no. While investors representing 27% of the company's shares did vote against the pay package — a not insignificant amount — the vast majority of the rest backed it.

"We believe the final plan is well-aligned with shareholders' long-term interests," T. Rowe Price, a big mutual fund company told Bloomberg in an article Tesla's board sent to shareholders to encourage them to vote for the package.

Such support is not unexpected. The big mutual fund companies often rubber-stamp executive pay and other initiatives proposed by corporate boards. Most are happy to go-along to get-along, and many of those mutual funds are eager to stay on good terms with directors in hopes of winning their business elsewhere.

It's hard to have sympathy for such shareholders. They, after all, are the ones that approved Musk's pay package. They ought to reap both the benefits and consequences of that decision.

But others stand to lose from it too

Unfortunately, though, Tesla shareholders aren't the only ones who stand to lose from Musk's outrageous pay package.

Corporate boards and their advisors typically justify their executive pay decisions by looking at the pay given to executives at what they consider to be their peer companies. Because of what's been called the Lake Wobegone effect — where every company considers their executives to be above average — boards typically pay their managers above the average rate. With everyone looking at everyone else, executive pay gets ratcheted ever upward.

Thanks to that effect, you can expect corporate boards at other companies to look at Musk's pay package and figure they need to up the pay of their own executives to astronomical levels also. So, thanks to Tesla setting a new bar for executive pay, stakeholders at other companies are likely to lose out as well.

But the phenomenon of ever-increasing executive compensation does more than affect corporate investors and shareholders. It's also played a significant role in the growth in inequality in this country. Even as executive pay has soared over the last several decades, the pay of average workers has stagnated.

That's not just a coincidence. CEO pay has increased almost in inverse proportion to the decline in the power and membership of labor unions, one of the forces that had previously helped to keep it in check and tilt companies' economic spoils toward their employees.

Because so much of executives' pay these days comes in the form of shares of their companies, and share prices are tied in large part to companies' profits, executives see their pay rise as their companies' bottom line improves. And one sure way to better the bottom line is to hold down costs — most notably labor costs.

tesla factory Tesla is a case in point. Even as it was preparing its gargantuan pay package for Musk, the company was fighting off union efforts to organize its Bay Area factory workers, who reportedly get paid well below the industry average even while living in one of the most expensive regions in the United States.

Free market absolutists dismiss the danger of rising inequality, arguing that in a capitalist economy, you need to offer outsized gains to spur risk taking, innovation, and entrepreneurship. But the types of outsized gains Musk and other executives are seeing now are arguably way past what's needed to encourage such ends.

And on the flipside, rising inequality is antithetical to democracy. It's tied to a whole host of social ills. And it's linked to slow economic growth and financial and political instability. Indeed, the last time the United States saw this much inequality was right before the Great Depression.

But, hey, maybe I'm wrong. Maybe Elon Musk really does need the lure of another $55.8 billion on top of the $106 billion he'd already see to give him the motivation to drive Tesla to new heights.

After all, shouldn't a CEO who's shooting for the stars have a payday that's equally lofty?

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