Opinion: Why Tesla is right to give Musk a R$304 billion compensation package

Elon Musk’s proposed compensation package at Tesla continues to generate headlines, and it’s no wonder: its estimated value of US$56 billion (about R$304 billion) is an impressive sum, even for the world’s best-known executive . How could this be justified? The answer is that most casual observers, and even many media reports, are not understanding the nature of the package. Based on our research as finance professors, our conclusion is that Musk was unlikely to earn anything close to this amount at the time of the grant, and if he did, it would be well deserved.

Before explaining why this is the case, it is useful to recall the context of the controversy. This includes a decision by a Delaware court in January of this year to reject the Tesla CEO’s proposed compensation package on the basis of inadequate process and conflicts of interest. The decision came even after 73% of shareholders approved the package in 2018. By almost the exact same margin, they voted to approve it again in June of this year — while Musk responded to the court ruling by announcing he would reincorporate Tesla in Texas.

To assess whether the package is fair — as most of Tesla’s presumably sophisticated investors have done — it is necessary to understand three aspects of any compensation package: the rewards realized by the CEO, the cost to the company, and the incentives for future performance.

First, it is important to note that the US$56 billion figure represents the reward realized by the CEO and not the cost to the company. The grant consisted of 12 Tesla stock options, each equivalent to 1% of shares outstanding at the time of the grant. Each of the options would be earned by the CEO only by reaching specific performance milestones. If these milestones were not achieved, no option would be gained by the CEO and the reward realized would also be zero.

This grant differs from typical vesting grants, which are automatically earned by the CEO as long as he or she remains in office. Performance-based vesting grants, like the Tesla grant, are given annually to CEOs and are not uncommon, but structuring them solely based on stock options is rare. Over the 2007-2023 period, only 4.2% of outstanding grants to S&P 1500 CEOs were performance vesting option grants.

Tesla’s CEO would only receive the full benefit of the 2018 compensation plan if he was able to increase Tesla’s market capitalization to $650 billion, approximately 13 times the market capitalization at the time of the grant, and increase revenue and EBITDA adjusted by 15 times and 22 times, respectively, relative to the corresponding 2017 numbers. If Tesla were to reach this $650 billion market capitalization target, it would also become 13 times the size of Ford and GM in 2018. From the point From a 2018 perspective, the likelihood that Tesla would perform so well that it would overcome all performance hurdles was seen as highly unlikely. In fact, an article at the time cited experts who said that increasing Tesla’s value to $650 billion was “ridiculously impossible.”

Nobody expected Tesla to achieve this. Data supports this: only 1.2% of observations in the sample of US firms from 1950-2017 had achieved this growth rate.

But Tesla performed surprisingly well. Tesla achieved all of these milestones in six years, four years before the end of the performance period. The increase in Tesla shareholder value over the same period was $523 billion. In sharp contrast, GM and Ford shares today are valued at $53 billion and $43 billion, respectively, slightly below 2018 levels.

As a result of this performance, the Tesla CEO gained options on 303,960,630 shares. If the CEO paid the $7.09 billion required to exercise the options, he would own the shares in full. The closing share price was $182.47 on June 13, 2024 (the date shareholders voted again on the compensation package). Multiplying these two figures gives $55.46 billion, which looks a lot like the $56 billion reported in the press. Coincidentally, this $56 billion is also the reward estimated by Tesla’s board in its 2018 proxy statement at the time of the options grant.

The second thing to evaluate when considering the compensation package is the cost to the company. According to Tesla’s 2019 proxy under clearly defined accounting standards, the fair value of the grant was $2.3 billion. While this is not a small amount, note that the CEO has not received any other pay since 2018. A good approximation of the “annual pay” for Tesla would be $230 million, which is 1/10th the amount because the CEO’s compensation package CEO was planned for 10 years.

It is also worth noting that the CEO is required to hold shares for 5 years after exercise, a requirement to ensure that their interests remain aligned with those of shareholders. Given this constraint, financial evaluators would discount the value of the grant by about 30% — so the grant, on an annual basis, would be worth $158 million per year instead of $230 million.

Another way to think of the grant is that Tesla gave its CEO a lottery ticket valued at $2.3 billion (the fair value under accounting rules) with a potential payout of $56 billion — but winning the lottery depended on of the CEO’s ability to transform a start-up car company into a global giant. One estimate of the probability that the Tesla CEO could win the $56 billion reward was 1.2% (as mentioned previously). This low probability helps explain why the cost to the company was estimated at $2.3 billion.

The third aspect of the compensation package to pay attention to is the built-in incentives designed to motivate future performance. That is, the contract was structured so that for every $1 increase in shareholder wealth, the CEO’s wealth increased by approximately $0.12. This “delta” (a measure of how aligned the CEO’s wealth is with the company’s value) of 0.12 is high, but not absurdly high.

The 90th percentile “delta” for CEOs of large US corporations between 1996-2009 was 0.07, and this has only increased in recent years. In the case of Tesla, high delta appears to have done what it set out to do — achieve “jaw-dropping” performance. We interpret the positive shareholder vote as an indication that they are satisfied with this gain split. And after the vote, investors remained positive, with Tesla’s market capitalization peaking at $836 billion on July 9, 2024.

In conclusion, our analysis of Tesla’s CEO compensation package highlights the need for a more detailed understanding of executive compensation. Executive compensation is inherently complex, and a thorough analysis of its multiple aspects, rather than fixating on a single figure, is essential to assess whether the contract is effectively aligned with the interests of shareholders. In the end, consider a simple question: Would you share 1% of the earnings every time a company’s CEO doubled his money? Tesla shareholders decided yes.