May 19, 2024

Reuters BreakingViews: Incentives Play Role in Success of Netflix

The star attractions at Netflix keep winning over new, and sometimes unlikely, fans. But one feature of the movie streaming service’s business model is less well known: the unusual way it offers incentives to its staff. Rivals struggling to compete with the company, which is led by its founder, Reed Hastings, might want to take a peek.

Defying and converting skeptics with innovation has become standard operating practice for Netflix. An additional 3.3 million people subscribed last quarter, bringing the total to 23 million, while operating margins held strong at 14 percent.

A new adversary sounds intimidated. Charlie Ergen, whose Dish Network bought Blockbuster out of bankruptcy, says he does not plan to challenge Netflix on streaming because of its “insurmountable lead.” Even Time Warner’s boss, Jeffrey L. Bewkes, who once likened Netflix to the Albanian Army, changed his tone recently and expressed some admiration for what the $12 billion company had accomplished.

Part of the success may stem from the uncommon way Netflix rewards its people. Employees eligible for stock options can tailor the mix of salary and equity in their compensation packages. The amount of options used to be restricted, but the cap was lifted last year. Mr. Hastings took only about 9 percent of his $5.5 million pay in cash.

Equally unusual is how Netflix doles out options. They are granted monthly instead of annually, as is typical. Given how Netflix shares swing wildly, this makes sense. About a fifth of them are also on loan to short sellers, who think the company is overvalued or the business model is not sustainable.

This can help smooth volatility and reduce some frustration that might discourage managers. To wit, on Nov. 1, the shares were at about $167. A month later they were up to $200. And they opened 2011 at just over $178. Because of the dollar-cost averaging afforded employees, they can worry less about underwater options and more about how to keep Netflix a step ahead of the competition.

Heeding Say on Pay

Companies that ignore say-on-pay votes may pay a hefty price: lawsuits. Shareholders are speaking up on executive compensation with the voice they were given by last year’s financial overhaul legislation. Their advice is not legally binding, but that has not stopped disgruntled investors from calling in lawyers to enforce their views.

The Dodd-Frank Act created say-on-pay to blunt criticism that executives were compensating themselves like rock stars. Beginning on Jan. 21, most public companies had to put pay packages for top officers to an “advisory vote” by shareholders. The law did not change directors’ fiduciary duties, so ignoring a thumbs-down verdict is allowed.

Few boards have faced that option. On Friday, for example, just 27 percent of Goldman Sachs’s shareholders voted against 2010 pay of $18 million for its chief, Lloyd C. Blankfein. At last count, only 12 of more than 350 companies that have held meetings received less than majority support for their executives’ pay. Still, those few could face costly consequences.

A negative vote can lead to bad publicity or the ouster of directors. But for Jacobs Engineering and Beazer Homes, which lost say-on-pay votes this year, it has meant lawsuits against management by major shareholders.

The suits claim the votes were slam-dunk evidence that executive pay was excessive. By not altering pay after the votes, the suits argue, management unjustly enriched itself, breached its duties to shareholders and, in Jacobs’s case, wasted company assets.

These are tough arguments to win. The law generally leaves compensation decisions up to the directors. It is easy to see the reasoning for that. Most shareholders do not pay enough attention to make informed decisions about corporate matters, and some others might have agendas that diverge from the interests of smaller investors.

Still, executive compensation has generally soared, even when profits and share prices have fallen. Many incentives for chief executives are misaligned with shareholder interests. When that perception is wrong, boards should explain why. And when it is not, they are better off heeding shareholder concerns about pay, and adjusting accordingly than squandering more of their owners’ treasure on defending themselves in court.



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