Golden Parachutes: Why it’s bad business

April 11, 2014, 7:19 PM UTC
Craig Ferguson reportedly stands to make at least $8 million – simply for not getting David Letterman’s job.

FORTUNE – Now that David Letterman is leaving his Late Show on CBS, his former protégé Craig Ferguson reportedly stands to make at least $8 million — but not for replacing him, since Stephen Colbert has actually landed that gig. Ferguson gets compensated simply for not landing Letterman’s spot, which effectively means he wins by default while CBS loses millions.

Talk about a sweet deal! As absurd as the arrangement might sound, if that happens, it’s not unheard of. What’s more absurd is how commonplace and inflated golden parachutes, which include payment for change of control as well as severance for being fired, have become throughout corporate America.

According to a study by GMIRatings, 21 CEOs across industries received more than $100 million each in walk-away payments since 2000, collectively pocketing $4 billion of compensation — and indirectly, shareholder value — for tenures ranging from nine months to two and a half years. Of these, three of the CEOs were paid even though they never lost their job.

Take for instance, Rob Marcus, the CEO of Time Warner Cable (TWC), who will net $80 million if the company’s merger with Comcast (CMCSA) goes through, despite having been there for only three months.

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From a pay-for-performance standpoint, parachutes actually offer a disincentive for executives to do their best for a company. If a CEO or CFO gets a payout, which is often three or more times their regular salary and bonus, it can actually be more profitable for them to perform poorly and get fired than to succeed. Our capitalist system works on the basic principle of financial motivation, and oversized severance payments violate that understanding. If an executive can do an average or even a poor job, which requires minimal effort, get paid and suffer no consequences except the temporary embarrassment of being let go (which smart executives are adept at downplaying or spinning to their advantage anyway), it is illogical to expect him or her to work hard and do a great job.

Golden parachutes were originally created not to provide severance, but rather for protection in case of change of control. It was a mechanism to encourage CEOs to explore deals that are in the best interests of the company without worrying about their own continued livelihood.

In the case of Time Warner Cable, this purpose seems to have been served since Marcus was instrumental in pursuing the Comcast merger. But two crucial factors have been overlooked:

When CEOs receive large payouts for leaving, the payout can increase the effective price tag for the merger or acquisition, making it more expensive for buyers and derailing the transaction (or making it necessary to cut costs elsewhere). Also, encouraging CEOs to explore opportunistic deals by offering them exorbitant severance packages can also motivate them to make hasty decisions and pursue bad deals for the sake of personal profit. Poorly conceived, expensive, and ultimately disastrous mergers are often the result of this miscalculation on the part of companies.

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There is nothing wrong with companies offering severance packages for employees. But most rank-and-file and mid-level employees rarely receive the type of payouts (even proportionally) that top managers get, and their severance is typically based on time worked for the company (about two weeks of salary for each year worked), which imposes a much lower ceiling than for senior executives. This disparity creates a de facto class structure inside an organization, which can foster resentment and also hurt the ability of managers to credibly sell the idea of pay-for-performance to their workers.

For all these reasons, it is important for companies to reconsider handsome payouts to executives who don’t continue with the enterprise. Paying people to do a good job is smart policy, but compensating them to leave is not exactly a winning formula for business.

Sanjay Sanghoee is a political and business commentator. He has worked at investment banks Lazard Freres and Dresdner Kleinwort Wasserstein, as well as at hedge fund Ramius. Sanghoee sits on the board of Davidson Media Group, a mid-market radio station operator. He has an MBA from Columbia Business School and is also the author of two thriller novels. Follow him @sanghoee.