Tesla's $26 Billion Challenge: How Elon Musk's Pay Package Could Consume Years of Profits

Elon Musk's 2022 stock options were valued at $56 billion, but today they've appreciated to $116 billion.

While Tesla's proposed $1 trillion compensation package for CEO Elon Musk has captured headlines, a more immediate financial concern looms: the fate of Musk's 2018 pay package could substantially impact the company's future profitability.

The Delaware Supreme Court will soon rule on whether to overturn a lower court's decision invalidating Musk's previous compensation arrangement. Should Tesla's appeal fail, the company faces a potential $26 billion reduction in profits over two years to account for Musk's replacement compensation package at today's elevated stock price.

To put this in perspective, $26 billion represents more than half of Tesla's total net income since it first achieved profitability in 2019.

Even if Tesla wins its legal battle, future profits could still be significantly compressed over the next decade if Musk achieves performance targets in his trillion-dollar package, with each milestone triggering billions in payouts and corresponding accounting expenses.

The extraordinary profit impact highlights the unprecedented risks associated with Musk's outsized compensation. Most major corporations rarely worry about CEO pay affecting their bottom line, as typical executive packages are measured in hundreds of millions rather than billions.

Musk's exponentially larger compensation creates unique financial uncertainties for Tesla during a period when earnings are already declining due to falling vehicle sales, disappearing electric vehicle incentives, and increasing investments in speculative ventures like humanoid robots.

While stock-compensation expenses won't affect cash flow, and some investors may dismiss it as merely an accounting issue, Brian Dunn, director of Cornell University's Institute for Compensation Studies, notes that significant net income reductions from CEO compensation indicate Tesla's board isn't following "reasonable fiduciary practices."

"They're backdooring a massive transfer of wealth from the shareholders to the single largest shareholder," Dunn explained.

Tesla's board has defended Musk's newest compensation package, arguing it provides him with benefits only if the company achieves "Mars-shot milestones" including ambitious profit targets. If Tesla reaches these higher profit goals, Musk's compensation would consume a smaller proportion of earnings.

However, even the most attainable goals in Musk's package could trigger tens of billions in payouts without fundamentally transforming Tesla's business or profitability, as Reuters has reported. The maximum potential payout to Musk is $878 billion, as the $1 trillion stock award would be reduced by the share value when Tesla's board approved the package in September.

Neither Tesla's board nor Musk responded to Reuters' comment requests.

The immediate financial risk hinges on the upcoming court decision regarding Musk's 2018 compensation. Last year, a Delaware judge invalidated the package, ruling in a shareholder lawsuit that negotiations were compromised by Tesla board members' excessive compensation and close personal connections to the CEO.

If the Delaware Supreme Court sides with Tesla, Musk would retain his stock options from the 2018 package, and the company would incur no additional accounting expenses. By the time he met the plan's performance targets in 2022, those stock options were valued at $56 billion and have since appreciated to $116 billion.

Should the original ruling be upheld, Musk's replacement package would provide fewer shares but would cost Tesla's balance sheet significantly more than the original $2.3 billion valuation of the 2018 package due to Tesla's much higher current stock price.

The replacement package would be valued at $26 billion based on the stock price when the board approved it in August. Tesla would need to record this charge by August 2027, when Musk becomes eligible to receive the shares.

Distributing the $26 billion across eight quarters would reduce quarterly profits by $3.25 billion – exceeding Tesla's net income for all but four of the last 25 quarters since 2019.

In its filing, Tesla disclosed that an unsuccessful appeal could cause "a material adverse impact on our business and reported earnings." The board has argued that failing to replace the 2018 package might prompt Musk to leave the company.

While Tesla won't need to pay cash for the stock – it can simply issue new shares – accounting rules require recording stock compensation as an expense since the company could have sold those shares in the open market, according to corporate accounting experts.

Such stock transactions dilute other shareholders' voting power by reducing their proportional ownership stake as the total share pool expands with more shares allocated to the CEO.

"Without question, you are hurting the shareholders," said Schuyler Moore, an attorney specializing in corporate financing and tax law at Los Angeles firm Greenberg Glusker.

Typically, Moore noted, such a substantial profit reduction would cause investors to devalue a company for "running at a loss." However, traditional financial metrics have historically had minimal impact on Tesla's market valuation, which is primarily based on Musk's promises of future products like self-driving robotaxis and humanoid robots.

Regarding Tesla, Moore observed, "nobody seems to care, because this company is in fantasy-land."