How to pay executives to align with shareholders interests
Constellation Software’s executive compensation program has received praise from many investors as a blueprint of how it should be done.
Last week, there was a debate about Purple Group directors talking up the company while selling millions in shares which could hurt retail investors.
AltVest Capital chairman Koshiek Karan said EasyEquities executives dumped R100 million in stock across the past 18 months while retail investors burned.
36ONE Asset Management founder and CEO Cy Jacobs also expressed concern about Purple Group CEO Charles Savage’s share sales.
He said, “It always concerned me listening to Charles Savage at the fourth Biznews Conference. So bullish but selling shares while on stage.”
Savage hit back, saying, “99.9% placed with institutions who wanted the shares and hold them today. Personally, I was a net buyer, as was the CFO.”
What sits behind the debate is a share option scheme where executives get options issued at the Purple Group share price at the time.
Executives can only exercise these options after a few years, which serves as a retention tool and align it with share price growth.
However, there is no obligation to these options. If an executive does not exercise his options, they expire after seven years.
Nolte said Charles Savage and Gary van Dyk sold shares over the last 18 months to enable them to exercise options, including paying for them and the tax and managing some debt.
It is a widely used executive compensation scheme but does not fully align with shareholder interests as there is no downside risk to executives.
Berkshire Hathaway chairman Warren Buffett is one of the biggest critics of executive share options because they can reward mediocrity.
In his 1985 chairman’s report, he said many share options have worked by gaining value simply because management has retained earnings and the workings of compound interest.
These executives, therefore, have greatly benefitted from share options despite not performing well with the capital at their disposal.
Another problem is dilution, where new options increase the number of shares, diluting the existing pool of shareholders and reducing shareholders’ value.
“I am disgusted by the situation in which shareholders have suffered billions in losses while the CEOs, promoters, and other higher-ups who fathered these disasters have walked away with extraordinary wealth,” he said.
Constellation Software shows the way
Constellation Software’s executive compensation program resolved this problem by developing a shareholder-friendly way to reward top management.
A hedge fund manager dubbed Sleepwell provided an overview of the Constellation Software executive remuneration strategy.
Its executive compensation program consists of a base salary and incentive compensation, paid as a cash bonus.
The company believes shareholder value is created by managing two financial components over the long term – profitability and growth.
As such, the performance metrics used to calculate incentive bonuses are return on invested capital (ROIC) and revenue growth.
ROIC is calculated by dividing net income by average invested equity capital and must exceed a risk-free rate, or else no bonus is paid out.
Incentive bonus calculation also includes an individual factor to account for the operating group’s responsibilities, skills, and size.
Executives must invest 75% of their after-tax bonus into Constellation Software shares and hold them for an average period of four years.
Board directors must also invest most of their compensation in shares in the open market and hold them for four years.
Merchant West Investments Value Fund manager, and RAC and Astoria director Piet Viljoen said this is how executive compensation should work.