"What pay for performance looks like: the case of Michael Eisner"

By Stephen F. O’Byrne, Stern Stewart & Co.

It’s easy to think of Disney CEO increase in Disney’s stock value – above
Michael Eisner as a classic case of the company’s CAPM-expected return –
executive pay run amok. His total would increase the value of Eisner’s
compensation in his first six years on the contract by 279%. A 67% decline in
job exceeded $250 million. In reality, he Disney’s shareholders’ wealth would
is a classic example of what “pay for reduce the value of Eisner’s contract by
performance” looks like. 71%.
When Eisner was hired in late What happened? Eisner and his
1984, he took over a troubled company. team took risks, transformed the
Disney had just been through a bitter company in many ways and achieved
takeover battle, theme park attendance remarkable success. (The Disney Touch
was declining, and return on equity had by Ron Grover provides a fascinating
fallen below 8%. When he joined chronicle of Eisner’s tenure.) By the end
Disney, Eisner agreed to a six-year of the original contract term, the price of
employment contract with three main Disney stock had increased to $102 per
compensation provisions: a base salary share, an increase of more than 600%.
fixed at $750,000, an annual bonus equal Over that same period, Eisner’s
to 2% of Disney’s net income in excess compensation (including unrealized
of 9% of stockholders’ equity, and a ten- option gains) from his original contract
year option on two million shares was $190 million, an increase of more
exercisable at Disney’s current market than 750% over the initial contract
price of $14. value. The shareholder gain from
While Eisner’s contract provided Eisner’s performance was enormous.
for guaranteed payments with a present The wealth of Disney shareholders had
value of only $3.9 million, its expected increased from $1.9 billion in 1984 to
value was, of course, much greater. The more than $14 billion at the end of 1990,
expected value of his options, based on a gain of $9.5 billion more than they
the Black-Scholes option pricing model, would have realized with an investment
was $16 million. I also estimate that the in the S&P 500. The cost of Eisner’s
expected value of his total contract, performance incentive was about 2% of
including bonus and pension rights, was the excess return realized by Disney
$22 million. shareholders.
The Disney directors were In late 1988, Eisner signed a new
presumably willing to enter into a ten-year employment contract. The
contract worth $22 million because it contract extension presented Disney with
provided a tremendous performance a difficult choice. Should the key terms
incentive that could provide great of the contract – a bonus of 2% of net
benefits to Disney shareholders. The income in excess of 9% of equity and an
contract made Eisner’s wealth even option on two million shares exercisable
more sensitive to Disney performance at the current market price – be extended
than the shareholders’ wealth. A 200% even though they now had an expected

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value of more than $120 million, far in CEO has a bonus plan that shows little
excess of competitive pay levels? Or performance sensitivity over time
should the bonus formula be changed because targets are adjusted to the level
and the option grant reduced to bring the of recent performance. The typical CEO
contract value closer to competitive receives annual long-term incentive
levels even though doing so would be to grants (often including restricted stock)
penalize Eisner for his own superior with “fixed value” grant guidelines that
performance? If Disney penalize Eisner penalize performance instead of the
for superior performance, it would be front-loaded options that Eisner
undermining the strong performance received. “Fixed value” grant guidelines
incentive it originally sought to create guarantee the same dollar grant
and that served it so well. regardless of stock price performance.
Disney made the right Superior stock price performance is
decisions. The company chose to effectively penalized by reducing the
maintain the integrity of Eisner’s number of shares granted and poor stock
performance incentive at the cost of price performance is rewarded by
paying far above the market. Disney and increasing the number of shares granted.
Eisner agreed to extend the original “Fixed value” restricted stock grants are
contract terms (including the $750,000 particularly pernicious since they ensure
salary) with three modest changes: large gains for poor performance.
increasing the bonus threshold to 11% The net result is that the typical
beginning in 1991, paying the portion CEO has a much weaker performance
of the bonus attributable to net income incentive than Michael Eisner. A 200%
in excess of 17.5% of equity in restricted increase in shareholder wealth would
stock (also beginning in 1991) and increase the typical CEO’s company-
making a quarter of the two million related wealth by only 91% – far less
new option shares exercisable at $10 than the 279% change in Eisner’s wealth
above the current market price of for the same performance. A 67%
$69. By the end of 1990, Eisner had decline in shareholder wealth would
an unrealized gain of $60 million on the decrease the typical CEO’s company-
new option grant, in addition to the related wealth by only 30%, as
$190 million in compensation he compared to the 71% decline in Eisner’s
received under the terms of his original wealth for the same performance.
contract. One lesson of Michael Eisner is
Eisner’s contract is very that true pay for performance will – and
different from the typical CEO’s should – lead to very high pay levels. A
compensation program. The typical second lesson is that the average CEO’s
CEO has much more guaranteed pay. total compensation program needs a lot
Salary and pension on salary represent more performance incentive to fully
38% of the typical CEO’s total align the CEO’s interests with those of
company-related wealth vs. 18% of the shareholders.
Eisner’s contract in 1984. The typical

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