Court Rules Tesla Mega Grant Is Excessive
February 01, 2024
I have another reason in my growing list of reasons not to issue mega grants (also sometimes referred to as “transformational grants”): a shareholder might successfully sue to require the executive to give the grant back. That’s what has happened with the mega grant that Elon Musk received from Tesla.
Background: The Mega Grant
The stock option in question was granted in 2018 and is notable in several respects.
At 20.3 million shares (12% of Tesla's total outstanding stock) and an estimated grant date valuation of $2.6 billion, the stock option is arguably a mega mega grant. In the year Musk received the grant, Tesla’s CEO to median employee pay ratio was 40,668:1. At the time the option was granted, Tesla estimated that it could be worth $55 billion.
An article by Bloomberg calculates that the option was worth over $100 billion when Tesla’s stock price peaked (this article provides a great summary of the ruling and conditions at Tesla that led to it). According to the ruling, the option is “250 times larger than the contemporaneous median peer compensation plan and over 33 times larger than the plan’s closest comparison, which was Musk’s prior compensation plan.” Any way you look at it, it is a big grant.
The option, which is now fully vested, has 12 vesting tranches. For each tranche to vest, Tesla had to achieve a specified amount of market capitalization and an operational metric. There were several unique aspects to the design of the vesting conditions:
- Metric Choice: The award specified 16 possible operational metrics that could trigger vesting, eight revenue targets and eight adjusted EBITDA (earnings before interest, taxation, depreciation, and amortization) targets. These targets were not tied to specific vesting tranches. Vesting would occur whenever Tesla achieved both a) a market cap target and b) either a revenue or an EBITDA target.
- No Explicit Service Period: Vesting in the award was not contingent on service for an absolute time period. The only service condition was that Musk had to be employed as CEO, Executive Chairman, or Chief Product Officer at the time the performance targets were met. If all the targets were met in a year, the entire award would have vested in a year.
- Market Cap Targets: It is unusual for vesting in equity awards to be tied to market capitalization. The more typical design is to tie vesting to relative total shareholder return. One advantage of market cap over TSR is that market cap is not reduced by share dilution (in fact, issuing more shares can increase a company’s market cap).
History Repeats Itself
Tesla issued a similar grant to Musk in 2012 (for about one-fourth the shares and a fraction of the value of the 2018 grant). The grant vested in ten increments and, as noted in Tesla's 2013 proxy statement, was intended to compensate Musk "over its ten-year term." In 2018, a little more than halfway through that term, almost all but one of the performance conditions had been met, resulting in the need to grant a second option to Musk.
Last year, in 2023, just five years later, the 2018 grant, described in Tesla’s February 2018 proxy statement as “intended to compensate Mr. Musk over its 10-year term” fully vested. Now Musk is again asking for more stock, this time to bring his total ownership stake up to 25% of the company.
The stock option was submitted to Tesla’s shareholders for approval. Tesla held a special shareholder’s meeting so shareholders could vote on the option grant (Musk abstained from voting, as did his brother). One reason Tesla might have asked shareholders to approve the grant could have been to protect against a shareholder lawsuit challenging it. Unfortunately, this didn’t prevent a lawsuit or a ruling in favor of the plaintiff.
At 200 pages, the post-trial opinion is long but actually quite readable. The judge, Delaware Chancery Court Chief Judge Kathaleen St. J. McCormick, is apparently known for including a little flair in her written decisions. Her opinion quotes Star Trek. Here are the key arguments in the ruling.
Business Judgement Rule Does Not Apply
The court ruled that Elon Musk was the controlling shareholder and, consequently, the business judgement rule does not apply. Normally, a grant approved by the company’s board or compensation committee would be protected from legal challenge under the business judgement rule, even in the absence of shareholder approval of the grant. Without the protection of the business judgement rule, the defendants had to prove that the grant was “entirely fair,” both in terms of the process and price (i.e., the value delivered to shareholders in exchange for the grant).
This decision is interesting because Musk doesn’t own a controlling percentage of Tesla’s stock (and didn’t at the time the option was negotiated and granted). The court found Musk to be a controlling shareholder because of his overall influence over the board and the company:
Musk was the paradigmatic ‘Superstar CEO,’ who held some of the most influential corporate positions (CEO, Chair, and founder), enjoyed thick ties with the directors tasked with negotiating on behalf of Tesla, and dominated the process that led to board approval of his compensation plan.
You might expect that a grant approved by shareholders would be immune to legal challenge. However, the court found inadequacies in the disclosures made to shareholders with respect to the grant:
The defendants were unable to prove that the stockholder vote was fully informed because the proxy statement inaccurately described key directors as independent and misleadingly omitted details about the process.
Entire Fairness Standard
The court found that the grant did not meet the fairness standard both in terms of the process and the price, stating that “The process leading to the approval of Musk’s compensation plan was deeply flawed.” These flaws include the following:
- Musk was closely tied, both professionally and personally, to the board members and other individuals negotiating the grant on behalf of Tesla.
- There was little actual negotiation over the grant. The comp committee chair testified that they “were not on different sides of things.”
- Musk controlled the process. He proposed the grant, paused and restarted board discussions of the grant, often made changes to the timeline or terms of the grant prior to board meetings, and board members did not challenge the grant. The post-trial opinion comes to the following conclusion:
Musk launched a self-driving process, recalibrating the speed and direction along the way as he saw fit.
In terms of the price, the court questioned whether the grant was truly necessary to retain or incentivize Musk, given the equity position he already held in Tesla at the time of the grant and his stated commitment to the organization. The court also questioned whether the growth in shareholder value that triggered vesting was a result of the award.
Will Musk Actually Have to Give Back the Grant?
Maybe. Everything I’ve read indicates that the decision is expected to be appealed. It isn’t clear, however, that the appeal will be successful. According to the Washington Post, legal experts say “Musk likely will be forced to return at least some of the stock options …”
What Does This Mean for Your Company?
Well, possibly, not much. The circumstances that led to the court’s decision seem to be, if not entirely unique, at least unusual for a public company. I hope that most public companies have controls in place to ensure both the independence of the directors that serve on their compensation committee and rigor in negotiation of executive grants. But, just in case, here are a few red flags that might indicate that your company is headed down a similar path:
- Grant Size: The opinion notes four times that Musk’s grant constituted the “largest potential compensation plan in the history of public markets.” CEO compensation is an area where being number one might not be ideal; maybe aim a little lower.
- Director Independence: The court found that the directors were not truly independent because of their business and personal relationships with Tesla, Musk, and Musk’s other companies. Consider how cozy the directors who serve on the comp committee are with your CEO. For example, do they regularly vacation together? Do they have other business dealings together? Does the CEO invest in their companies?
- Benchmarking: The post-trial opinion notes that no effort was made to benchmark Musk’s grants against market data. Know how your executive compensation compares to that of their peers. If exec pay packages aren’t aligned with the market, make sure there is a solid rationale for this. The NASPP Advisor article “How to Make Sense of Pay vs. Performance Data” explains how the data in your Pay vs. Performance disclosure can be used to assess the alignment of executive pay with both company performance and the market.
- Stretch Goals: Although Tesla’s management team characterized the performance targets as stretch goals, in the first 10-Q reflecting the grant, the first three operational metrics were considered to be at least 70% likely to be achieved. And, as noted above, the award fully vested within five years of grant. This caused the court to doubt the “stretch” nature of the grant. If your executives regularly achieve better than target performance or earn their awards more quickly than expected, this may signal that the targets are not sufficiently rigorous. The NASPP Advisor article “Taking the Guesswork Out of Setting Vesting Criteria for Financial Metrics” illustrates how statistical modeling can be used to assess the rigor of operational metrics.
The Other Problems with Mega Grants
Wondering what the other problems with mega grants are? Check out the following blog entries:
With this reason, I’m up to six. Four more and I’ll have a Top Ten List for the NASPP Advisor.