I admire Elon Musk. I want Tesla (TSLA) to succeed. I’m inspired by the idea of solar roof tiles, wall-mounted batteries for the home, self-driving, high-performance cars, and many of his other ideas, including his vision and achievements via SpaceX.
But the models of risk we run have been telling a story about Tesla and suggesting that risk capital could be deployed more efficiently elsewhere.
From the article below, which was originally published on January 24, 2018:
“… [our] internal models placed the probability that Tesla stock would outperform the broad market over the next year in the bottom 1% of companies … as being in the 98th percentile of expected future volatility – worse than all but 2% of the companies analyzed. And, the probability that Tesla would experience an above-average draw-down in stock price over the next year was already more than 75%, ranking in the 97th percentile for large downside risk.”
Our Sustainable Value Grades® for Tesla as of Monday this week were as follows:
Quality: F-
Financial Governance: F-
ESG: C
Price Risk: F-
Value: F-
The pay package discussed in the original article below may be rendered to the status of a footnote, at least in the near-term as the markets make their risk-adjustments to Tesla’s value. As that adjustment occurs, though, the CEO compensation plan’s options are getting further out-of-the-money. Out-of-the-money options require even greater risk-taking/volatility for intrinsic value to ever be realized. So, perhaps the risk issues around CEO pay at Tesla have become even more important with the recent sell-off in its stock.
I hope that the Tesla board soon recognizes these risks and, even after all of their highly public work leading up to this pay package and its approval – some of which was good, will look at ways to address the concerns raised in the article.
“It’s heads you win, tails you don’t lose,” was a “tell” to any risk manager. Even though this article is from two months ago, it is still a timely read:
Original Article (January 24, 2018) [1]:
“It’s heads you win, tails you don’t lose,” said Tesla Compensation Committee Chair, Ira Ehrenpreis when asked about shareholders and the new incentive pay package announced for Tesla’s CEO, Elon Musk.[2] Except it’s not.
Ehrenpreis was quoted as saying this to Andrew Ross Sorkin of the New York Times, who went on to suggest, “if Mr. Musk does not perform, shareholders pay nothing.” It’s not clear in the article if Mr. Ehrenpreis made this last statement, or if it was Sorkin’s analysis. But, it is a definitively incorrect assessment.
I’ve just completed three months of work with an extremely talented group of directors and chief risk officers defining a set of Guiding Principles for Compensation Committees around the governance of risk related to pay and performance. [3] Our governance council published these guiding principles earlier this month [January 2018]. So, let me first begin with the most positive aspects of what I have read so far about Mr. Musk’s new pay plan.
- Should Musk receive incentive compensation, it will be “at risk” for five years. This is exactly aligned with our recommendations.
- The company is being highly transparent with owners about Musk’s pay. This is also aligned with our views.
- The company engaged large shareholders in a conversation about the incentive package before bringing it forward to all shareholders. We can hope that they also included other key parties interested in their success.
- The board is making a statement that this plan is “fit for purpose,” which is also consistent with our recommendations.
- The design seems clear and simple, decreasing the risk of miscommunication about the board’s goals.
Where Tesla’s Compensation Committee seems to believe they have aligned corporate performance with investor interests is a three-way tie-up between top-line revenue, bottom-line revenue, and stock price (market cap). On the surface, their interplay should make these non-gameable measures. But, gaming of company performance may not be the negative outcome about which the Tesla board should be worried.
What has happened in this pay structure is that Musk is being driven to become a more risk-sensitive forager. In the study of risky behaviors, animals that have insufficient food reward in their present place are forced to take higher risks to find enough food to survive. [4] If their risk-taking in pursuit of food fails, they die. Their forced search for food comes with significant potential peril and they only take this potentially perilous route out of necessity.
If Musk’s search for reward fails, it is not just his compensation that “dies.” If Musk fails to find sufficient reward, it is likely because he has taken risks that would not have been necessary except for the compensation conditions placed upon him. This should worry shareholders.
Musk’s new compensation plan is entirely stock options. Options increase in value when there is more volatility. Investors dislike volatility and more volatile stocks tend to under-perform more predictable ones. One of our governance council’s guiding principles states that the total compensation of the Chief Executive Officer should be driven by their impact on a balanced view of the enterprise, including how effectively the organization takes risk.
A study by professors Wm. Gerard Sanders and Donald C. Hambrick found that CEO stock options have inherent flaws that ought to spell an end to their significant use.
By their very nature, stock options in large numbers motivate CEOs to “swing for the fences”… Even more important, “option-loaded CEOs have a disproportionate tendency to generate more big losses than big gains; they strike out much more often than they hit home runs.”[5]
Because of this unintended (and often unknown or misunderstood) consequence, our guiding principles recommend against any significant use of option-based compensation. Again, Musk’s future compensation is described as 100% stock options.
I am a big fan of Elon Musk’s ability to create, communicate, and realize BHAGs (big, hairy, audacious goals). Watching the landing of a reusable rocket on a drone ship was more amazing to me that even the moon landing that occurred when I was a child. I’m inspired by the idea of solar roof tiles, wall-mounted batteries for the home, self-driving, high-performance cars and many of his other ideas. And, Musk does already own a significant amount of Tesla stock – comforting to other owners as he already has highly aligned interests with them.
But, Elon Musk seems stretched thin across Tesla, SpaceX, the Boring Company, and other interests. His corporate duties seem Herculean and he is now being incented to engage in risky foraging on behalf of Tesla shareholders. For their benefit, that risky foraging should be commanding his full attention.
Prior to this announcement, my company’s internal models placed the probability that Tesla stock would outperform the broad market over the next year in the bottom 1% of companies that we examine. Further, the models assessed Tesla stock as being in the 98th percentile of expected future volatility – worse than all but 2% of the companies analyzed. And, the probability that Tesla would experience an above-average draw-down in stock price over the next year was already more than 75%, ranking in the 97th percentile for large downside risk.
Again, this analysis was done before yesterday’s [January 23, 2018] announcement.
Tesla states that the new incentive package is modeled on the one from 2012, since when Tesla’s market capitalization has increased 17-fold. [6] Shareholders from that time did win. Still, since early 2014, Tesla stock has only performed in-line with the broad market and has been substantially more volatile. For so much potential and so much innovative genius, this company should have outperformed consistently over that time. Shareholders over the past four years have only done as well as if they had their money is a much-less-risky index fund. And, if returns are adjusted for risk, which they should be, shareholders have not been rewarded fairly.
The work of boards and Compensation Committees is difficult. It could be that the board of Tesla is looking for ways to stimulate further interest from Musk to continue his role as CEO. If so, this would suggest that the plan is in-line with a risk-loving persona and may further the worry about future stock price volatility. Most risk-lovers enjoy roller-coasters and most investors do not.
My company’s work is geared towards helping organizations do a better job of taking risk. Despite my portfolio position in Tesla stock to underperform the broad market, I want Tesla and Musk to succeed. I want his innovation to continue. I hope the Tesla board will consider our guiding principles and do as they suggest about the negative risks of option-based compensation: The Compensation Committee should ensure it has a thorough understanding of these concerns and it should employ efforts to mitigate them.
Shareholders in Tesla can indeed pay if this incented risk foraging fails. The new incentive plan may have increased that likelihood, which is exactly the opposite of what most shareholders should want.
Article By David R. Koenig, Founding Principal, The Governance Fund
[1] Koenig, David R., Tesla CEO Elan Musk’s Pay Package Brings More Risk Than Realized, LinkedIn Pulse, January 24, 2018, See https://www.linkedin.com/pulse/tesla-ceo-elon-musks-pay-package-brings-more-risk-than-koenig/ [2] Sorkin, Andrew Ross, Tesla’s Elon Musk May Have Boldest Pay Plan in Corporate History, New York Times DealBook, January 23, 2018, See https://www.nytimes.com/2018/01/23/business/dealbook/tesla-elon-musk-pay.html [3] DCRO Guiding Principles for Compensation Committees: Governing the Link Between, Pay, Performance, and Risk, The Directors and Chief Risk Officers Group, January 2018, See https://dcro.org/publications [4] See a discussion in Koenig, David R., Governance Reimagined: Organizational Design, Risk, and Value Creation, Chapter 12, p. 150, John Wiley & Sons, May 2012. [5] BYU study: Option-loaded CEOs strike out swinging for the fences and Wm. Gerard Sanders and Donald C. Hambrick, “Swinging for the Fences: The Effects of CEO Stock Options on Risk-Taking and Performance,” Academy of Management, 2007, See https://news.byu.edu/news/byu-study-option-loaded-ceos-strike-out-swinging-fences [6] Tesla Announces New Long-Term Performance Award for Elon Musk, January 23, 2018, See http://ir.tesla.com/releasedetail.cfm?ReleaseID=1054948
Disclosure: Our internal portfolios continue to hold risk-transfer positions in TSLA, where this stock is shorted, and the capital is transferred to a broad market index long position.
About the Author – David R. Koenig is the Founding Principal of The Governance Fund, was responsible for developing risk management programs at three different companies, had risk oversight for all of the public mutual funds for one of the world’s largest banks, is the author of Governance Reimagined: Organizational Design, Risk, and Value Creation (Wiley, 2012), was awarded an inaugural M-Prize for Management Innovation, and was chosen as the recipient of the PRMIA Higher Standard Award for contributions to the risk management profession. He also manages the Directors and Chief Risk Officers group, a global association of board members and c-level executives from more than 115 countries whose work focuses on the governance of risk. His full bio is available at https://thegovfund.com/about-us.
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