What Michael Jordan and Ted Sarandos Teach us About Executive Compensation

My wife and I watched the new movie "Air" on Amazon Prime Video (highly recommended) which tells the story of how Nike landed Michael Jordan as a client and beat out Adidas and Converse.  The final clause that Michael's mother, Deloris, demanded of Nike was that Michael receive a royalty on all Jordan-branded products in Nike's portfolio.  This deal ultimately created a massive win-win for both Nike and Michael Jordan, and it catapulted MJ into the owner's box of the sport he dominated - an outcome that should be celebrated.  He added much more value to the NBA and to Nike than he extracted - well beyond his playing years - and he got to participate in that significant value creation.  It's capitalism at its best.  I highly recommend the movie, and it motivated me to write this post on incentives.  Let's evolve this to public company executive compensation. 

I was going through the Netflix proxy statement and noticed that Ted Sarandos at Netflix earned $20m/year of cash salary compensation, plus another $30m of equity compensation.  It's since been reduced by the board to $3m in 2023, but I'd never seen such a high cash salary before.  His salary increased from $1m in 2017 to $12m in 2018, $18m in 2019, and $20m for 2020, 2021, and 2022.  That's $90m of cash, no-risk salary over a 5-year period. 

My jaw was on the floor when I saw Ted's compensation package.  $20m of no-risk cash salary is unbelievable.  I looked around at other big companies to find someone that could come close.  Nobody does - especially in guaranteed salary.  Here are some noteworthy non-founder CEOs and how they compare:

• Ted Sarandos, Netflix - $20m salary, $28.5m in option award.  $50.3m total compensation

• Greg Peters, Netflix's COO and newly minted co-CEO had a $16m salary.  Looks like Netflix likes breaking salary records at all levels. 

• Tim Cook, Apple - $3m salary, $12m cash bonus, $93m stock award.  $99.4m total compensation. 

• Satya Nadella, Microsoft - $2.5m salary, $10m bonus, $42m stock award.  $55m total compensation

• Sundar Pichai, Alphabet - $2m salary, $218m stock awards (3 year award).  $226m total compensation.

• Andy Jassy, Amazon - $317,500 salary, 0 stock awards (but $212m in the prior year).  $1.3m total compensation in 2022.

• Jamie Dimon, JP Morgan Chase - $1.5m salary, $5m cash bonus, $28m PSUs.   $34.5m total comp.

No company comes close to Netflix on salaries.  I've never seen anything like it, and in my opinion it sets a horrible precedent.  Of course, the board would be forgiven if the stock performed amazingly.  However, Netflix's stock was up about 10% from year-end 2018 (its first year of huge salary jumps) to year-end 2022.  To be fair, it did rise significantly from 2018 to 2021, but it also fell materially in 2022.  It makes me wonder what the negotiations were between the management team and the board. Did the executives anticipate tougher growth ahead?

Zooming out, if we think about executive compensation with a blank sheet of paper, what would we hope for?  Conceptually, this is what I think:

1. We don't want talent leaving for competitors primarily because of compensation.

2. At a high level, we want managers to be aligned with shareholders.  The board should know what financial and operational outcomes will maximize shareholder returns over the medium- to long-term.  It should align incentive compensation with performance against financial and operational KPIs that ensure the company is on the right track.  There should be a mix of short-term and long-term KPIs that feed into the compensation formula. 

3. The board's compensation packages should allow the executives to become wealthy if their ambitious targets are met.  Packages should not allow executives and managers to become extremely wealthy simply for staying in the job.  I believe Ted's $90m in cash salary over 5 years qualifies for extreme, no-risk wealth creation. 

4. There should be a "punishment" mechanism included, such that bad management (e.g. highly manipulated results to hit KPIs for a period) should result in equity clawbacks.  Let managers participate in the upside and the downside - not just the upside. 

I think it's important to target financial and operational KPIs instead of total shareholder return (TSR).  TSR-based plans are a double-edged sword because returns are what we minority shareholders want at the end of the day, but they may incentivize managers to enter ethical grey or red zones to drive the stock higher, or to sacrifice long-term gains for short-term wins - an outcome that should be a top priority for boards to avoid.  Mike Pearson at Valeant Pharmaceuticals is the poster child for this concern (good Harvard Law discussion of that here).  

Now, let me walk through an example of a company that I think structures its compensation pretty well.  Armstrong World Industries (AWI), one of Recurve's portfolio companies, has a well-aligned plan.  It includes:

1. Competitive but not egregious base salaries.

2. Cash bonuses based on short-term financial performance (revenue and EBITDA targets).

3. Equity compensation (60% PSUs, 40% RSUs) based on long-term targets for Mineral Fiber (its largest segment) EBITDA, free cash flow, and total stock return. 

AWI's prior 3-year equity incentive plan was based on a combination of TSR, FCF and mineral fiber volume over the performance period (2020 to 2022).  The compensation committee granted PSUs to executives based on TSR (60% weight), FCF (30% weight), and mineral fiber volume (10% weight).  The stock had negative performance over the performance period and both FCF and mineral fiber volume were below the minimum thresholds required to earn shares.  The management team earned a 0% payout of performance shares.  On this basis, they were very aligned with shareholders - when fundamentals and equity performance were poor, executives did not get paid anyway.

Armstrong (and its executives) were unlucky to feel significant and lingering effects from Covid, but that happened to many businesses and industries during the Covid-affected period.  I would prefer that AWI would issue equity to its executives using different KPIs, such as a combination of (a) its win share on annual industry volume, (b) an index of its mix-weighted realized product prices compared to an index of its mix-weighted realized product costs, and (c) free cash flow per share.  The first two would allow executives to do well when the company does well even in a poor economic climate for the industry, and they would prioritize beating competition while also expanding gross margins.  If they do those well over time, free cash flow and earnings per share would follow naturally. 

In closing, executive compensation is a complicated topic.  A superstar CEO with the right incentive scheme should be celebrated and paid as Michael Jordan was with his Nike contract.  I am a big believer in win-win deal structures and incentive schemes, and I hope more companies implement executive compensation plans that fully align managers with shareholders and avoid enriching managers regardless of their performance, as we see too often in public companies. 

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