Elon Musk’s proposed pay package at Tesla keeps making headlines and no wonder: its touted value of $56 billion is a staggering amount, even for the world’s most prominent executive. How could that possibly be justified? The answer is that most casual observers, and even many media reports, are failing to understand the nature of the package. Based on our research as finance professors, our conclusion is that Musk was unlikely to earn anywhere near that much at the time of the grant, and, if he did, it would be well-deserved.
Before explaining why this is the case, it’s helpful to recall the context for the controversy. That includes a decision by a Delaware court this January to reject the Tesla CEO’s proposed pay package on the grounds of poor process and conflicts of interest. The ruling came even though 73% of shareholders had approved the package in 2018. By nearly the same exact margin, they voted to approve it again this June—while Musk responded to the court decision by announcing he would reincorporate Tesla in Texas.
In order to make a call on whether the package is fair—as the majority of Tesla’s presumably sophisticated investors did—it’s necessary to understand three aspects of any pay package: the rewards realized by the CEO, the cost to the firm, and the incentives for future performance.
First off, it’s important to note the $56 billion figure represents the realized reward for the CEO and not the cost to the firm. The award consisted of 12 tranches of Tesla stock options, each equivalent to 1% of shares outstanding at the time of the award. Each tranche of options would be earned by the CEO only on achievement of specific performance milestones. If these milestones are not met, no options would be earned by the CEO and the realized reward will also be zero.
This award differs from typical time-vesting awards, which are automatically earned by the CEO as long as the CEO remains in office. Performance-based-vesting awards, such as the Tesla award, are given annually to CEOs and are not uncommon, but structuring them solely based on stock options is rare. Over the 2007-2023 period only 4.2% of outstanding awards to S&P 1500 CEOs were performance-vesting option awards.
Tesla’s CEO stood to receive the full benefit of the 2018 pay plan only if he were to grow Tesla to a market capitalization of $650 billion, approximately 13x the market cap at the time of the grant, and grow revenue and adjusted EBITDA by 15x and 22x over the corresponding 2017 numbers. If Tesla were to achieve this stock market capitalization target of $650 billion, it would also become 13 times the 2018 size of Ford and GM. From the vantage point of 2018, the likelihood that Tesla would perform so well as to clear all the performance hurdles was viewed as highly unlikely. Indeed, a New York Times article at the time cited experts who said increasing the value of Tesla to $650 billion was “laughably impossible.”
Nobody was expecting Tesla to achieve this. Data supports this: only 1.2% of the observations in the 1950–2017 sample of US firms had achieved this rate of growth.
But Tesla did perform well, stunningly well. Tesla achieved all of those milestones in six years, four years prior to the end of the performance period. The increase in Tesla shareholder value over the same period was $ 523 billion. In stark contrast, GM and Ford stock today are valued at $53 billion and $43 billion, slightly lower than their 2018 levels.
As a result of this performance, Tesla’s CEO earned options on 303,960,630 shares. If the CEO paid the $7.09 billion required to exercise the options, he would own the shares outright. The closing stock price was $182.47 on June 13, 2024 (the date the shareholders voted again on the pay package). Multiplying those two figures gives $55.46 billion, which looks a lot like the $56 billion reported in the press. Coincidentally, this $56 billion is also the reward estimated by Tesla’s board in their 2018 proxy statement at the time of the option award.
The second thing to assess when considering the pay package is the cost to the firm. According to Tesla’s 2019 proxy, per clearly-laid-out accounting standards, the fair value of the award was $2.3B. While this is no small figure, note that the CEO had received no other pay since 2018. A good approximation of “annual pay” for Tesla would be $230 million which is 1/10th the amount because the CEO’s pay package was meant for 10 years.
It’s also worth noting that the CEO is required to hold the shares for 5 years after exercise, a requirement to ensure his interest remains aligned with those of shareholders. Given this restriction, financial assessors would discount the awards value by around 30%—so the award, on an annual basis, would be worth $158 million per year rather than the $230 million.
Another way to think of the award is that Tesla granted its CEO a lottery ticket priced at $2.3 billion (the fair value under accounting rules) with a potential payoff of $56B—but that winning the lottery depended on the CEO’s ability to transform an upstart car company into a global giant. One estimate of the probability that Tesla’s CEO could earn the $56 billion reward was 1.2% (as noted earlier). That low probability helps explain why the cost to the firm was estimated at $2.3 billion.
The third aspect of the pay package to note is the embedded incentives meant to motivate future performance. Namely, the contract was structured such that for every $1 increase in shareholder wealth, the CEO’s wealth increased by approximately $0.12. This “delta” (a measure of how closely aligned CEO wealth is to firm value) of 0.12 is high, but not crazy high.
The 90th-percentile “delta” for CEOs of large US corporations over 1996-2009 was 0.07, and this has only gotten larger in recent years. In the case of Tesla, the high delta appears to have done what it was meant to do—achieve “jaw-dropping” performance. We interpret the positive shareholder vote as indicating that shareholders are happy with that division of the gain. And after the vote, investors continued to be positive as well, with Tesla’s market cap peaking at $836B on July 9, 2024.
In conclusion, our analysis of the Tesla CEO’s compensation package highlights the need for a nuanced understanding of executive pay. Executive compensation is inherently complex, and a thorough examination of its multiple facets, rather than fixating on a single sound-bite figure, is critical to evaluate whether the contract effectively aligns with shareholder interests. In the end, consider a simple question: would you share 1% of the gains every time a company CEO doubles your money? Tesla shareholders decided they would.
Jeffrey L. Coles, is a finance professor at the University of Utah whose research pertains to corporate finance, including executive compensation. Naveen D. Daniel is a finance professor at Drexel University, who has published widely on corporate governance. Lalitha Naveen is a finance professor at Temple University whose work on executive compensation has been widely cited. The opinions expressed in Fortune.com commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.
