Why Executives Cost So Much
Posted by Shannon Love on October 29th, 2008 (All posts by Shannon Love)
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.
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# Shannon Love Says:
October 29th, 2008 at 8:15 pm
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.
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