A great deal of space has been devoted by the media to discussions relating to the pay of Elon Musk, CEO of Tesla.  The media outrage centers around his 2018 pay package, with many of the headlines reporting a whopping $56 billion as the pay awarded to the CEO under the package.  The pay package gained further notoriety when one shareholder filed a lawsuit against the company, seeking to void the award.  On January 30, 2024, the Delaware Chancery Court struck down the award citing poor process and conflicts of interest.  Following the ruling, a majority of Tesla shareholders voted once again to ratify the award in June 2024.  About 72 percent of shareholders voted in favor of the award, roughly the same percentage that voted in favor in 2018 also.

Was Musk really awarded $56 billion as the media headlines state? Why might Tesla have structured such a compensation contract that way? If the contract was not optimal from the shareholders’ viewpoint, what might explain the fact that they voted not once, but twice, to keep the award? To better address these questions, we perform an in-depth analysis of the award.

First, as to the question of whether the award was really $56 billion, the short answer is “No.”  To see why, consider that CEO (or executive) pay has three dimensions: the cost to the firm of the CEO’s pay package, the incentives that arise from the pay package to motivate the CEO’s future performance, and the rewards realized by the CEO due to his performance.  For Tesla, we find that this $56 billion is not related to the cost or the incentives, and only loosely related to the maximum rewards that the CEO could earn.  This is not the number that is typically thought of as “CEO pay” and as such is not comparable across CEOs. Thus, this clickbait figure of $56 billon is misleading.  In fact, the cost to the firm of the pay package is $2.3 billion, and this is the number the firm discloses in its proxy statement under “fair value” of the grant. This is the number that is closest to what is considered “annual pay” when comparisons of CEO pay are made. In the case of Tesla, however, a better approximation of “annual pay” would be $230 million which is 1/10^th the amount because the CEO’s pay package was meant for 10 years. Indeed, the CEO has not received any pay since 2018.

To address the questions of why Tesla might have designed such a contract and why shareholders might have voted in favor of the contract both times, we scrutinize all the features of the 2018 award.  Our conclusion is that shareholders likely voted in favor of it because the award was generally structured to align the incentives of the CEO with the interests of shareholders.  Our conclusion is based on the following observations.

First, it was an option rather than a stock award and could have ended up worthless if the stock price did not go up after the grant.

Second, it was a performance-vesting rather than time-vesting award and would be earned only if the CEO met certain performance measures. For example, if a three-year time-vesting grant of 300,000 shares is made to a CEO on Jun 30, 2020, the CEO typically will have full ownership of 100,000 shares on June 30, 2021; another 100,000 shares on June 30, 2022; and the remaining 100,000 shares on June 30, 2023. With time-vesting grants, as long as the CEO remains in office, the CEO receives the award without regard to firm performance. If the stock price goes down 50 percent in the three years since the grant date, the CEO will still pocket the 300,000 shares. With a performance-vesting award, in contrast, the CEO will not earn any shares unless pre-specified benchmarks are met.

Third, the award was designed to be earned in 12 tranches over its 10-year maximum term, with each tranche requiring the CEO to meet certain performance measures (market capitalization, Total Revenue, Adjusted EBITDA).  Earning each tranche required the CEO to increase the market capitalization by $50 billion, a number that was apparently chosen by the firm to reward the CEO every time he increased the market cap by an amount equal to the market cap of Ford and GM at that time. Earning the final 1/12^th of the award required the market capitalization to reach $650 billion.  These performance milestones were objective, clearly defined, easily verifiable, and, importantly, all related to shareholder wealth.

Fourth, the CEO had to hold the shares obtained from the exercise of earned options for a further five-year period.  This not only made any manipulation of performance targets less likely, but also provided incentives to the CEO to improve Tesla’s performance for the next five years.

Fifth, the specified targets for these benchmarks were difficult to achieve.  To earn the full award, the CEO had to not only increase the market capitalization of the firm to $650 billion (from $59 billion as of the board approval date), but also achieve 12 of 16 total operational milestones with respect to total revenue and adjusted EBITDA. To quantify the difficulty of achieving the full award, we estimate what fraction of the U.S. firm-years (i.e., each firm in each year of existence is considered as one observation) had historically achieved the targets needed for the Tesla CEO to earn the entirety of the award.  We find that only 6.4 percent of the 243,366 firm-years in our sample from 1950–2017 achieved the approximately 1200 percent growth in market capitalization within the time frame that was required to earn all 12 tranches. When we combine that with the total revenue and adjusted EBITDA benchmarks that were also required to be met, only 1.2 percent of the firm-years achieved this target.

Overall, we conclude that the features of the contract are shareholder friendly.  Whether the firm should have given away 12 percent  of itself to achieve this near-improbable growth is a fair question, but one that is not easy to answer. Presumably, shareholders thought it was fair as, otherwise, they would not have voted for it.

This post comes to us from professors Jeffrey L. Coles at the University of Utah, Naveen D. Daniel at Drexel University, and Lalitha Naveen at Temple University. It is based on their recent article, “Musk’s $56 billion: Pay, Incentives, or Rewards?” available here.