By: Michael Khouw
June 5th, Stephen Wilmot, Editor and Columnist at The Wall Street Journal, wrote “The Case Against Elon Musk’s $46 Billion Pay Deal”. Here’s what the Delaware court, Stephen Wilmot, and others opposing his pay deal are getting wrong and why shareholders should vote for Elon Musk’s pay deal at Tesla’s coming annual general meeting.
How we got here.
In January 2018, Tesla shareholders approved an extraordinary compensation plan for CEO Elon Musk, which Musk proposed. Rather than receiving any cash compensation, Musk would receive twelve options tranches. Each tranche would give Musk the right to purchase 1% of the company at the prevailing market price when the compensation plan was approved. Each of the twelve tranches would only vest if Musk achieved two milestones concurrently. “Each tranche would vest in the event Tesla’s market capitalization grew by at least $50 billion and Tesla met either an adjusted EBITDA or revenue target in four consecutive fiscal quarters.” Six years later, after Elon Musk guided Tesla to all of the milestones outlined in the compensation package, in January of 2024, the Delaware Court of Chancery rescinded the pay package.
What the Delaware Court of Chancery decision got wrong.
The employee retention and compensation straw man.
According to an American Bar Association summary of the Court’s decision, “The Court reasoned…(by) virtue of his 21.9% ownership. Musk already had “every incentive to push Tesla to levels of transformative growth.” The logic in this argument was that because he owned a chunk of the company, he had an incentive for it to grow and might be reluctant to leave its management in someone else’s hands.
Of course, every shareholder of every company has an incentive for transformative growth. Every shareholder wants the best person for the job at the helm. The CEO should share the shareholders' goals and objectives, but common goals and objectives are not compensation.
Example: To understand that, imagine a partnership with 100 partners, one general partner who created and operated the business and owned 20%, and 99 limited (passive, non-working) partners who owned the remaining 80%. After several years of exceptional management, the general partner’s compensation is up for review, and a plan is presented to the limited partners for a vote.
Using the Court’s reasoning that 20% ownership is incentive enough, the limited partners could respond to any compensation offer, however large or small, by saying. “No, by your large stake in the business, it seems you’ve got a lot more to gain or lose than we do so we won’t pay you anything for your work.”
Following this flawed and parasitic logic creates a disincentive for company management to invest in the businesses they work for, as non-working shareholders would reduce the compensation for the work performed by shareholders who did. Taken to the extreme, the shareholders of publicly traded companies could vote not to pay executives at all and simply leave company management to the largest shareholders, figuring that they, because they had the most to gain or lose, would be compelled to do the work paid or unpaid “or else,” because they had the most to lose.
“The Court rejected Musk’s arguments that rescission would leave him uncompensated because ‘Musk’s preexisting equity stake provided him tens of billions of dollars for his efforts.’” This is an astonishing conclusion for the Court, but it is precisely the logical fallacy I outline above. Their conclusion ignores 1) that all remaining shareholders were provided hundreds of billions and 2) those were provided by Elon Musk’s efforts and none of their own. There are other flaws in the Court’s decision, but this, by far, is the worst.
The “independent” directors argument.
The plan was approved by “a majority of disinterested stockholders (i.e., excluding Musk and his affiliates).” However, the Court reasoned that the company’s outside directors, who recommended the plan, were not “independent” partly because they had “long-standing, lucrative relationships with Musk.”
This argument is interesting because it implies a conflict of interest between the directors and Elon Musk. There was no evidence or even suggestion of a potential ex-ante or ex post facto quid pro quo, meaning it was never suggested that they had a prior agreement that he would be rewarded for the financial benefits they had previously received via their prior business relations, or a promise of future benefits if they recommended the compensation to shareholders. Therefore, the entire basis of the argument is that the directors were not independent because they viewed him favorably based on their past business relationships with Elon Musk.
The reasoning is bizarre because it suggests that the independent directors of Tesla, who oversaw company management on behalf of shareholders, would have been better at judging the value he brought to the company, his capabilities, and how he should be compensated if they had not had prior experience with him.
To understand how ludicrous this argument is, let’s consider the groundbreaking endorsement deal that Michael Jordan signed with Nike when he turned pro in 1984. Nike has its entire endorsement budget on a single athlete, paying him $500,000 per year for five years, a record-setting amount for a rookie and an enormous amount for any NBA at the time. The deal also set four lofty milestones. He had to be named to an All-Star or All-NBA team. He had to win Rookie of the Year; average 20+ points per game or sell over $4 million worth of Nike Air Jordans. He was crowned Rookie of the Year. He was named to the All-Star and All-NBA teams, averaged 28+ points per game, and sold $162 million of sneakers. Where his deal most closely parallels Musk’s deal, though, was the incentives. Michael Jordan’s Nike deal had a revenue share. Although he played for 9 years, making a total of $90 in salary, he has been paid an estimated $2.4 billion in endorsements, most of that money came from his extraordinary deal with Nike.
The company, led by founder Phil Knight and marketing executive Sonny Vaccaro, agreed to the deal with Jordan because they recognized he was unique. If they had treated him like any other player and not entered into a novel compensation arrangement, he might have gone with Adidas, which had more money at the time.
The revenue-sharing arrangement was unprecedented, and the earnings Michael Jordan made were orders of magnitude greater than that received by prior generations of NBA players. Still, Nike and Nike shareholders were also winners. As big as MJ’s compensation was, most value creation went to Nike shareholders. So 1) business collaboration can be win-win, and 2) the negotiators need to truly understand the unique value proposition that might come from working with the person across the table. Some players, some executives…some people are unique.
“absence of any evidence of adversarial negotiations.”
Negotiation between parties with adverse interests involves value provided for value received. When negotiating with a dealership over the price of a new car, for example, the lower the negotiated price, all else equal, the bigger the savings for the buyer and the lower the profit for the dealer. This type of negotiation is zero-sum. One party’s gain is the other party’s loss, and where cash salary compensation is concerned for an executive’s salary, this would be true. However, non-cash, incentive-based compensation is not necessarily zero-sum. This is not simply because it can align incentives, such as increasing the share price or improving financial operating results, but because the package can increase the enterprise value. Consider that 2018 the 20th highest-paid executive was Steve Wynn, who was paid $34.5 million at a company with $6.3 billion in revenues. Elon’s stewardship of Tesla was more remarkable, and the company’s revenues nearly doubled Wynn's. However, if he had simply been awarded cash compensation equivalent to Steve Wynn’s, that would represent more than 20% of the company’s trailing 12-month EBITDA.
Investors value free cash flow, they value superstar CEOs, and they value incentive-based compensation. Who would claim that the value of Tesla would not have fallen had Elon stepped down in January of 2018? The company was trading at nearly 4.5x price to sales at year-end 2017, where no other automaker came close. Ford was trading ~.32x, GM was trading ~.39x, Toyota was .65x, BMW was .58x, and Mercedes was .46x. The much, much higher multiple assigned to Tesla was because investors believed its growth potential was much higher. The growth came with Elon Musk at the company's helm since its IPO.
“The Court also questioned whether the plan’s milestones were ambitious, because Tesla’s roughly contemporaneous projections supported that Tesla would probably meet most of the milestones if it successfully executed on its business plan.”
The flaws in this logic are breathtakingly ignorant and reductive. As Mike Tyson famously said before his fight with Evander Holyfield, “Everyone has a plan till they get punched in the mouth.” By the Court’s reasoning, then, a business plan, once in place, essentially puts a business on “autopilot”? This assumes two things, both false. 1) It assumes that the business plan is a kind of “steps to follow”; success will automatically follow if these steps are followed. No “how to” textbook existed that would ensure success for whoever was around to read it, and 2) it assumes that successful execution does not depend on the person executing the plan.
It was, after all, Elon Musk himself who had put those plans in place. Were they so good that the company’s success over the decade to come was a foregone conclusion? This must be quite a revelation to business leaders who deal daily with sharp, sharp-elbowed competition, changing customer tastes and regulations. In this case, though, we’re dealing with complex manufacturing and distribution of complex products. If planning to build 1 million self-driving electric cars is hard, it’s a wonder that everyone isn’t doing it. Running a competitive business without losing ground is an everyday fight.
The world’s best professional golfers go into every shot at every tournament with a plan, seeking to avoid shots that could penalize them severely, bogeys or worse, while setting themselves up to gain strokes on the field with birdies and eagles when possible, and otherwise make par. Indeed, that was the plan for every one of the world’s best players when they entered the field at the US Open at Pebble Beach in 2000, yet by the end of the tournament, a single player, Tiger Woods, was under par. These were the World’s best players, playing the same course with similar plans. The next best player finished 15 strokes back. A good plan is essential, but it’s the easy part.
We must return to the original pay package to understand how we got here and the value of Elon Musk’s pay package contemporaneously. The following is an excerpt from the board letter to shareholders filed with the SEC in January 2018.
“Elon will receive no guaranteed compensation of any kind — no salary, no cash bonuses, and no equity that vests by the passage of time. Instead, Elon’s only compensation will be a 100% at-risk performance award, which ensures that he will be compensated only if Tesla and all of our stockholders do extraordinarily well. The award consists of stock options that vest only if Tesla achieves specific milestones, which, if fully achieved, would make Tesla one of the most valuable companies in the world with a market capitalization of at least $650 billion — more than 10x today’s value.
In crafting this award, we were mindful of Elon’s existing stock ownership levels and the strong belief that the best outcome for our stockholders is for Elon to continue leading the company over the long-term. We created the award after more than six months of careful analysis with a leading independent compensation consultant as well as discussions with Elon, who, along with Kimbal, otherwise recused themselves from the Board process.”
I have emphasized the portion that highlights the entirety of Elon Musk’s compensation would be in the form of stock options. It is critical to understand the value of those options at the time the compensation was originally granted, not now with the benefit of hindsight (we’re going to come back to this). To understand the value of the grant, we need to understand a bit about options, and options pricing.
First, a quick primer on the distinction between the standard, or “plain vanilla” exchange-listed options with which many readers are familiar and bespoke complex options, also known as “Exotic Options.” Standard or “vanilla options” are the basic calls and puts trade daily on exchanges worldwide. The terms of these options, such as their strike prices and expiration dates, are standardized, and the counterparty for these contracts are clearing houses of which clearing firms - banks, brokerages, and trading firms are members. These options do not incorporate unique payoffs or contingencies unrelated to the price or tradability of the underlying security or future.
Exotic options, by contrast, are agreements between two counterparties and can be customized in almost any way. The options compensation that Elon was awarded by the shareholders in 2018 had several unusual features. All of these features were for the benefit of shareholders and reduced the value of the options in the compensation plan. Let's examine each of these.
Exercise Price:
A call option gives the holder the right but not the obligation to purchase the underlying stock at the “Exercise Price” or “strike price.” The exercise price of the pay package options was $350.02 per share, the closing price on January 19th, 2018, the last trading day before the grant date. In other words, if Elon Musk hit a series of milestones in the future, upon each of those, he would receive the right to purchase 1% of the company at a $350 share price. Assuming he exercised the options, he would have to pay Tesla $650 million for each 1% of the company he purchased.
Vesting Schedule:
Vesting is a legal term for when someone acquires legal ownership of an asset, in this case, options. The vesting schedule for the options in the granted pay package included 12 market capitalization and 16 operational milestones, which were astonishingly ambitious. From the “Award Terms” (Appendix A) in the corporate filing, we’ll first focus on the market capitalization milestones.
Vesting Part 1
Market Capitalization Milestones
a. 12 Market Capitalization Milestones
b. First tranche milestone is a market capitalization of $100 billion; each tranche after that requires an additional $50 billion in market capitalization to vest, up to $650 billion market capitalization for the last tranche
c. Sustained market capitalization is required for each Market Capitalization Milestone to be met, other than in a change in control situation. Specifically, there are two prongs that must be met to achieve a given Market Capitalization Milestone:
• Six calendar month trailing average (based on trading days); and
• 30 calendar day trailing average (based on trading days).
The fact that these options would only be awarded if the stock rose by pre-determined levels means they are an exotic option known as a “knock-in.” “Knock-in options are a type of barrier option that only comes into existence once the price of the shares hits an upside price “barrier” during the option's life. The higher the barrier, the less likely the option will “knock-in” and therefore the lower the value of the option. The milestones started at an increase in the company’s value of 53.85% and the top milestone would be achieved if the stock price increased by 900%.
The table above suggests that his pay plan's value is almost $3.26Bn over ten years. But is it? No, because the pay plan included 16 other operational milestones.
Vesting Part 2: What were the odds of hitting the operational milestones?
It’s one thing for a stock to rise 50% or more; as JP Morgan famously said of the stock market, “it will fluctuate.” As the table above illustrates, Elon’s pay package also required huge operational gains. To understand just how big it is, consider that the company reported $11,758.8B in revenues and $167.4M in EBITDA for FY2017, which ended December 31, 2017. The first milestone would require a 70% increase in revenues and 896% growth in EBITDA. The highest operational milestone targeted a nearly 15-fold increase in revenues and a roughly 84-fold increase in EBITDA.
To better understand the value of the options, we need to understand the likelihood of achieving results in those milestones. Here, we’re faced with a bit of a data analysis dilemma. We’re curious how extraordinary those results might have appeared at the time (media reports marveled at the goals). Still, the problem with that type of analysis is that business climate varies. A strong economic period might lift many boats, while a depressed one might disguise good performance. So for this exercise, I’m reviewing all large and mega-cap companies in the Russell as of January 2018, looking at the performance through the 2023 year-end, the data then available to the Delaware Chancery Court that struck down the pay package the shareholders had earlier voted for. What we find is that those milestones were indeed a very, very high bar. Of the 1,000 companies in the index, only 19, just under 2% of the Index, managed to grow their market capitalization 9-fold+. Of those that did, several were small-cap companies. It’s easier for small companies to grow quickly than large ones, but even including those, only 17 managed to increase their revenues by ~15x or more, and of those 15, only two managed to grow EBITDA by 84-fold or more. Advanced Micro Devices was one. Tesla was the other.
I made a rough approximation of the probability of a Russell 1000 company hitting each of these milestones based on operating improvements for the index constituents between the original grant and the Chancery court ruling in January this year, normalized to percentage terms, which is admittedly imperfect, and came up with the following.
Based on these numbers, the chances of hitting the first four operational milestones, just picking companies randomly from the index, were better than I expected. Too good - so good I have to double-check the data, and if needed, we’ll post an edited version, but it suggests that the probability that the first four tranches would vest was decently high. However, if we just rank the probabilities from best to worst in order, we find that the chance of hitting the 10th tranche was at best 7.14% and the chance of hitting the 12th tranche was at best 2.18%
If we compare the probabilities of the option actually vesting versus its value, we get the following values for January 2018.
Over ten years, a $1.3 billion pay package would make Elon Musk one of the highest-paid executives ever. Still, it’s worth noting that 22% of that would be compensation he’s effectively paying to himself because that’s how much of the company he already owned, so the remainder of the shareholders would be, in effect, giving him a 10-year $1 billion deal to manage their portion of the company. To understand this, consider that Elon, were he not an insider and thus ineligible from doing something like that, could have structured exotic derivatives to place a similar bet, but interestingly, purchasing it from the company was better for shareholders for two reasons anyway. 1) it was a non-cash expense for ten years, and 2) they issued the options and, therefore, they would receive $6.5 billion in equity investment from Elon in the event he exercised his options.
How does that stack up against other pay packages for comparably sized companies? Well, this is pretty challenging because the way that compensation is reported by companies and the nature of that compensation, as well as the way that those reporting on it interpret the data, differs, but in 2023, CEO World offered the following:
So while high, Elon’s compensation using its value at the time it was granted would not even be 3rd highest. One could argue that Tim Cook oversaw more shareholder value increase, as Apple increased in value by more than $2 trillion; however, Elon Musk oversaw more shareholder value creation than Hock Tan, Nikesh Arora, or Stephen Schwarzman. Moreover, the path to Apple’s success had already been in motion for some time, and Elon’s operational challenges were far more daunting.
The Moral Dilemma
Stephen Wilmot, who penned “The Case Against Elon Musk’s $46 Billion Pay Deal,” says, “Not every shareholder was around in 2018. Since Tesla, responding to a legal challenge against the original deal, has asked investors to vote on it again with the benefit of hindsight, it would be insane not to use that hindsight.”
The company agreed to a non-cash compensation expense, valued in 2018 at $1 billion. Bad decisions, by courts and otherwise happen all the time. The Delaware Chancery court decision was a wrong decision, likely made by people with no understanding of how this was valued at the time. Had the company issued a bond, and some aggrieved individuals identified a potential loophole and sued the company for not paying it, the shareholders could have done the right thing and satisfied their obligation. If the options were vested pro-rata to all employees, would we have this conversation? I would offer an example to prove that envy may hold more sway in this conversation than fairness.
Imagine you purchase a rental property for $1mm that generated $223,700 in revenues and about $3,200/year in income, excluding interest, depreciation, and amortization (taxes in the case of EBITDA refer to corporate income taxes, which wouldn’t apply in my analogy). A property manager comes to you with the following proposition.
I will manage the property for no salary. Still, if I can increase its value by 10x without your capital investment, increase the property’s revenues by 15x, and increase its net income by 35x, I will pay you $120,000 for 12% of the property. If I only increase the value by 50%, I get nothing.
This is a good deal. A hedge fund manager would have asked for 2% and 20% of the upside; they only bought it for you. A private equity manager would give an even worse deal.
It was the deal of the century for shareholders, and they got one of the best-performing CEOs of all time, but when it came time to pay him, they reneged. Elon Musk wove gold but wasn’t Rumplestiltskin. He just wanted to keep 12% of whatever he made. The Delaware Chancery Court and the parasites that brought the case prevented it, but shareholders can nullify that injustice if they want to. They agreed to it before, and they should again.
Get Expert Assistance with Delta Group Advisors
Looking for transactional consulting? With extensive experience in the financial industry, Delta Group Advisors offers cutting-edge technologies with significant understanding of transactional history. Contact Michael Khouw below for more information:
Phone: (775) 306-7715
Social Media: https://www.linkedin.com/company/delta-group-advisors/
Comments