Misalignment

I heard the most remarkable thing the other day from none other than the brilliant Alan Greenspan. When questioned about his feelings about the current financial crisis, he said (I’m paraphrasing a little here) that he believed that self-interest in protecting shareholders would keep corporate executives from taking unnecessary risk.

First, with the increased deregulation, encouraged by Mr. Greenspan himself, there was less exposure to risk.

Second, and more importantly, executives of public companies generally are not incented on long-term corporate health. Instead, the focus is on short-term corporate gains. Shareholders are different from investors. Investors take a stake in a company with, generally, an eye toward the long-term. Venture capitalists are excused from this consideration, as their main function is to get companies in a position to sell. Shareholders, on the other hand, buy shares hoping for them to perform a certain way before selling them again for a profit.

Thus, executives are compensated by their ability to maximize that value. That is what drives their self-interest.

If you want to mitigate your risk as a shareholder, create a compensation plan for the executives that adequately reflects that desire. But that will only work if you are more concerned with the long-term health of the company and not the quarterly profits. That means sacrificing a little now to build something for later.

As we have learned from the current crisis, there simply aren’t many willing to do that.