CONFLICTS BETWEEN MANAGERS AND STOCKHOLDERS7

It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization. In particular, managers might be more interested in maximizing their own wealth rather than their stockholders’ wealth, hence pay themselves excessive salaries. For example, Disney paid its former president, Michael Ovitz, $140 million as a severance package after just 14 months on the job—$140 million to go away—because he and Disney CEO Michael Eisner were having disagreements. Eisner himself was also handsomely compensated the year Ovitz was fired—a $750,000 base salary, plus a $9.9 million bonus, plus a $565 million profit from stock options, for a total of just over $575 million. As another example of corporate excesses, Tyco CEO Dennis Kozlowski spent more than $2 million of the company’s money on a birthday party for his wife.

Neither the Disney executives’ pay nor Kozlowski’s expenditures seem consistent with shareholder wealth maximization. Still, good executive compensation plans can motivate managers to act in their stockholders’ best interests. Useful motivational tools include (1) reasonable compensation packages; (2) direct intervention by shareholders, including firing managers who don’t perform well; and (3) the threat of a takeover.

The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation should be structured so that managers are rewarded on the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, because intrinsic value is not observable, compensation must be based on the stock’s market price—but the price used should be an average over time rather than on a spot date.

Stockholders can intervene directly with managers. Years ago most stock was owned by individuals, but today the majority is owned by institutional investors such as insurance companies, pension funds, and mutual funds. These institutional money managers have the clout to exercise considerable influence over firms’ operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, institutional investors such as Calpers (California Public Employees Retirement System, with $165 billion of assets) and TIAA–CREF (a retirement plan originally set up for professors at private colleges that now has more than $300 billion of assets) act as lobbyists for the body of stockholders. When such large stockholders speak, companies listen. Second, any shareholder who has owned $2,000 of a company’s stock for one year can sponsor a proposal that must be voted on at the annual stockholders’ meeting, even if management opposes the proposal. Although shareholder- sponsored proposals are nonbinding, the results of such votes are clearly heard by top management.

Stockholder intervention can range from making suggestions for improving sales to threatening to fire the management team. Until recently, the probability of a large firm’s management being ousted by its stockholders was so remote that it posed little threat. Most firms’ shares were so widely distributed, and management had so much control over the voting mechanism, that it was virtu- ally impossible for dissident stockholders to get the votes needed to overthrow a management team. However, that situation has changed. In recent years the top executives of AT&T, Coca-Cola, Fannie Mae, General Motors, IBM, and Xerox, to name a few, have been forced out. Also, Tyco’s Kozlowski is gone and Disney’s Eisner is under pressure and will soon be leaving. All of these departures were due to their firm’s poor performance.

If a firm’s stock is undervalued, then corporate raiders will see it to be a bar- gain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target’s executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock’s price. In the words of one executive, “If you want to keep your job, never let your stock sell at a bargain price.”

Again, note that the price managers should be trying to maximize is not the price on a specific day. Rather, it is the average price over the long run, which will be maximized if management focuses on the stock’s intrinsic value. How- ever, managers must communicate effectively with stockholders (without divulging information that would aid their competitors) in order to keep the actual price close to the intrinsic value. It’s bad for both stockholders and managers for the intrinsic value to be high but the actual price low, because then a raider may swoop in, buy the company at a bargain price, and fire the managers. To repeat our earlier message: Managers should try to maximize their stock’s intrinsic value and  then communicate effectively with stockholders. That will cause the intrinsic value to be high and the actual stock price to remain close to the intrinsic value over time.

Because the intrinsic value cannot be observed, it is impossible to know if it is really being maximized. Still, as we will discuss in Chapter 9, there are procedures for estimating a stock’s value. Managers can then use these valuation models to analyze alternative courses of action in terms of how they are likely to affect the estimated value. This type of value-based management is not as precise as we would like, but it is the best way to run a business.

  • What are three techniques stockholders can use to motivate managers to try to maximize their stock’s long-run price?
  • Should managers focus directly on the actual stock price, on the stock’s intrinsic value, or are both important? Explain.