Question

21) At a stockholder's meeting it is discovered that the CEO of the firm, who is compensated with $25 million in cash, is busy interviewing for jobs with other firms and might as a result take the intellectual property to another firm unless a new offer is made. Several fellow stockholders suggest that the CEO compensation be increased to $30 million. You instead suggest that the CEO be given $ 15 million in cash and $10 million worth of stocks. The CEO is given your option and accepts the new deal and stays with the firm. Why were you correct in making this suggestion (what problem did you solve?) and why did the CEO accept this offer? Explain.

Answer 1

The CEO has leadership as well as other expertise which is beneficial for the company in the long term. However, he is free to join another company if he is not getting well paid in the present company.
The shareholders are the principal and the CEO is the agent in this scenario.

The principal and agent problem is quite old and only credible incentives, as well as credible threats, can ensure its solution. The agent is appointed by the principal and the assets are owned by the principal. The agent has the duty to maximize the benefits of the principal but most of the time they try to maximize their own benefits.

In the above situation, the CEO had no incentives to maximize the shareholder's wealth if he has been offered $50 million cash and that payment would have been done from the shareholder's wealth.
However, $10 million worth of stock options has given him the reason to maximize the share price in the market which will also maximize shareholder wealth.

Further, $50 million would have been a fixed amount but the share price can rise manifold and that would be a very profitable offer for the CEO as he can rake even $100 million from that stock options.