Elon Musk's $56 billion Tesla pay bundle is affordable

Elon Musk’s proposed pay bundle at Tesla retains making headlines and no surprise: its touted worth of $56 billion is a staggering quantity, even for the world’s most outstanding government. How might that probably be justified? The reply is that almost all informal observers, and even many media experiences, are failing to grasp the character of the bundle. Based mostly on our analysis as finance professors, our conclusion is that Musk was unlikely to earn anyplace close to that a lot on the time of the grant, and, if he did, it could be well-deserved.

Earlier than explaining why that is the case, it’s useful to recall the context for the controversy. That features a determination by a Delaware court docket this January to reject the Tesla CEO’s proposed pay bundle on the grounds of poor course of and conflicts of curiosity. The ruling got here despite the fact that 73% of shareholders had accredited the bundle in 2018. By almost the identical precise margin, they voted to approve it once more this June—whereas Musk responded to the court docket determination by saying he would reincorporate Tesla in Texas.

In an effort to make a name on whether or not the bundle is honest—as the vast majority of Tesla’s presumably subtle traders did—it’s mandatory to grasp three features of any pay bundle: the rewards realized by the CEO, the fee to the agency, and the incentives for future efficiency.

First off, it’s essential to notice the $56 billion determine represents the realized reward for the CEO and never the fee to the agency. The award consisted of 12 tranches of Tesla inventory choices, every equal to 1% of shares excellent on the time of the award. Every tranche of choices can be earned by the CEO solely on achievement of particular efficiency milestones. If these milestones will not be met, no choices can be earned by the CEO and the realized reward may also be zero.

This award differs from typical time-vesting awards, that are mechanically earned by the CEO so long as the CEO stays in workplace. Efficiency-based-vesting awards, such because the Tesla award, are given yearly to CEOs and will not be unusual, however structuring them solely primarily based on inventory choices is uncommon. Over the 2007-2023 interval solely 4.2% of excellent awards to S&P 1500 CEOs had been performance-vesting possibility awards.

Tesla’s CEO stood to obtain the complete advantage of the 2018 pay plan provided that he had been to develop Tesla to a market capitalization of $650 billion, roughly 13x the market cap on the time of the grant, and develop income and adjusted EBITDA by 15x and 22x over the corresponding 2017 numbers. If Tesla had been to realize this inventory market capitalization goal of $650 billion, it could additionally turn out to be 13 instances the 2018 measurement of Ford and GM. From the vantage level of 2018, the chance that Tesla would carry out so nicely as to clear all of the efficiency hurdles was seen as extremely unlikely. Certainly, a New York Occasions article on the time cited specialists who mentioned rising the worth of Tesla to $650 billion was “laughably inconceivable.”

No one was anticipating Tesla to realize this. Knowledge helps this: just one.2% of the observations within the 1950–2017 pattern of US corporations had achieved this charge of development.

However Tesla did carry out nicely, stunningly nicely. Tesla achieved all of these milestones in six years, 4 years previous to the top of the efficiency interval. The rise in Tesla shareholder worth over the identical interval was $ 523 billion. In stark distinction, GM and Ford inventory at present are valued at $53 billion and $43 billion, barely decrease than their 2018 ranges.

Because of this efficiency, Tesla’s CEO earned choices on 303,960,630 shares. If the CEO paid the $7.09 billion required to train the choices, he would personal the shares outright. The closing inventory worth was $182.47 on June 13, 2024 (the date the shareholders voted once more on the pay bundle). Multiplying these two figures offers $55.46 billion, which seems to be rather a lot just like the $56 billion reported within the press. Coincidentally, this $56 billion can be the reward estimated by Tesla’s board of their 2018 proxy assertion on the time of the choice award.

The second factor to evaluate when contemplating the pay bundle is the fee to the agency. In response to Tesla’s 2019 proxy, per clearly-laid-out accounting requirements, the honest worth of the award was $2.3B. Whereas that is no small determine, notice that the CEO had obtained no different pay since 2018. An excellent approximation of “annual pay” for Tesla can be $230 million which is 1/tenth the quantity as a result of the CEO’s pay bundle was meant for 10 years.

It’s additionally price noting that the CEO is required to carry the shares for five years after train, a requirement to make sure his curiosity stays aligned with these of shareholders. Given this restriction, monetary assessors would low cost the awards worth by round 30%—so the award, on an annual foundation, can be price $158 million per yr somewhat than the $230 million.

One other means to think about the award is that Tesla granted its CEO a lottery ticket priced at $2.3 billion (the honest worth below accounting guidelines) with a possible payoff of $56B—however that successful the lottery relied on the CEO’s capability to rework an upstart automotive firm into a world big. One estimate of the likelihood that Tesla’s CEO might earn the $56 billion reward was 1.2% (as famous earlier). That low likelihood helps clarify why the fee to the agency was estimated at $2.3 billion.

The third facet of the pay bundle to notice is the embedded incentives meant to inspire future efficiency. Particularly, the contract was structured such that for each $1 improve in shareholder wealth, the CEO’s wealth elevated by roughly $0.12. This “delta” (a measure of how intently aligned CEO wealth is to agency worth) of 0.12 is excessive, however not loopy excessive.

The Ninetieth-percentile “delta” for CEOs of enormous US companies over 1996-2009 was 0.07, and this has solely gotten bigger lately. Within the case of Tesla, the excessive delta seems to have executed what it was meant to do—obtain “jaw-dropping” efficiency. We interpret the optimistic shareholder vote as indicating that shareholders are pleased with that division of the achieve. And after the vote, traders continued to be optimistic as nicely, with Tesla’s market cap peaking at $836B on July 9, 2024.

In conclusion, our evaluation of the Tesla CEO’s compensation bundle highlights the necessity for a nuanced understanding of government pay. Government compensation is inherently complicated, and an intensive examination of its a number of sides, somewhat than fixating on a single sound-bite determine, is crucial to guage whether or not the contract successfully aligns with shareholder pursuits. Ultimately, contemplate a easy query: would you share 1% of the positive aspects each time an organization CEO doubles your cash? Tesla shareholders determined they’d.

Jeffrey L. Coles, is a finance professor on the College of Utah whose analysis pertains to company finance, together with government compensation. Naveen D. Daniel is a finance professor at Drexel College, who has revealed broadly on company governance. Lalitha Naveen is a finance professor at Temple College whose work on government compensation has been broadly cited. The opinions expressed in Fortune.com commentary items are solely the views of their authors and don’t essentially mirror the opinions and beliefs of Fortune.