Introducing shadow equity: a fresh idea to escape the low wage trap

This is the second in a three-part mini-symposium on Wages, Unemployment and Underemployment presented by The Conversation and the Academy of the Social Sciences in Australia. Read the other pieces in the series here.

For the past half-decade Australian wages have barely moved after adjusting for inflation.

In the United States the picture is far bleaker — the real wages of average workers have changed little in 40 years.

Not so for US chief executives.

In 1965 the heads of America’s 350 biggest companies earned 20 times what the average worker did. By 2017 they earned 312 times as much.

As is often the case, things aren’t quite as extreme in Australia, but the pattern is similar. In 2017 the heads of the 100 biggest ASX-listed companies earned an average of A$4.75 million – roughly 78 times as much as the average worker.

They get the bulk of their income not from their salaries, but from stock options or payments tied to the share price of the companies they run.

It at least raises the possibility than one way to get pay to rise for average workers is to structure their pay a little more like that of chief executives.

There are upsides to paying workers in shares…

Paying workers in the stock of the company would not affect the day-to-day profitability of the company. It would just mean the shareholders owned a bit less of the company.

That might not sound like an important distinction, but the everyday costs —- of which wages and salaries can be a big part -— help determine how competitive a firm is compared to its rivals. Paying workers in stock could give firms a strategic advantage.

It could also better align their interests with those of senior management and shareholders. It could reduce intra-firm conflict about wages, benefits and employment terms.

One manifestation occurs when executives receive large payouts from stock options while “ordinary workers” are facing redundancies or pay cuts.

Giving workers a slice of the same type —- if not the same level -— of compensation could help reduce this conflict.

…and downsides

If the idea was perfect, we would go to the extreme and pay workers exclusively in stock.

We wouldn’t, in part because equity-based compensation imposes risk on workers, as workers employed by firms whose share price is falling know well.

A basic principle of contract theory – the field that gave rise to the 2016 Nobel Prize in Economic Sciences for its creators Oliver Hart and Bengt Holmstrom – is that if a compensation contract imposes more risk on an employee than wages, it’ll need to be larger than wages on average to make up for the additional risk. It would cost the firm more.

And it would encourage workers to put most of their investment eggs in one basket (the same basket that employs them), which is always a bad idea.

Despite appearances, for many or even most, it woudln’t link their efforts to their compensation. Stock price movements often have little to do with the efforts of paper-shufflers or cleaners. Another key principle of contract theory is that it is suboptimal to reward workers for luck.

Shadow equity might be better

New developments in blockchain technology offer a way to link the efforts of employees to an equity-like security —- or what one might call “shadow equity”.

Initial Coin Offerings are used in the US as an alternative to venture capital. They involve creating a digital currency that is linked to performance but not to share price.

They can be used to invest in or bet on specific components of a company. Take the pharmaceutical giant Pfizer. It has a whole portfolio of drugs. Buying stock in Pfizer is a bet on its entire portfolio. But suppose Pfizer issues, say, 1 million Xtandi tokens to help it develop the colon cancer drug Xtandi. Suppose it also agrees that all future purchases of Xtandi will have to be done with those tokens. That would link the aggregate value of those tokens to the value of revenue from the drug.

An investor who bought those tokens would be betting on a specific part of Pfizer’s portfolio.

The idea could be extended to traded securities tied to a granular level of performance within an organisation. It wouldn’t mean it was possible to have securities in the impact of single worker (expect perhaps for superstars such as actors or recording artists) – but it would be conceivable to have such securities for divisions of companies, or even teams within divisions.

How could it work?

It will take time for these technological developments to play out, but there are steps we could take to hasten it. One would be increased tax deductibility for equity-based compensation.

We are not suggesting workers’ pay be cut to allow equity-based compensation, or that it not rise to keep up with the cost of living. But as extra pay rises happen from time to time, they could be offered in the form of shadow equity.

It would mean workers would be paid (at least in part) the same way as executives. And it might start to reverse the trend of rising executive to worker pay ratios.

The Academy of the Social Sciences in Australia is one of Australia’s four learned academies. The ASSA coordinates the promotion of research, teaching and advice in the social sciences, promotes scholarly cooperation across disciplines, comments on national needs and priorities in the social sciences, and provides advice to government on issues of national importance.