Managing Partner, Pay Governance Japan
In my book Trinity Model of Management, I presented the concept "everyone becomes wealthy together," which is led by management innovations based on a sense of ownership that encourages managers and employees as well as investors holding sufficient amounts of shares in their own companies. In this way, everyone shares the benefits of the innovations in the form of a rise in long-term share prices.
In fact, the most impactful examples of the trinity model of management can be observed in U.S. IT companies, particularly GAFAM (the acronym for U.S. IT firms Google, Apple, Facebook, Amazon, and Microsoft). In Japan, it is not widely known that GAFAM have achieved massive market capitalization, which has resulted in abundant wealth for many employees, thanks to the generous allocation of firm shares to employees (equity incentive), from the rank-and-file employees to managers, who are able to benefit from the creation of the countless innovations.
In Japan, where this arrangement is not a common practice, I often hear complaints of "Why is it that innovative companies like GAFAM do not emerge in Japan?" and "Japan should have created innovations like the iPhone." However, if the huge difference between the equity incentive plans of Japanese and U.S. technology companies is understood, one must realize that the underlying assumptions of those kinds of complaints are irrational and unrealistic.
This article first explains the difference between the Japanese and U.S. compensation systems, which has driven the dramatic reversal of fortunes between Japanese and U.S. companies in terms of market capitalization, after providing readers an understanding of the historical trends in market capitalization across the Pacific and the current gap between the two sides. Furthermore, by describing the compensation philosophy of Google, one of the GAFAM firms, the paper provides tips for how Japanese companies can create innovations and ensure that "everyone becomes wealthy together." Finally, it presents proposals for revising the legal regulations that stand in the way of realizing that concept.
Dramatic Reversal of Fortunes between Japanese and U.S. Companies in Market Capitalization
The U.S. investment conglomerate Berkshire Hathaway's annual general shareholders' meeting, which attracts around 40,000 shareholders in a typical year, and which is known as "Woodstock for Capitalists," was held in an online format in 2021. At the online meeting, Warren Buffet's famous "annual letter to Berkshire Hathaway shareholders" was issued as in usual years, and a large variety of insightful data were also presented.
Figure 1 below shows the global ranking tables of companies in terms of market capitalization in 2020 and in 1989, compiled from reference materials used in the presentation made by Buffet before the shareholders' meeting.
In 2020, Apple was the global No. 1 company in terms of market capitalization at around 200 trillion yen, followed by Saudi Aramco in second place. The third to the sixth positions were occupied by the rest of the GAFAM IT giants. The ranking table highlights the dominant presence in the digital world that GAFAM has gained by rolling out innovative products one after another and by receiving high plaudits from the market.
On the other hand, in the market capitalization ranking table in 1989, Japanese companies occupied six of the top 10 positions. At that time, Industrial Bank of Japan was the global No. 1 company in terms of market capitalization. The rest of the top 10 positions were held by four U.S. companies that were well-known in Japan, namely Exxon, GE, IBM and AT&T.
However, in the 2020 ranking table, there are no Japanese companies among the top 10. Japanese technology companies competing with GAFAM, not to mention the Japanese banks that were sweeping through the global market in the 1980s, failed to make it into the top 10. Unfortunately, even among the top 20, there are no Japanese companies.
This article focuses on the background to the creation of the huge gap in market capitalization and the difference between the compensation systems of Japanese and U.S. companies that have driven the expansion of the gap.
Innovation Driver—A Huge Gap in the Compensation System
In fact, there is a huge difference between the compensation systems of U.S. technology companies, represented by GAFAM, and their Japanese counterparts. More specifically, the gap lies in the scale of equity incentives for executives and employees. Presented below is a comparison between GAFAM and Japanese technology companies in terms of the ratio of the number of shares granted under equity compensation plans in a certain year to the total number of outstanding shares (known as the annual burn rate).
As shown in Figure 2, the average annual burn rate among the five GAFAM firms (in 2019) was 1.36%. This means that in 2019 alone, 1.36% of the total number of outstanding shares in those five companies were granted to the whole of executives and employees.
To give you a real-world sense of this figure, let us translate it into the monetary value. In the case of Apple, the No. 1 global company in terms of market capitalization, the market capitalization was around 100 trillion yen and the burn rate was 0.83% in 2019. This means that in 2019 alone, equity incentives (RSU, or restricted stock units, in this case) worth around 830 billion yen were granted to executives and employees. To help you better understand the significance of the value, let us calculate the per-employee value. Assuming that the number of employees at Apple in 2019 was slightly less than 140,000, the per-employee value of the shares granted, on a simple-average basis, comes to around 6 million yen. At Apple, employees receive equity incentives of this scale in addition to salaries and bonuses (which are already high enough).
That alone is a large sum of compensation, but there is more to the story. The average price of Apple shares, which was about 50 dollars in 2019, rose to about 95 dollars in 2020. If we assume that employees continued to hold shares granted in 2019, the total value of equity incentives, including the increase in the price of granted shares (including unrealized profits), comes to 1.6 trillion yen, or 1.9 times as high as the value of 830 billion yen at the time when the shares were granted. Let us once again calculate the per-employee figure of this value. If we assume the total number of employees in 2019 was slightly over 140,000 people, the per-employee increase in the value of equity incentives (potential capital gains) is around 5.3 million yen (the total value, including the original value of the incentives, comes to 11.30 million yen) on a simple-average basis. In Japan, a storm of controversy arose when a government estimate indicated that if Japanese workers are to secure a peaceful post-retirement life, they must amass savings of at least 20 million yen before retirement in order to augment pension income, but the average Apple employee earned a quarter of that amount just in a single year in the form of capital gains.
Moreover, the estimated value of equity incentives merely takes into consideration the original value of granted shares in 2019 alone and the subsequent capital gains. In fact, GAFAM continues to grant shares at around the abovementioned burn rate year after year, so the actual wealth acquired by employees staying with the companies over the years is presumed to be much greater than the estimate suggests. Some may suspect that the bulk of the wealth created by equity incentives is held by senior managers, but such suspicion is misguided. The number of shares granted to the five most senior executives, including the CEO, at Apple in 2019 accounted for only around 2% of the total number of shares granted in that year (namely a burn rate of around 2%). In other words, around 98% is granted widely to executives below the top level and to rank-and-file employees.
Now, let us look at the situation of Japanese technology companies listed in Figure 2. The average annual burn rate among the companies listed there is 0.074%. That is, the percentage of shares granted to executives and employees at Japanese technology companies is only around one-twentieth of the average rate of 1.36% among GAFAM.
If market capitalization is taken into consideration, the difference across the Pacific can be more easily understood. Sony, a major Japanese technology company whose innovation-focused corporate culture is often compared with Apple's culture in Japan, had a market capitalization of around 7 trillion yen in 2019. The burn rate for Sony, at 0.26%, is unusually high for a Japanese company. Based on these figures, Sony is estimated to have provided equity incentives worth around 6.2 billion yen (Note 1) (calculated on a fair value basis using the Black-Scholes Model because equity incentives take the form of stock options in Sony's case) in 2019. For some people, 6.2 billion yen may appear to be a large sum, but Apple granted shares worth 830 billion yen. Not only is Apple's market capitalization 14 times as large as Sony's, but the former's annual burn rate is also about triple the rate for the latter.
Let us calculate the per-employee value again. As the number of employees at Sony in 2019 was around 110,000 people (not very different from the number at Apple), the per-employee value of shares granted comes to about 60,000 yen. As for the per-employee capital gains on the shares granted, the average price of Sony shares rose from around 5,800 yen in 2019 to around 7,500 yen in 2020, resulting in capital gains of 5.6 billion yen as of the end of 2020. Assuming that the number of employees remained unchanged at 110,000 in 2020, the per-employee capital gains come to about 50,000 yen (Note 2).
In the market capitalization rankings of Japanese companies, Sony was in third place as of April 2021. Sony's market capitalization expanded due to a favorable evaluation of its management innovation and strong business performance, bringing the company up from the previous year's fifth position in the market capitalization rankings. There is no doubt that around 60,000 yen in the average value of shares granted to employees in a single year and around 50,000 in capital gains over the following one year are relatively high among Japanese companies. However, when those figures are compared with the fair value of Apple shares granted to employees, which was around 6 million yen at the time of grant, and the subsequent capital gains of around 5.3 million yen per employee over the following one year, most people would be appalled at the huge gap.
Compensation Philosophy behind U.S. Incentives
In Japan, there are some criticisms against the U.S. brand of capitalism as represented by Milton Friedman's economic doctrine, such as the idea that it "merely provided opportunities to use companies as a means to pursue profits by introducing a compensation system centering on stock options and, unfortunately, by releasing managers from the risk of fiduciary duty violation on the ground that turning managers into shareholders is the path to maximizing shareholders' profits (Note 3). However, does this criticism also apply to GAFAM, which has succeeded in creating long-term value through numerous innovations?
To consider this issue, let us look at the compensation policy (Note 4) of Alphabet (the parent company of Google). The following are the key points of Alphabet's compensation philosophy as disclosed by the company.
(i) Attract and retain the world's best talent
"We offer competitive benefits to promote the health and happiness of our employees, unique perks that make life and work more convenient, design compelling job opportunities aligned with our mission, and create a fun and energizing work environment."
(ii) Support Alphabet's culture of innovation and performance
"We believe in pay for performance. Compensation is tied to performance for all employees who receive more than nominal compensation. The proportion of overall pay tied to performance is higher for employees at more senior levels in the organization."
(iii) Align employee and stockholder interests
"We use equity awards to align employee and stockholder interests. We require our named executive officers and other senior executives to maintain significant holdings of Alphabet stock."
If you look at this compensation philosophy, you will understand that Alphabet's burn rate (2.02%), which is the highest among GAFAM, is directly linked to the competition strategy of attracting the world's best talent, enhancing employee motivation and promoting innovation.
As for technicalities, a transfer restriction period of around three to four years is set for Alphabet's equity incentive plans, so the plans serve as a longer-term incentive compared with annual bonuses. After the lapse of the restriction period, continued holding of a significant number of shares is required under the guidelines for the holding of Alphabet shares in order to strengthen the equity compensation's primary role as a long-term incentive.
A project which is difficult to carry out but, if realized, could have a significant social impact is called a moonshot, in reference to the Apollo program, which led to the first landing of men on the moon. Joseph Schumpeter argued that innovation occurs through discontinuous growth. At U.S. technology companies aiming for discontinuous growth and innovation, equity incentives embody the compensation philosophy that underlies their innovation-oriented competition strategy. If we look across industries in general, it is clear that technology companies emphasize providing a long-term incentive through equity compensation incentive plans compared with other industries. According to ISS, which provides advisory service related to the exercise of voting rights, the cumulative burn rate for the "Software & Services" industry group among the Russell 3000 companies is 9.24%, much higher than the rates for other industries. Naturally, the benefits of the creation of long-term enterprise value are also sufficiently shared with employees.
On the other hand, bonuses linked to annual business plans, which are common at Japanese companies, are not considered to be as important as equity incentives. Incentive plans linked to single-year performance achievement, which assume a performance level similar to the current one, are regarded as a short-term incentive. In the U.S. technology industry, the entrenched consensus is that bonuses linked to short-term performance that assume the continuation of the status quo can in no way function as an incentive for innovation.
Of course, financial motivation is not the only factor that drives human behavior. However, when we look at the huge gap between Japan and the United States in terms of the compensation philosophy and system, we have to wonder whether Japanese companies have sufficient capacity to globally attract, hire, motivate and retain the competent workers necessary for creating significant innovations.
We often hear complaints along the line of "Why was it not Japan that created the iPhone?" However, is it actually possible for Japanese companies to compete against innovation-oriented companies represented by GAFAM without developing the kinds of compensation philosophy and systems that have taken hold in the United States? The gap in the compensation system across the Pacific may be one of the underlying factors that have allowed U.S. companies to pull off the dramatic reversal of fortunes against Japanese companies in terms of market capitalization over the past three decades. The author feels that this fact is paramount. (While we focused our argument exclusively on technology companies in this article for simplicity's sake, the approach of placing emphasis on equity incentives is widespread among other industries as well. That is true with respect to either financial institutions represented by investment banks or consumer goods makers, such as Procter and Gamble.)
Policy Proposals: Implement the "Trinity Model of Management" by Enhancing Equity Incentives
In Japan, since the second half of the 1990s, bans on stocks options, restricted stocks (RS) and restricted stock units (RSU), and performance share units (PSUs) have been lifted one after another under the Ministry of Economy, Trade and Industry's initiative. The tax system has also been revised, while the Corporate Governance Code included equity incentive plans among appropriate incentives for executives. Indeed, equity incentives are increasingly adopted as part of executive compensation. In fiscal year 2019, 86 of the TOPIX100 companies began adopting equity incentives.
Even so, the reality is that there is a huge gap between the annual burn rates for Japanese and U.S. companies. One reason for the gap is that the value of equity incentives for executives is still low in Japan, and another is that the practice of providing equity incentives to employees, which account for most of the burn rate in the United States, has not become at all or sufficiently commonplace in Japan.
The authors present the following three policy proposals in order to realize the concept of "Everyone becomes wealthy together"—presented in The Trinity Model of Management—under which management innovations based on a sense of ownership are promoted by having managers and employees, in addition to investors, hold shares in their companies, so that everyone shares the benefits of the innovations in the form of increasing long-term share prices.
(i) Revise the principle of paying wages in currency (cash)
As is clear from the high level of the annual burn rates for GAFAM, shares represent the most important component of compensation not only for executives but also for employees. However, the principle of paying wages in currency under the Japanese Labor Standards Act is applicable (equity incentives for executives are exempted) to the grant of shares as compensation to employees. When equity incentives are provided to employees, payment must be made in the form of additional cost items, such as voluntary benefits or pension benefits, separately from "wages." We believe that it is urgently necessary to revise and review the Japanese Labor Standards Act in a way that is suited to the changing trends exemplified by the direct competition that Japanese companies face with technology companies such as GAFAM and the global competition for talent.
(ii) Expand the scope of tax qualification
In the case of ordinary-type stock options, when they meet the tax qualification requirements, they are not taxed when the options are exercised but are taxed for the first time for capital gains when the acquired shares have been sold. From the viewpoint of incentivizing employees and promoting corporate growth and innovation, changing the taxation rules to expand the scope of eligibility to restricted stocks is considered to be an effective measure.
Under the current income taxation rules, restricted stocks are subject to income tax when the restriction has lapsed, so it is difficult to continue to hold them for an extended period of time. If the taxation rules are changed to expand the scope of eligibility, that would give an incentive for holders of restricted stocks to continue to maintain some of their holdings instead of selling off all holdings once the restriction lapses in order to make tax payments and meet their own financial needs.
(iii) Revise regulations on the introduction of equity incentives under the Companies Act and the Financial Instruments and Exchange Act
As a result of the recent amendment of the Companies Act, it has become possible to grant shares as direct compensation without transfer of monetary claims. However, this method of compensation is applicable only to directors and executive officers, with employees excluded. When providing equity incentives to executives and employees, companies may be able to choose the method of not using monetary claims for payment to executives, but obstacles remain because transfer of monetary claims is still the only basis for payment to employees.
In addition, when companies provide new equity incentives to employees at the time of recruitment or promotion in addition to the periodic provision of incentives (e.g., in the July bonus period), they are required to submit a securities registration statement, or a securities notification and a statutory public notice (in cases where the value is less than 100 million yen) on each such occasion, but it is both extremely cumbersome to follow this procedure and to exercise flexibility in providing incentives.
As a result of the amendment in 2019, regarding the issuance of restricted stocks, companies can meet the abovementioned reporting requirement by submitting an extraordinary report (in cases where the total issuance value is 100 million yen or higher). However, during the restriction period, some obstacles still remain. For example, companies may have no option but to submit a securities report (in cases where the value is less than 100 million yen) when it is not possible to design equity incentive plans in accordance with the standard practice of lifting the restriction regarding incentive recipients who have terminated their employment contract without incident during the restriction period.
We hope that the regulatory authorities will study the design of equity incentives plans, which are quite commonplace in the United States and Europe and will examine the burdens and obstacles present for companies when they actually implement such plans so that they can promptly revise the legal regulations.
Akio Morita, the co-founder of Sony, which we compared with Apple in this article, contributed an article titled "My Argument for Expelling Idle Executives" to the July 1964 issue of the Bungei Shunju magazine. In the article, he stated the following: "It is about to be tested on the global stage whether Japanese companies are really competitive internationally and have sufficient capabilities to survive the harsh winds of the free economy world. I believe that what individual Japanese companies should do first of all in order to become winners in international competition is to reconsider fundamental matters such as the corporate organization and the approach to work."
A long time has passed since global firms became competitors to Japanese companies, particularly technology companies for which innovation is essential. Global firms have developed organizations that are suited to attracting, hiring, motivating and retaining competent workers from around the world and established a fundamental approach of sharing incentives for innovation and growth with employees.
For Japanese companies as well, "the urgency of the necessity to develop such organizations and systems is obvious (as Morita also argued). Of course, it goes without saying that it is important to develop the system in a way that will expand the implementation of equity incentive plans at the same time as cultivating a compensation philosophy that is oriented toward innovation creation, which underlies the system.
^ As most equity incentives are provided in the form of stock options, we calculated the fair value using the Black Scholes model with a volatility rate of 33%.
^ As Sony's share price was higher than 10,000 yen as of May 2021, reflecting the company's strong business performance, realized profits increased. Unlike Apple, Sony has manufacturing divisions, and therefore, it is conceivable that the number of employees covered by the Japanese company's equity incentive plans is significantly different. It should be kept in mind that this difference is the reason for the different numbers indicated in this article for capital gains and the per-employee values of equity incentives provided by the two companies.
^ IWAI Katsuhito, distinguished professor, International Christian University, "Reflections at Critical Historical Junctures (1) Capitalism in Japan—Time for Reconstruction," Nihon Keizai Shimbun, January 4, 2018