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Stanford Report, July 16, 1997

Making money and jobs with technology, part II: 7/16/97

Successful entrepreneurs talk about
how it's done

(Continuation of article)

Executive pay, 'free agency'

Nearly every speaker at the conference spoke of difficulties finding and keeping good chief executives. A market similar to free agency in baseball may have developed for the best corporate executives, Shoven suggested. While research has yet to establish that there is greater mobility for top executives, he said that the possibility raises such questions as how much compensation a company needs to pay to keep its leadership and if there are better ways to design incentives.

Research has been hampered by the limited public access to data but Richard Lambert, an accounting professor in Stanford's Graduate School of Business, explained why more companies are using stock options to compensate executives and often even lower-ranked employees.

Stock-option­based compensation packages, which were first common in technology startup companies, are considered to be a good way of aligning management and stockholder objectives, he said. Performance is evaluated not on an individual basis but for the firm as a whole by outsiders who decide what price they are willing to pay for the firm's stock.

Such contracts also save cash because the employees are financing the company, and some owners believe the contracts are effective screening devices ­ attracting those workers who are the most willing to take risks and work hard or who have greater faith in their abilities. Stock options can also offer tax advantages over salary payments depending upon the structure of corporate and individual tax rates, he said, and some people even think they have value in that the cost of them is buried deeper in legally required financial reports.

The contracts are extremely hard to value, however. Lambert said that the formulas used for valuing publicly traded options greatly overvalue options that are tied to employment. This is because individuals view risk differently than businesses, and employees don't have the hedging and diversification abilities of option traders. As time goes on, Lambert said, the downside risk of keeping the option is greater than the potential upside gain to the employee. As a result, employees tend to exercise their stock options as early as possible, with some studies showing 40 percent being executed in the first half of their life.

To keep incentives high over the course of the employment, Lambert suggested companies should stagger stock options, making initial options modest with promises of additional grants in future years.

Chief executive officers need strong owner support if they are to succeed, said George McCown, who has been involved in more than 30 leveraged buyouts of divisions of public companies. Even though his firm, McCown DeLeeuw & Co., has required its chief executive officers to invest some of their own money, he said, "we've had to change 40 percent of them. . . . We decided we have to do a better job of managing ourselves if we are going to help these guys." His company has hired a French firm to help come up with ways to align the needs of stakeholders, including customers. Not everybody is interested only in working for the highest bidder, he contended, and the firm's success has been greater when key people feel they have a "noble goal."

Corporate boards

Weak boards of directors are part of the management problem of many companies. Stanford law Professor Joseph Grundfest, former commissioner of the Securities and Exchange Commission who teaches courses at Stanford Law School for members of boards of directors, said that stockholders and managers of companies should ask themselves what would happen if their board of directors was abducted by aliens. Specific questions to ask, he said, are: "Would you notice? How much would you pay to get your board back? Would you pay in cash or stock? Would your stock price change at all?"

Many companies assume they need boards of directors but can't list any real functions they perform, Grundfest said. Boards of directors began as a way for individual owners to get advice from their friends and associates but have evolved in many Fortune 500 companies into do-nothings.

In Silicon Valley, where venture capitalists do not just give money but take an active role in managing startups before they go public and often afterward as well, "everybody knows why they are on the board," Grundfest said. "The CEO's job is on the line every day. In corporate America, CEOs easily have three years of grace."

Companies should list what roles they expect boards to perform and evaluate members annually on that basis, Grundfest said. In some, board members perform "housekeeping" chores such as monitoring compliance programs relevant to the industry or functioning as ombudspersons who handle complaints such as sexual harassment against officers. In some they are "mudflaps," helping restore public confidence in case a crisis occurs; in others they are experienced coaches to chief executives. Their most important function, he said, usually should be maintaining continuity in the handoff from one CEO to the next.

The education problem

Stanford Business School economist Paul Romer, the author of "new growth theory," which stresses the importance of new technology to the world's economic well-being, challenged the theme of Cain's book ­ everybody wins.

There is "no question" that everyone in the United States benefited over the last 120 years from technological innovations, which raised the standard of living of the country as a whole, Romer said, but "a rising tide" of wealth from innovation doesn't automatically "lift all boats." The nation's growing income gap between the rich and the poor may be a negative side effect of labor-saving technical innovation, he said, which reduces the demand for the lowest-skilled workers. Innovation has not increased the income gap in the past, he said, because the country gradually increased the educational level of most workers, thus reducing the supply of the low-skilled to better fit the lower demand.

Unless America finds a way to deliver a better K-12 education and some postsecondary education to most future workers, Romer said he feared "the country will lose its nerve," gradually adopting policies that will discourage economic growth. "I don't think anybody is going to set out intentionally to kill off technological change at the policy level, but there is a good chance it will just bleed to death from a thousand small cuts."

Cain agreed. "As a grandfather," he said, "I am much more interested in leaving a better world for my grandchildren than in making money. . . . They can do better if they have a high-growth economy." But that requires "getting Social Security under control and fixing our poor educational system that is responsible for the bad distribution of wealth in this country." SR