1997: Thoughts on incentive compensation.

WARREN BUFFETT: Well, we’ll talk about comp then, a little.

CHARLIE MUNGER: Yeah, comp, yeah.

WARREN BUFFETT: The — comps — there are three or four aspects to that.

On the subject of options, I would say that most options are constructed poorly, from the standpoint of the owner, but they’re constructed very well from the standpoint of the person who receives them, which is not entirely unexplainable because the — it’s a very strange form of negotiation when the beneficiary is the one that also really does all the design and hires the experts to come in and tell him what is good for the company when the expert knows that the guy who signs the check would be quite interested also in hearing what’s good for him.

There’s nothing wrong with options per se, at all. Frankly, in terms of Berkshire, it would have been perfectly appropriate if a properly designed option had been given to me or to Charlie.

I mean, we have responsibility for the whole enterprise, and we believe that any kind of incentive for performance should be related to the area in which you have responsibility.

We feel that if you want a typist to type 100 words a minute, that you ought to pay for typing 100 words a minute, not what the earnings per share were last year.

We feel if a salesman gets paid for how many of the product is sold, he should get paid for that and not for some production quotas met.

So we believe in tying incentive comp to performance for which you have responsibility. And there are certain areas of a business that don’t lend themselves to that staff performance and so on.

But that would lead to the corollary, that the people that are responsible for the entire results of the business, it’s perfectly appropriate to compensate them by options that in some way reflect the performance of that entire business.

The trouble is that stock prices reflect other things than the performance of the business.

For one thing, over a period of time, they reflect simply the reinvestment of earnings. You know, I have pointed out in the past that if you gave me an option on your savings account — to manage your savings account — and you reinvested all the interest, I would take away a significant payment at the end of ten years simply because you left the interest in.

With a company that pays no dividend like Berkshire, if you’re going to leave all your capital in every year, for me to get a fixed-price option for ten years would mean that I was getting a royalty on money that you left with me. And I made the choice to have you leave it with me. So that does not strike me as equitable.

So I think any option should have a step-up in price that reflects the fact that money is reinvested by the shareholders annually. That if somebody wants to pay out a hundred percent of the earnings every year, then I’d say that you can have a fixed-price option. If you give me the money every year, and you do more with the money that’s left with you than the original sum, that’s fine.

But if money is left with someone for ten years, there’s going to be some increase in value even if they spend every day golfing. And to give a piece of that away simply over — to have a royalty on the passage of time for them is a mistake.

I think options ought to be granted, basically, at the fair value of the business at the time they’re granted. Sometimes that’s the market price, sometimes it isn’t the market price, but —

Certainly the management of a company would not give an option on their business to some third party at a market price they felt was way too low, so I find it a little disingenuous when managements say that they’re — when they get a takeover bid, they say that the company’s really worth twice that much, but they’re perfectly willing to issue options to themselves at this price which they say is totally inadequate, when the owners get the option elsewhere.

But options, properly structured, for people with responsibility for the business, I think, makes — can make sense. And I think that if something happened to me and to Charlie, in terms of the manager of the business subsequently, if it was structured properly, I would not see anything wrong with an option arrangement.

We carry this philosophy down to our subsidiaries where they generally get incentive arrangements that relate to the operation of their business. But they don’t have incentive arrangements that relate to Berkshire overall, because if Chuck Huggins does a wonderful job at See’s Candy, as he has done, and I fall on my face, in terms of allocating capital, Berkshire stock will go no place despite what Chuck does.

And to penalize him, or to tie his rewards to something over which he has no control, I think, is kind of silly. So we tie it instead to the operations of the candy business.

In terms of overall level of compensation, the real sin is having a mediocre manager. I mean, that is what costs owners very significant amounts of money over time.

And if a mediocre manager is paid a relatively small sum, it’s still a great mistake. And if they’re paid huge sums, it’s a travesty. And that happens sometimes.

It’s almost impossible to pay the outstanding manager a sum that’s disproportion to the value of that outstanding manager, when you get a large enterprise.

Coca-Cola had a market value of $4 billion when Roberto Goizueta took over. It had stagnated during the previous decade under an earlier management, despite having the same product and those great Mean Joe Greene commercials you saw, that was — Mean Joe Greene was in the ’70s. The “Teach the World to Sing” commercial was in the ’70s. All these great commercials. But the company didn’t do much.

Roberto — if we’d bought the entire Coca-Cola Company — I wish we had — in 1981 or ’2, whenever he came in, for 4 billion and we now had a business worth 150 billion, Roberto would have earned more money with us than he’s earned under the present arrangement.

I mean, having the right person in place is just enormously important.

How much they should take is another question. That’s more a philosophical question.

Tom Murphy, best manager, you know, in the world, he just didn’t feel like taking a lot of money out of it, you know. And you know, I tip my hat to him, but I don’t think that necessarily makes it wrong for somebody else to take more money for doing the job. But I think it ought to be related to doing the job.

When I ran a partnership in the 1960s, I took a quarter of the profit over 6 percent a year. And I didn’t get paid any salary, but I could make a lot of money doing that. And that thought occurred to me as I ran the place from day to day, and I think it probably helped a little. (Laughter)

So I don’t think it’s a terrible thing to have somebody get paid for making money for the shareholders.

But they ought to get paid for really making it, not simply because the shareholders reinvest money with them. They ought to make it based on the fair value of what they had when they took over, and they ought to make it really for just excellent performance.

Charlie?

CHARLIE MUNGER: Well, we have remarked in previous Berkshire Hathaway meetings that we regard present mandated corporate accounting, with respect to stock options as weak, corrupt, and contemptible. And it is.

WARREN BUFFETT: Otherwise, we’re undecided. (Laughter)

CHARLIE MUNGER: If something is so wonderful as a standard technique of compensation, why does it have to be masked under weak, corrupt, and contemptible accounting? I think it is no credit to our civilization that we’ve drifted into this particular modality.

And you can get, if you overuse stock options, where the whole thing is sort of a chain letter. I mean, in Silicon Valley there’s one company that practically paid everybody in options, and as long as the chain letter galloped, it worked as far as the income account because nothing went through expense.

And then once everybody is issuing stock options, everybody else feels that he has to do it. And the practice spreads.

So I am not totally wild about the extreme prevalence of the stock option modality in American corporate life. Personally, I would vastly prefer different modalities, which would probably involve stock instead of stock options.

I’m all for sharing with the kind of people who are doing the important work pretty well down in the organization in a place like Costco or Coca-Cola or any other such company. But I don’t much like the present scheme that civilization has drifted into.

With respect to the subject of do we have some wretched excesses in American corporate compensation, my answer would be yes. I don’t think the excess is necessarily the guy who got the most money. In many cases I agree with Warren, that the money has been deserved.

But such is the envy effect that the practice spreads to everybody else. And then the taxi driver and everybody starts thinking the system is irrational, unfair, crazy.

And I think that’s what causes some people, as they rise in American corporations, to, at a certain point of power gaining and wealth gaining, they start exercising extreme restraint as a sort of moral duty. And that’s what Warren was saying about Tom Murphy.

And I would argue that the Tom Murphy attitude is the right attitude. And it goes way, way back in the history of civilization. The word “liturgy” comes from a Greek word which is just the same. I mean, if you were an important citizen of Athens, it was a lot like being an important person in Jewish culture.

I mean, you had duties to give back and to act as a certain example. And the civilization had social pressures that enforced those duties. And I would argue that the Berkshire Hathaway compensation system, considering what the people at the top already have, it would be better if we saw a little more of it.

WARREN BUFFETT: A few —

CHARLIE MUNGER: I think Warren and I do all right. (Laughter and applause)

WARREN BUFFETT: A few years — I think an added problem is the sort of, in terms of the accounting, the sort of hypocrisy that it pushes people into, and then which becomes accepted and sort of a norm, particularly when leaders do it.

And you know, you had a situation a few years back when there’s no question that any manager would say that stock options are a form of compensation. They would say that compensation is a form of expense, and they would say that expense belongs in the income account. But they didn’t want to have stock options counted because they felt that it might restrict their use.

So when the federal — the FASB, Financial Accounting Standards Board — came up with a proposal to actually have reality reflected en masse, corporate chieftains descended on Washington to pressure legislators to have Congress start enacting accounting standards, which as I mentioned, one time in Indiana in the 1890s, there was a legislator that introduced a bill to have the value of pi changed to an even 3 because he thought that 3.14159 was too tough for the schoolchildren and it would ease computational problems.

Well, that sort of behavior by corporate chieftains when they are in there, you know, arguing that black is white, in order to feather their own nest and maybe create a little higher stock prices, I think that it means that they forfeit, to some degree, their right to be taken seriously when they claim they’re operating for the good of the Republic, and march on Washington in other regards.

And I just think that when the organization recognizes its hypocrisy and so on, I think there’s a degradation that can set in through an organization that — whose leaders are also leaders in hypocrisy.

Like I say, we have no strong feelings on this subject, but — (Laughter)

Charlie, do you have anything?

CHARLIE MUNGER: It’s rather interesting, though. There’s an earlier example. Commodore Vanderbilt took no salary from his railroads. After all, he controlled the railroads. They paid all the dividends that he needed, and he got the fun of running the whole railroad, and he thought it was beneath Commodore Vanderbilt to take a salary.

We’ve never quite reached the Vanderbilt standard, but — (Laughter)

WARREN BUFFETT: We don’t have any dividends, Charlie.

CHARLIE MUNGER: Yeah, yeah. (Laughs)

Well, maybe that’s the reason. (Laughter)