“Managers have incentive to cause their firms to grow beyond the optimal size,” argued Jensen in 1986. Lucian Bebchuk and Yanic Grinstein use data on CEO compensation to show that compensation practices give CEOs incentive to expand firm size. Expansion of firm size is positively correlated with higher CEO compensation, even if the expansion does not add value to the firm. Interestingly, a decrease in firm size does not equate with a decrease in CEO compensation.
The CEO can has influence over company decisions. In an attempt to align CEO goals with that of the shareholders, most companies award the CEO with stock incentives. However, because firm expansion is so frequently coupled with higher CEO compensation, stock holdings can at best only mitigate the expansion push.
Bebchuk and Grinstein use Execucomp, a database for CEO compensation information from all the companies in the S&P 500, Mid-Cap 400 and Small-Cap 600 (80% of total public market capitalization). Focusing specifically on the 1997-2002 period, the authors begin by confirming the positive correlation between firm size (combination of market capitalization and sales numbers).
In analyzing how much compensation increase is related to actions the CEO can make, the variables are changed to measurements the CEO can influence, such as past increases in market capitalization and sales. As it turns out, there is a positive correlation between compensation and past increases in market cap and sales. Because these results would only be showing the relationship between pay and past stock returns (stock prices increase market cap and can spur sales), the authors think the results don’t provide concrete enough evidence for a firm size and pay correlation.
The authors attempt to disentangle the pay-past stock return relationship by looking at the connection between pay, growth in shares outstanding and changes in sales per share. An interesting correlation is between current compensation and growth in shares outstanding. Because increasing the number of shares is not necessarily increasing firm value, this correlation is the first negative consequence firm growth for increasing compensation. In addition, the positive correlation between higher compensation and changes in per share sales shows a similar conclusion. Like how increasing the share number won’t always increase firm value, increasing sales per sales does not mean stock return will increase.
Now that Bebchuk and Grinstein have shown the compensation increases are positively correlated with activities that don’t always increase firm value, the authors look to make their findings robust by using two and four years for stock returns and using book value of assets for firm value instead of market cap and sales. Same conclusion.
However, when Bebchuk and Grinstein divided the positive increases in firm size from the negative, they found an asymmetry. While firm size increase means a compensation increase, a firm size decrease does not mean a compensation decrease.
Looking further at what might motivate CEOs, Bebchuk and Grinstein separate stock returns into capital gains, which contribute to firm size, and dividends, which do not affect firm size. As suspected, CEO compensation was positively correlated with capital gains, but not with dividends. It seems as though the fear that CEOs don’t have enough incentive to pay dividends might be true.
This paper was straightforward and used easy-to-understand data. Because I had heard a similar theory before, I was not shocked by the outcome of this study. However, CEO compensation often comes under attack for the wrong reasons. While many CEOs do work to increase the size of their firm, growth is an expected part of a CEO’s job. I have heard people say about firms, “If you aren’t growing, you are dying.” This type of pressure pushes CEOs to continue to expand the firm. Yet, expansion is not what this paper really is against. It is against poor CEOs who are self-interested and expand with no strategy. The distinction should be made, because many CEOs who increase the size of their firm create billions in revenue, and that value added is priceless to the board and shareholders. Bad CEOs are the problem, as they have only themselves in mind. The only consolation is that a bad CEO is usually fired.