Last week we tuned into a free presentation by the Small-Cap Institute, hosted by David Scher and Adam Epstein. Small-cap Institute's mission is to provide unbiased capital markets insight to small-cap executives and directors, so that they are more effective in their roles as leaders of public companies. To join, you must be an officer or director of a public company, though you can join their general email list here.
Small-Cap Institute: 7 Valuation-Killing Small-Cap Boardroom Mistakes
Below are some of the key concepts and take-aways, (transcribed by SCD) from the presentation, which should aid any investor’s due diligence on how to examine a company’s corporate governance practices.
Introduction The majority of CEO's we meet, think of corporate governance as a form of wasted substance over time, or more applicable to larger companies. However, there's a reason large fund manager’s such as BlackRock and CalPERS have floors full of people analyzing the corporate governance in their portfolio companies. It’s true to say that, better governed companies make more money. Should that matter to small-cap companies or does it even apply? It clearly does, since more and more of today’s money flow comes from these large institutions and fund managers, and if they are focused on it, you as an investor should be too.
The 7 valuation-killing small-cap boardroom mistakes (from least to most important): 7. Serial capital-raising companies that lack board members with material, recent and relevant capital markets experience. A Board of Directors that lacks capital markets experience, usually results in poor performance for the shareholders. Think about it, it’s not like the Board of Directors receives a report card when they raise capital, so who’s going to tell them that a recent financing was done at horrendous terms? While new investors are high fiving over the cheap opportunity, the bankers don't have any vested interest, nor do the brokers to tell the Board the terms are horrendous for current shareholders, which means, no one’s going to tell them. It’s needlessly dilutive. These mistakes can be avoided by filling these gaps and adding fund raising skills to your board.
6. Executives and Board compensation that is unhinged from reality. Investors are wise to companies that use 'aspirational' vs 'real' executive compensation. What we mean is that investors are aware when Executives and Boards are overly compensated. We suggest reviewing the peer groups for compensation and scrutinize. Is comparably company X or Y a current comparable today? Or is the comparable company something they hope to be in 3-4 years from today? If its something they hope to be, why should the compensation be the same? There’s a reason that greater than 80% of shareholder activism is in small-cap companies and executive compensation is a key-part of shareholder activism. If your company is the worst performing company when compared to its peers, then investors are going to think that the board should be the least compensated. Most large cap companies have instituted stock ownership guidelines for the Board of Directors. If large cap companies are doing it, why shouldn’t small-cap companies? The rationale is simple. When officers and directors own stock, in which they use after tax dollars to purchase shares in the open market, their interests are aligned with shareholders and have a better long-term focus for the company. It’s simple because that’s the only way investors can buy the stock. Some ideas we’ve seen for ownership guidelines are using benchmarks such as 3x annual cash retainers, where the Board members have 3-5 years to comply with the ownership guidelines. Of course, there’s hardship clauses to protect against the unpredictable. We get asked this often, “do institutional investors view stock options as skin in the game?”. The answer is a resounding, No.
5. Boards that decline to meet directly with investors. A newer trend is that with Fortune 1000 companies, it’s now common that boards meet with investors. The function of a Board is to protect shareholders interests, establish policies for management and oversight of the corporation. Thereby, Board members are elected by the shareholder to oversee on the behalf of all shareholders. Therefore, there should be no question, under appropriate circumstances, that Board members meet with investors. In addition, it helps the Board members to stay informed by connecting with shareholder and investors as opposed to hearing about the company they oversee from the C-suite or management.
4. Boards that assume that management are appropriately expert at interfacing with the street.
Many small-cap CEO's are shepherding a public company for the first time. It's impossible for anyone to make up for experience that they don't have. The facts can’t be ignored, the scorecards, which are used as a tool to evaluate management, most often don’t include a grade for CEO’s who have little to no experience interacting with institutions, analysts, investment bankers and investor relations. These CEO’s may have been successful in private companies, but if they don’t have capital markets experience, they must be considered capital markets novices – full stop. By adding a Board member with actual capital markets experience and vested interest in the company, the company can dramatically improve its communication with the street. If you are a Board member, a few examples in which you can review the scorecard of your current CEO is by attending and reviewing them perform at a conference, a one-on-one meeting with an investor or a meeting with a sell-side research analyst. Here are a few of the key mistakes CEO’s make; under promise and overdeliver, speak miles over and above an investor, the story is deficient, violate regulations by telling inside information, and wrongfully believe that analysts with recommendations are friends of the company. All of these can be incredibly value destructive for any company. If a company had a board member with the relevant experience, he or she, could ferret out and fix these issues as they arise and address them moving forward so the company can have more positive interactions with the street.
3. Boards that don't objectively assess what management are recommending. Board members need to trust but verify the actions or inactions and suggestions from the Board to management, and all boards need rigorous boardroom debate. If the Board get's 100% information from management, they are not thinking or acting independently. Great independent boards do their own research, then connect with other independent board members both with and without the CEO present. This is super important in small-cap companies given the limited CEO experience. To restate it, Board members need to trust, but independently verify management.
2. Boards that don't benchmark strategic failure to avoid wasteful capital allocation. Have you ever lost a fortune due to poor capital allocation? It’s the silent killer of small-cap companies. Capital allocation is rarely reckless or malevolent, but as an example goes something like this: Management is working on generation 2.0 of their hardware chip, which has the potential to be highly successful, but technology development is not linear and despite the company’s great expectations, falls behind schedules. Engineers present to the board and the CEO makes the case to the Board that if the company had access to XYZ dollars it could catch-up to the production schedule while also improving on the technology. Another 1-2 meetings occur over the next 1-4 quarters where the company ends up further over budget and even further behind the original schedule. It’s good money, being thrown after bad. This doesn't happen as often with great boards, because great boards benchmark failure for a product. When a great Board is overseeing the corporation here’s an example of how the capital allocations looks like: When management fails to deliver on generation 2.0 of their hardware chip by not meeting both the funding or delivery date, funding is shut-off, or released thereafter in smaller tranches with milestones attached. Benchmarking success is easy, but what’s more important for capital starved small-cap companies is benchmarking failures. It’s simple, if a company doesn’t use growth capital wisely, they don’t get any more of it. Or in the future the company has more penal terms based on their history of poor capital allocation and waste. Outside investment also recognizes the wasteful capital allocation and discounts appropriately.
1. Boards that are comprised of the CEO's friends and family. In other words, boards designed to be "oversight-lite". The agency objective meant to be fulfilled by the Board of Directors is hard to oversee when it’s friends and family. There’s always going to be some version of oversight-lite, but inversely many CEO’s install a Board of Directors for exactly this reason Seasoned investors are skeptical to others outside the CEO, for example, investors have learned the hard way that small-cap boards should avoid large cap executives and celebrities. Board members should be nominated based on the recommendation from the independent nomination committee and shareholders ratify them. It’s the independent directors’ duty to nominate the slate for shareholder election. While CEO's can have insights and suggestions for Board members, CEO’s should not be in the director picking business. To recap Sophisticated investors want to see highly engaged, proactive, fiercely objective, experts in business, capital markets and risk and opportunity assessment. The more lacking your company is of these attributes the greater the likelihood an investor will believe they won't make any money investing in this company. The folks who manage trillions of dollars are 100% right, and smart small-cap investors know they are right in that, better governed companies make more money. To your wealth, Paul & Brandon
| 
