Insights on Elon Musk's Compensation Arrangement
In 2018 the Tesla Board of Directors approved a 10-year compensation arrangement meant to incentivise their CEO into growing Tesla to one of the largest companies on the planet. Mr. Musk’s yearly salary remains at the minimum level required by California state law, which in 2018 was a modest $56,160, however he still does not accept any of his salary. His stock option reward plan is another story. In total Mr. Musk’s compensation arrangement includes 20,264,042 stock option awards and in 2018 the aggregate fair value of his compensation was $2.62 billion.
In order for Mr. Musk to receive any of this compensation however, Tesla must first meet a set of different milestones. The first milestone pertains to Tesla’s market cap and becomes vested once the market cap hits certain intervals, starting at $100 billion and then increasing by $50 billion increments thereafter. Tesla even states in their proxy statement that if all milestones are met they will have a market cap of at least $650 billion, larger than GM, Ford, Toyota, and Volkswagen combined.
This type of arrangement, while seemingly logical to some people, poses a major problem with not only Tesla but a number of other corporate enterprises that have similar arrangements. The primary issue with the arrangement is that from year to year Elon Musk has little to no control over the market cap of Tesla (apart from sporadic price movements due to his twitter account). Instead, its market cap is controlled by the emotions and movements of the equities market. Emotions that over the past 6 months have pushed Tesla’s market cap higher than Ford & GM even though they sell a fraction of the number of vehicles.
It is therefore absurd to tie Mr. Musk’s compensation directly to factors that he has no control over such as Tesla’s market cap over the next 10 years. As history has shown the market cap of a corporation can move from one extreme to another with little interaction from the CEO. Instead, a more rational arrangement would correlate Elon’s compensation to the number of vehicles that are produced and the manufacturing capabilities of Tesla, factors that he very much has control over but which might not be accurately reflected in Tesla’s market cap.
This is where the second part of Mr. Musk’s compensation arrangement comes in, which states that in addition to Tesla obtaining a certain market cap they must also meet one of 16 operational milestones. 8 of which relate to Tesla’s annual revenue and the other 8 to Adjusted EBITDA. While these milestones come closer to correlating compensation to actions of the CEO they fall short due to the use of “Adjusted EBITDA” as an operational metric; which as all rational investors know is a meaningless figure used by people who either 1) do not understand basic accounting or 2) are wanting to hide something from shareholders. It's of course ridiculous a company create a compensation arrangement saying that depreciation and compensation expenses are actual expenses. What on earth else would they be?
These kinds of arrangements have grown more and more common in corporate America and aren’t unique to Tesla at all; although Tesla has certainly taken it to a new level. However, regardless of how impressive Mr. Musk’s achievements have been (I’m personally a huge fan of his) it is important for current shareholders and prospective shareholders to get a full understanding of how their CEO is being compensated. The most important thing to understand is that with every share exercised through a stock option arrangement, existing shareholders own less of the corporation, and less of the corporation's earnings (assuming they have any) can be distributed to them. Therefore, as Tesla becomes more profitable and reports their earnings per share figures shareholders should take into account the options that have yet to be exercised in their analysis of a company’s earnings and then from there make their investment decision. Afterall, the shareholders are the ones paying these compensation expenses.
More details on Mr. Musk's compensation arrangement can be found in Tesla’s 2018 10-K starting on page 121.
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