Management Compensation: Primer on Aligning Incentives in Bankruptcy

Welcome to the 114th Pari Passu newsletter,

Today we are going to be digging deep into management compensation and incentive structures in distressed businesses.

Founders and CEOs are the faces of corporations when they succeed – Steve Jobs with Apple, Elon Musk with Tesla, and Brian Niccol with Chipotle. They are also the first to blame when they fail – Adam Neumann with WeWork and Ken Lay with Enron. Choosing and properly incentivizing the right leadership teams is crucial. So, how do companies motivate successful and valuable talent to help ballast a sinking ship? How does the Bankruptcy Code prevent managers from enriching themselves using creditor assets?

In this newsletter, we will begin by exploring the importance of corporate management in distressed businesses and then provide an overview of the typical incentive structures key employees receive in a Chapter 11 scenario. To bring it all together, we will examine surgical implant and healthcare tools manufacturer Exactech’s 2024 bankruptcy and the debates surrounding its executive compensation structure. Let’s dive right in.

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Introduction

At its core, a business is just a collection of people that produce goods or provide services. A company’s operating metrics and financing structure can be reorganized into neat financial statements and kept track of using accounting systems, but the essence of a business is always driven by its people. The economic contribution of an organization’s culture, leadership, and management is difficult to quantify; in good times, it can be the key intangible differentiator between a successful company and a struggling one. In distress, it can be the difference between a going concern and a liquidation. Managing a company heading for bankruptcy can be very different from leading a startup or spearheading a new product launch. 

The Role of Managers: Healthy vs Distressed Companies

Healthy Company: In a healthy company, the role of the executive is to find ways to continue to grow. Classic financial economic theory dictates that a corporation should provide returns (r) above its cost of capital (k). If this happens, the excess value should accrue to shareholders because their ownership of the company is worth more. To ensure that r>k, healthy companies are constantly investing in capital expenditures, making acquisitions, and expanding their operations. The decision-making structure for corporations is from the top-down. At the top is a corporation’s board of directors which acts as the organization’s “governing body”. These individuals have the power and responsibility to enact company policy and set executive compensation targets. Perhaps most importantly, they hire and fire corporate officers, who actually operate the business day-to-day [12]. It is not uncommon for individuals to serve on both the board of directors and as officers in their company. In a healthy company, both the board of directors and the officers they elect to operate the company are direct representatives of shareholder interests. In other words, they have a fiduciary duty, or the legal and ethical obligation to act in the best interests of the owners of the company. Practically speaking, shareholders enforce this legal and ethical ideal using economic incentives to “align” management’s interest with their own. Management is generally compensated in one of three ways for their work [1]:

Stock options: Participants are given the opportunity to purchase an agreed number of shares at a set price at some point in the future.

Restricted stock units: Participants are given a specified number of shares or their cash equivalents in accordance with a pre-determined “vesting” schedule.

Cash-based performance bonuses: If a series of operational or financial targets are achieved, participants receive a cash bonus or pre-determined percentage of the incremental operational improvement.

Strictly speaking, public companies also provide officers incentives for achieving short-term earnings targets which do not always have long-term benefits. Earnings-per-share can be artificially inflated through non-economic share-repurchases, deferred R&D and capex, or through bolt-on acquisitions. While management incentive structures can vary greatly from company to company, the theoretical concept remains the same: if the company is able to make r>k, the manager shares in the equity upside with the other shareholders of the business. For the typical executive, most of their compensation comes from their incentive-based pay. For example, in 2023 Chipotle ex-CEO Brian Niccol took home ~$22.5mm in total compensation, of which ~98% was incentive-based pay [13].

Distressed Company: In a distressed company, by definition, r<k. Perhaps there was an economic downturn, a structural trend the company missed out on, or an unexpected liability that jeopardized the earning potential of the business going forward. As trouble mounts, the expected incentive pay for a senior manager can be non-existent. Several considerations complicate the company’s options going forward. 

First, the shareholders of the business may still have…

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