Eli5: How do CEOs from failing companies bail out with golden parachutes? Where does the money come from?
In: Economics
Answer: Departure compensation is usually in their employment contract or inserted by the board, as a retention agreement, before a transaction, expansion, or closure occurs.
Investors, lenders, acquiring companies, and employees each have different reasons for wanting executive continuity during tumultuous times.
The funding can come from a number of places, including free cash, cash reserves, transaction proceeds, or debt notes.
the company still has money. Even companies “in the red” have money, they just also have debts that exceeds the amount of money they have made. But that doesnt mean they stop paying employee benefits, even if that is the severance package for the CEO. They keep trying to honor their obligations until they cant.
CEOs may sign on to a company with a guarantee that they’ll be compensated well even in the event of a company failure.
Think of it this way: you believe you’re very good at your job. You get a good and interesting job offer from Company A to have an important role, but that company is not doing so hot. You get another job offer from company B, and it’s doing great. Both companies will you pay you the same amount.
Company A is a huge risk to your career and finances. You could spend years taking a risk there and never see a compensation increase if you can’t turn the ship around.
Meanwhile, company B is on the up-and-up, you’re almost guaranteed that if you join, the company will continue to grow well and your career and personal brand will grow as well.
So, how does company A get you, a good CEO to join? They eliminate a large part of the risk by offering you a deal that says if the company doesn’t do well, you’ll still be paid well, because you took the _risk_ of joining (or sticking around).
Now, you’re much more likely to join company A.
A struggling company usually still have money. If they’re still making some money, they’re not insolvent, Even if they have more debt than revenue. As long as they’re still able to make their scheduled debt payments, they still have money. Now, struggling could mean their revenue is unable to cover any expenses or debt. Or revenue ceases, and they only have cash in savings. Then, they’ll file for bankruptcy. Bankruptcy protects certain assets from debt obligations. However, it doesn’t protect them from certain expense obligations. The expense obligations include wages, benefits, and severance.
So to pay severance to the CEOs, it could come from diminishing revenue, current cash on hand, selling off assets, or another company buying them out.
Its like when a sports coach is fired. Their compensation was already in the contract before they started. So it was already decided (added as a way to get them to sign) when they came on board.
Failing is not dead. Chapter 7 bankruptcy is different than chapter 11.
Chapter 11 is a reorganization where the firm still runs in order to pay off debts.
The bond holders, whose debt it is, doesn’t want a clown show, or people actively sabotaging them. So they will pay the people at the top to do stuff they don’t want to do, like fire a bunch of people and take the blame for the failure, and in return, the people at the top agree to stay and not make things worse.
Here’s what a bankrupt company looks like:
It has $100m of assets and $200m of debt. That debt requires them to pay $5m a month in interest. Over time the company has been slowing running short of cash and so now it no longer has cash to make the interest payments. This triggers a default on the debt, making it immediately payable in full. So the company files Chapter 11.
[Important to note: Generally a company in Chapter 11 is cash flow positive – or could be if restructured – without the interest expense. The purpose of Chapter 11 is to restructure the debt / operations of the company to try to make it profitable.]
Chapter 11 in this situation generally results in the creditors taking over the business. But it takes a while to settle on what the business is worth, and which creditors get what.
To keep the company running during the bankruptcy process, the company will generally get a debtor-in-possession (“DIP”) loan. This loan has super priority and will be paid off first when the company emerges from bankruptcy.
The DIP financing (and possibly positive cash flow from operations sans interest expense) is where the money comes from to pay for things like executive compensation, as well as the various expenses incurred in the bankruptcy process. And ultimately, the cost is borne by the creditors. They’re now the owners now and they have to pay off the DIP loan when they take over.
It’s in their contract before they ever sign. Why would you take on a highly visible and stressful role without ensuring your come out ok either way.
These companies buy insurance policies to fund the events. Much cheaper than using cash on hand.
To highlight an important detail that these other answers touch on, related to “where does the money come from”.
Because the CEO parachute is specified in a contract, it is a liability that becomes a debt once the contract is triggered.
Even a bankrupt company tries to pay all its debts, and some of the debts have higher or lower priority (i.e. the company is obligated to pay debt X before it pays debt Y). A savvy CEO will ensure that their debt has high priority. Eg. it is in preferred stock, or some other type of debt that gets paid out before common stockholders and regular employees.
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