17 June, 2011

Why do CEOs get paid so much?

First, you have to put aside your prejudices and the tone of media reports. Although drongoes will occasionally fluke their way to the top jobs, they’re exceptions; the competition is too fierce. That doesn’t make CEOs perfect human beings - they can be as worthy or as venal as the rest of humanity and some CEOs do work the system to undue personal advantage - but most are decent enough people and good at what they do. But why do they command such big bucks?

A CEO capable of running a $1 billion company is a pretty smart cookie. They could easily run their own business. What would be a reasonable salary and bonus to persuade them to run yours instead? What’s the alternative for that individual?

Now this may come as a surprise to the wage slaves among you, but owning a $10-15 million turnover business is, well, while not easy, also not impossibly hard. Private equity firms are keen to help good executives buy good businesses. (Actually, an executive capable of running a $1 billion business could get PE funding for a business much, much bigger than my example, but let’s be conservative). A $10-15m turnover business doesn’t need much administrative overhead, just good leadership and marketing on top of the basic product and service delivery. A 7-10% EBIT result isn’t an unreasonable expectation in a good business, although clearly it goes up and down year by year. Assuming you’ve paid off the PE firm and the bank, and you don’t get too reckless or lazy, that’s $1 million profit on average every year, and a possible exit value of $3-6 million when you sell. Think I’m kidding? A lot of ordinary business people do just that and more. The chances are, you know some; they just don’t shout about it.

Admittedly, a $1m a year pay package (salary and bonus) doesn’t require anything like the same risk as a $1m a year profit (right now, many business owners will be using past profits to keep their companies and your jobs afloat). However, a $1 billion business is a very complex beast, and couldn’t be run by many people who run $10m businesses. At the risk of offending some people, I suggest that most (but not all) of the few people who can command a $1 million package are considerably ahead in smarts and executive ability compared to the average $10m revenue business owner. A $1 million pay package starts to look reasonable to get a really top manager to not run his or her own business and instead run your $1 billion business. What would you rather invest in? A $1 billion business run by someone paid $200k, or a $1 billion business run by someone on $1 million? And wouldn’t you incentivise them to do even better?

First posted March 2nd, 2009

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