Plenty has been written about Salesforce.com (CRM), particularly from the short-sellers (of which I am one, albeit with a small position). While much has focused on the egregious use of non-GAAP earnings, little has been said about the stock options that are the primary component of the non-GAAP figures. I would like to take some time to simply look at the company’s compensation practices:
For offices, employees, directors,and consultants, the company has four different equity compensation plans; here is a description of equity plans from the filing:
“We grant stock options to our executives when they join us, and periodically thereafter, to align their interests with those of our stockholders and as an incentive to remain with the Company. The Compensation Committee believes that options to purchase shares of our Common Stock, with an exercise price equal to the market price of the Common Stock on the date of grant, are the best tool to motivate executives to build stockholder value. Because these options are not transferable, they have no value unless the market price of our Common Stock increases during the period that the option is outstanding. Further, because these options typically vest over a four-year period, they incent our executives to build value that can be sustained over time.”
I find this interesting for multiple reasons; the first example comes from the next paragraph in the proxy that describes awards granted in fiscal 2012:
“In November 2011, in connection with the hiring of Mr. Norton, the Compensation Committee granted Mr. Norton a stock option award to purchase 45,000 shares of our Common Stock and a RSU award for 45,000 shares of our Common Stock. The stock option to purchase shares of our Common Stock was granted with an exercise price of $108.25 per share, and all equity awards were subject to our standard four-year time-based vesting schedule.”
Here was the example of a fellow executive:
“In February 2012, in connection with Mr. Van Veenendaal’s promotion to Vice Chairman and assumption of additional responsibilities at the Company, the Compensation Committee approved additional equity awards be granted to Mr. van Veenendaal. He received a stock option award to purchase 28,842 shares of our Common Stock and a RSU award for 2,740 shares of our Common Stock. The stock options were granted with an exercise price of $143.46 per share, and all equity awards were subject to our standard four-year time-based vesting schedule.”
Two things in particular jump out to me; the first is the timing of the vesting, as described later in the footnotes of the proxy: “Options granted under the 1999 Stock Option Plan and the 2004 Equity Plan vest over four years, with 25% of the total shares granted vesting on the first anniversary of the date of grant and the balance vesting in equal monthly installments over the remaining 36 months.” Using this 25% figure, we can see that Mr. Norton’s one-year anniversary date is quite important – he has the potential to purchase 11,250 shares of stock at that price, and could either pocket $30,000 or walk away with nothing, all of which depends on just a 5% move in the stock price.
Mr. Van Veenendaal has it even worse off. He decided to join the company when the stock was north of $140 per share, roughly 10% above the current market price. Now, there are some simple questions to ask: First, did the intrinsic value of CRM change by more than 30% in that three-month period as the market price implies? My answer would be a resounding no: The market is not efficient, and this is simply volatility. This leads me to my second question: Why is compensation tied to changes in the stock price for Mr. Norton, the company’s chief legal officer? In his role, what direct impact does Mr. Norton have on value creation at Salesforce.com?
My response to those two questions is straightforward: Both of these issues point to why stock options as issued by CRM are a poor methodology for aligning employee incentives with those of shareholders. These executives have no control of the stock price, particularly on some arbitrary date in the future; compensation should be set on a case-by-case basis, with measurable financial goals that are tied to the executive’s direct performance (Mr. Norton’s performance, as stellar as it may be, has little to no impact on CRM’s share price).
The reason I point these things out is due to a recent development at Salesforce; over the past three months, the stock has declined by nearly 20%. Considering how irrationally investors tend to act when they are watching their fortunes go up in flames, one has to wonder what effect a sustained decline in the stock price would have on CRM’s employees; how does it feel to know that you’re performance has little to no impact on the bonus that you receive, or your compensation as a whole? For key executives, total compensation generally outweighs the cash salary 10 to 1, with the remaining compensation largely coming from stock option awards (meaning the short-term stock price is generally more important than one's weekly paycheck); this is a real concern that Salesforce.com has yet to face in a big way (longest wait from peak to recovery has been just 18 months over the past 10 years).
During the good times, when the stock is heading to the moon, it’s all gravy, but if the stock continues its current decline for a sustained period of time, it will be interesting to see the reaction from employees with compensation plans that are poor proxies of their actual performance at the company.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.