Why Did the Tesla Board Attempt to 'Ratify' Musk's Obscene Options Package Instead of Granting a New One?

Legally, the only clear course was to create a new stock options grant for Musk. Yet the Tesla board is trying to revive the old one. Let's explore why.

[Preliminary Note: there has been lots of action in the Tornetta v. Musk case since the Chancellor’s January 30 ruling rescinding the 2018 options grant to Elon Musk. I intend, within the next few days, to write a post detailing the latest developments.]

I write again about the Tornetta v. Musk decision in January that voided the 2018 compensation package granted to Elon Musk, and about the Tesla board’s attempt to undo the result. For those just joining our program, you can read my thoughts about the Tornetta decision here and here, and about the board’s restoration effort here and here.

Why Do It the Hard Way?

My focus in this post is not the massive breach of fiduciary duty inherent in the effort. I have discussed that before, and may yet do so again.

(cover photo from the Walter Isaacson hagiography)

Rather, my focus is on the question of why the Tesla board chose to attempt a “ratification” of the 2018 package rather than starting from scratch with a new grant. After all, the ratification effort has some painfully obvious problems:

• The effort relies on Section 204 of the Delaware General Corporation Law, which, with its instructions on how to cure a “corporate act” that is “defective” by reason of “a failure of authorization,” appears designed to correct technical problems with statutory authorization rather than to cure breaches of fiduciary duty. If the ratification effort is challenged with an assertion that Section 204 is inapplicable, then, at the very least, some new law will need to be made if Tesla’s effort is to be accommodated. (And, lo and behold, after writing this, I discover that the formidable Professor Charles Elson, whose work is cited in the January 30 Tornetta decision, agrees wholeheartedly, as detailed in his very powerful proposed amicus brief filed on May 13.)

• As Professor Ann Lipton pointed out in a blog post published the day after Tesla’s April 17 proxy statement was released, Delaware law (with exceptions not here relevant) does not permit the award of compensation as a reward for past work that has already been accomplished. So, restoring the 2018 award would fall into the legal category of “waste,” which can be ratified only by a unanimous shareholder vote. (Professor Elson’s amicus brief also discusses this law, and he agrees.)

• In April, the Delaware Supreme Court handed down its decision in In re Match Group, Inc. Derivative Litigation. That decision would appear to require that the award granted to Musk be made by a truly independent committee, undertaking genuine negotiations, and guided by outside consultants. At least two of those elements (and, I would argue, all three) are absent here. (Professor Elson’s amicus brief has something supportive to say about this, as well.)

• The April 17 proxy statement may itself be materially misleading by omitting to disclose that Tesla and Musk are under criminal investigation related to autonomous driving claims and by omitting crucial facts about the Tesla stock owned by director Kathleen Wilson-Thompson. (No support yet from academia or the plaintiff’s lawyers on this point, but I’ll go it alone.)

So, why engage in an effort attended by all these risks with the certitude of a legal challenge (which quickly came) from plaintiff Richard J. Tornetta, acting on behalf of Tesla in the “derivative” litigation? (Tornetta still awaits a decision on attorneys’ fees — he is seeking a small percentage of the 304 million shares that, thanks to his lawsuit, Tesla will not be issuing to Musk.)

And why choose the ratification strategy when any legal challenge will be decided in the very Delaware Court of Chancery that took such pains to spell out in its 200-page opinion just how thoroughly tainted and unreasonable the original award was?

I think there are two clear answers, one for Tesla and one for Musk.

How the 2018 Sausage Was Made

For Tesla, granting Musk a brand new compensation package that matched the 2018 award would assure that the company would show massive losses for many years to come. And for Musk, such a package would create targets that would be all but impossible to achieve.

When the 2018 compensation plan was awarded, each of the stock options in the 12 tranches had a strike price of $305.02, which was the closing price of a Tesla share on January 19, 2018. (Adjusting for the two subsequent stock splits, the strike price is $23.33.) Assuming all milestones were achieved, the resulting $650 billion market capitalization meant that the award had a maximum value of $55.8 billion.

Tesla would have to reflect the compensation expense in its income statement. So, was it required to show a $55.8 billion expense? No, nothing close to that, because the stock options compensation consulting industry has several ways to beat that number down with various discounts.

First, there is the discount for uncertainty. At the outset of the plan, there were various degrees of doubt that all of the milestones could be achieved within the 10-year tenure of the compensation package. The earlier and smaller milestones were the most probable, and the probability decreased as the hurdles became taller. (Tesla’s compensation consultant used so-called Monte Carlo simulations to estimate the probability of hitting the various milestones. It’s evident from the Tornetta opinion that the data with which such simulations were run was shockingly incomplete, with the result that a larger discount was achieved.)

The issue is not merely the size of the discount, but also the timing of when Tesla would have to begin recording the expense. If the milestones were purely market capitalization targets, then Tesla would have to begin booking the expense on the date of the grant. However, if there were both market and performance conditions, then under GAAP rules, then Tesla could defer recording any expense for any of the 12 grants until the the probability of its achievement exceeded 70%. It was for this reason that Tesla’s then Chief Financial Officer, Deepak Ahuja, insisted on combining the market capitalization milestones with operational milestones.

(The Tesla board ultimately selected revenue and adjusted EBITDA for its operational metrics. It set revenue targets that were absurdly low in comparison with the market capitalization targets, and then made achievement even easier by calculating the adjusted EBITDA target as a very low 8% of revenues. But that’s another story.)

Another highly useful way to reduce the expense to Tesla was by creating a holding period during which any of the stock earned could not be sold. Tesla settled on a five-year holding period, which resulted in a further “illiquidity” discount.

By the time the sausage had finally been made, the grant’s $55.8 billion potential value had been beaten down to a maximum income statement expense of $2.6 billion. Now, there was some compensation consulting work worth every penny, as it most assuredly allowed Tesla to report far higher earnings than would have been the case with a more sober cost analysis. (But that, too, is another story.)

Tesla Can’t Afford the Earnings Hit from a New Award

The important point here is that what was possible in 2018 — achieving a relatively low stock-based compensation expense for the grant of options to Musk — is no longer possible. As I write this (on May 13), Tesla’s share price is more than seven times greater than the split-adjusted price at the time of the January 2018 grant.

Were Tesla’s board to award Musk a new option package (rather than attempting to revive the one from 2018 ), Tesla would face the obvious problem of a truly massive compensation expense. Even with the most heroic efforts of a compensation consultant, such an expense would be certain not only to wipe out any earnings for years to come, but also to put the income statement deep into the red.

Musk Knows a New Award Would Yield Him Nothing

Or, more accurately, the expense would put Tesla permanently in the red if, but only if, any of the options ever were earned.

Which brings us to the second problem with creating a new incentive option package: the prospects for further dramatic increases in Tesla’s share price (and, hence, its market capitalization) have all but evaporated. The opposite seems more likely: a continuation of the price declines that have seen the share price whittled down from almost $410 on November 4, 2021, to less than half that today (indeed, a few weeks ago, the price approached one-third of the all-time high).

The grinding decline is no surprise. The growth story is over. It’s now a shrinkage story. Musk is desperate, and rolling the dice on his latest “robotaxi” gambit.

Consequently,, Musk does not want a new package. He cannot replicate the stock pumping feats that he performed for the 2018 version. Therefore, even if it’s a dangerous choice, already facing legal challenges from Tornetta and all but certain ultimately to fail, the ratification effort is Tesla’s only choice if its board of directors is determined to give in to the petulant demands for a massive additional stock grant from its man-child CEO.

The Ratification Gambit Is Also a Tax Avoidance Scheme

[I am adding this section on May 14 based on this comment below from Keubiko, who has a superb Substack called Keubiko’s Musings that I highly recommend:

I think there would also be a huge tax issue for Musk in granting new in-the-money stock options. If I recall they would not by qualifying and would ultimately be taxed as normal income vs capital gains.

Keubiko is exactly right. Tesla could make a new award to Musk of in-the-money stock options in an attempt to give him the same financial benefit as the 2018 package. But this would have the same downside to Tesla noted earlier — massive compensation expense for years to come.

Moreover, because Musk’s stock option plan is “non-qualifying” (a consequence of owning more than 10% of Tesla), his options would be taxed at ordinary income rates upon exercise, and then again at capital gains rates upon sale. Even worse, while I’m no tax expert, my understanding is that the difference between the value of the options and their fair market value would be taxable even at the time of their receipt.

So, in effect, the ratification effort is not merely an effort by Tesla to dance around inconvenient accounting truths, it is also an audacious effort by Musk to engage in income tax avoidance.

Tesla’s Board & Its CEO: A Match Made in Hell

Only a board of directors completely beholden to its CEO, and utterly bereft of any ethical compass to steer it toward its fiduciary duties to its shareholders, would ever have attempted a stunt like the one outlined in the proxy statement for the June 13 annual meeting. But that is exactly the board of directors with which Tesla shareholders, thanks to Elon Musk, are saddled. Good luck with all that.

{Post-publication note on May 14: the original post made an error in calculating the split-adjusted strike price. Thank you to @howardoark at Threads for pointing this out.]