The ruling against Musk’s $55 billion compensation sets a bad precedent

Should a Delaware judge’s decision to deny Tesla CEO Elon Musk a $55 billion compensation package stand, it could establish a troubling precedent. The potential fallout might compromise the efficacy of performance pay plans, which are integral for aligning employees’ incentives with organizational goals.

A cornerstone of any performance pay plan is trust, specifically the assurance that conditions and expectations won’t change after the fact. But Delaware Chancery Court Chief Judge Kathaleen St. J. McCormick appears to challenge this principle in her 200-page ruling. Musk has a 30-day window to appeal.

In the lawsuit — initiated by investor Richard Tornetta, who holds just nine Tesla shares — the burden of proof did not fall on the plaintiffs to demonstrate the unfairness of the pay package. Instead, the judge ruled, the defendants — Tesla’s board — “bore the burden of proving that the compensation plan was fair.” Unsurprisingly, the attention-grabbing $55 billion figure, which the judge labeled “the largest potential compensation opportunity ever observed in public markets by multiple orders of magnitude,” has dominated discussions.

But a performance pay plan should be assessed based on its expected value, in particular the effects of the incentives at the plan’s initiation, rather than the best-case scenario.

When Musk’s performance pay plan took effect in early 2018, Tesla boasted a market capitalization of $59 billion with annual revenues at $12 billion. The set baseline presented a significant hurdle for targets in the incentive plan, demanding Musk to earn up to 12 tranches of stock options tied to specific goals for market capitalization, revenues and EBITDA (earnings before interest, taxes, depreciation and amortization). To secure the initial tranche, Tesla’s market capitalization had to almost double to $100 billion, with revenues reaching $20 billion or EBITDA hitting $1.5 billion (up from essentially nil).

Subsequent tranches were linked to an extra $50 billion in market capitalization, $20-$25 billion in revenue, and a $1.5-$2.0 billion EBITDA increase. To unlock all 12 tranches, Tesla’s market cap had to skyrocket to $650 billion, and revenues soar to $175 billion or EBITDA reach $14 billion.

This pay structure, reliant on option awards, placed 100 percent of the compensation at risk. According to Tesla’s SEC filing, “Elon will receive no guaranteed compensation of any kind — no salary, no cash bonuses, and no equity that vests by the passage of time. Instead, Elon’s only compensation will be a 100 percent at-risk performance award, ensuring compensation only if Tesla and all stockholders perform exceptionally well.” 

Complicating matters, in early 2018 Tesla’s market cap surpassed that of General Motors and Ford despite the latter two companies being profitable and generating over 10 times the revenue. Consequently, many analysts deemed Tesla overvalued and the targets of Musk’s performance pay overly ambitious.

Against the odds, most of the targets were met. As of January 2024, Tesla’s market cap neared $600 billion, having peaked at $1.2 trillion in 2021. 2023 annual revenues totaled $97 billion, with $20 billion in EBITDA. With these results, Musk was poised to receive the majority of the $55 billion performance pay package. While the pay package seems astronomical in sheer dollars, viewing it as a 10 percent “commission” on the $500 billion added to Tesla’s market cap over five years alters the perspective. In sales, a 10 percent commission is considered quite low.

My argument doesn’t center on whether Musk, already a multibillionaire, would be more or less incentivized with $10 billion instead of $50 billion. The concern lies in preserving and protecting the integrity and effectiveness of performance pay.

Performance pay can be highly effective in aligning a company’s goals with employees’ actions, even when the likelihood of hitting performance targets seems slim. It aids in retaining employees, particularly high performers. Bonuses, alongside stock and option awards subject to vesting, provide compelling reasons for talented individuals to remain with the company. Their effectiveness, however, hinges on trust in the stability of rules and the commitment that goalposts won’t shift if someone defies the odds.

George Georgiadis is associate professor of Strategy at the Kellogg School of Management, Northwestern University.