New on FinoLib · Volume II: Capital Markets
I have added a new article to FinoLib, my finance education website: Executive Compensation Design and the Executive Search Process, part of Volume II: Capital Markets. This page gives you the core of the topic in expert but plain language; the full article goes much deeper.
7.3 The Executive Search Process — How a Search Actually Runs
The idea in plain words
An outside CEO search usually runs through a retained search firm and moves in steps: the brief, a long list, a short list, board interviews, an offer and an announcement. The firm is typically paid one-third of the new hire’s first-year cash pay. The offer often includes a make-whole award, which replaces pay the candidate gives up by leaving the old job. That is why an outsider’s first-year disclosed pay can look inflated.
Key points
■Search fee example: ($1.4m base + $2.1m target bonus) ÷ 3 = $1.17 million.
■A make-whole replaces forfeited stock and bonus; in the example it adds $7.9 million to $12.0 million of ongoing pay.
■Replace like for like: stock for stock on the same vesting dates, performance shares at expected payout.
A closer look
When an external CEO search is warranted, the board typically does not run it directly — it engages a specialist executive search firm (sometimes called a “headhunter” or, at senior levels, a “retained search firm,” since payment is structured as a retainer rather than a contingent fee paid only on success). The process itself moves through a recognizable sequence.
Decision rule
Replace forfeited value like for like and no more: time-based stock with your time-based stock on the same vesting dates, performance shares with performance shares (or at their expected, not maximum, payout), and cash only for cash the candidate actually loses. If the candidate insists on cash up front, require repayment on departure within the original vesting period. When the forfeited awards are underwater options, their fair value, not their face value, sets the ceiling.
The costliest mistake
Paying the equity part of a make-whole in cash on day one. In the example, the forfeited stock is worth 4.5 + 2.4 = $6.9 million. Paid in cash, all of it is gone if the CEO leaves after twelve months. Replaced with stock vesting one-third a year (and the performance shares on their original three-year cliff), only 4.5 ÷ 3 = $1.5 million would have vested, so the cash route costs 6.9 − 1.5 = $5.4 million more in that outcome.
Recap
A retained search firm runs the external search, typically for one-third of first-year cash pay, from mandate through short list, interviews and offer. Make-whole awards replace pay the candidate forfeits and inflate first-year disclosed pay; they should mirror the forfeited awards’ form and vesting rather than be paid in cash up front.
7.4 Executive Compensation Design — Base, Bonus, and Equity
The idea in plain words
Executive pay has three parts: a base salary, an annual bonus and long-term equity. The long-term part decides whether pay really follows performance. Performance share units that vest on relative total shareholder return pay little when the company lags its peers in a rising market, while time-vested stock pays anyway. Since 2023, US-listed companies must also claw back incentive pay that restated results show was not earned.
Key points
■Value at vesting = units × payout × price; payout scales from 0% below the 25th percentile to 200% at the 75th.
■In the worked example, a laggard in a rising market receives $6.72 million under a 60/40 PSU/RSU mix against $16.80 million under all-RSU.
■SEC Rule 10D-1 and exchange rules (effective October 2, 2023) require no-fault recovery over three completed fiscal years.
A closer look
Modern executive pay is deliberately structured across three components, each serving a distinct governance purpose: aligning the executive’s personal financial interest with shareholders’ interests over different time horizons.
Decision rule
Put at least half of the long-term grant into performance-vested awards, measure part of it relative to peers so a rising market alone cannot pay out, and pay 0% below the 25th percentile. Before approving, run the grant through at least the four scenarios in the table: if the laggard case pays more than the grant value, the design rewards the market, not management. Where no credible peer group exists, use multi-year financial targets instead.
The costliest mistake
Letting time-vested stock dominate. In the laggard case, an all-RSU grant pays 120,000 × $140 = $16.80 million for bottom-fifth performance; the 60/40 design pays $6.72 million. The difference, 16.80 − 6.72 = $10.08 million for one CEO over one cycle, is pay for the market’s move. ISS ranks five-year CEO pay against five-year TSR within a peer group, so this is also what triggers a negative say-on-pay recommendation.
What the full article covers
In the full article I take you through these sections:
■7.3 The Executive Search Process — How a Search Actually Runs
■7.4 Executive Compensation Design — Base, Bonus, and Equity
It includes worked examples, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Executive Compensation Design and the Executive Search Process, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance