Aligning senior execs with shareholders
One of the adages of venture capital is ensuring that the team you are investing with is aligned with you financially. A key metric, naturally, is the team’s stake in the company that you are investing in.
With the rampant secondary transactions of late, this is a hot topic (see prior posts, such as “Has the deal of the year become a nightmare?” June 25-07). Some founders are even proposing secondary transactions to coincide with their first VC round, before they’ve recognized their first revenue dollar; doesn’t that bring back memories of 1999? But that’s a topic for another time.
Private company managers earn their equity in a simple fashion: found the company, hive off some of the share capital for employee options, sell some via a “friends and family” round to get things started. Whatever dilution that follows is a result of angel and venture investors. Occassionally, we see senior managers investing real cash in a round, and several of our existing and former portfolio companies are examples of this. We don’t normally require it, but many VCs (and certainly merchant banks) are starting to make it a facet of their term sheets.
But, what of the public companies? Is there a different standard, and if so, why?
There are four main ways for management to acquire shares of their public company: to receive them from an acquisition of their prior firm, to receive/acquire them via a share ownership or deferred profit sharing plan, exercising stock options, and the old fashioned way: buying in the market.
Starting with the last and most unusual: Buying in the market, of course, is a simple and commendable way for a manager to align him/herself with other shareholders. Money that could have been diverted to other useful places has been invested in the open market. That’s a genuine path to share ownership.
In the first example, the executive of the acquired company may or may not have invested cash in their original company, but let’s assume that in many cases, that individual had choices and decided to receive part of their proceeds in stock. That’s also a genuine path to share ownership.
The share ownership that flows from DSU plans is not nearly as pristine a path to share ownership, although the plans can have merit. Some plans are a bit like “free money”: Invest $1 and we’ll match that with a stock gift of $2, for example. Every manager and employee makes that bet to the maximum amount, if they can afford it. DSUs are popular as well, as many plans provide for tax-free growth of the security: let’s say you received a chunk of a bonus in a stock ownership plan. Rather than take a cash bonus and buy shares in the market after-tax, these plans generally allow you to invest that sum on a pre-tax basis, with no tax being paid until the ultimate sale. Who wouldn’t want their bonus + savings to grow on a pretax basis? Again, the choice is a bit like free money for the executive as deferred bonuses represent – in theory – funds that didn’t need to be paid at the time to retain the executive in your organization.
Owning via stock option exercise is potentially appealing to other shareholders as the employee in question had to pay the exercise price to get the underlying share (unless those options were priced a a penny, for example). Moreover, while the executive may choose to not sell the position to avoid capital gains tax, at least the implied gain is real capital at risk, even if the original position was subscribed for knowing that the option was deeply in-the-money; this is why most people never exercise in-the-money stock options. Although not as perfect as open market purchases, it still aligns the exec with the shareholders.
Across the landscape, there are many examples of senior executives that own decent sized stakes in their companies, and a few who don’t. Here is a medley of each (information taken from the most recent management information circular), and I’ve tried to avoid execs that joined their company very recently:
Bob Brown, CEO of CAE, 192,000 shares worth over $2.5 million
Phil Deck, Chairman and CEO, MKS Inc. (on our advisory council); ~5 million shares (9.8% ownership stake) worth over $7.5 million
Daniel E. Friedmann, President and Chief Executive Officer, MDA; 65,000 shares worth over $2.5 million
Michael Sabia, CEO of BCE; 134,000 shares worth over $5 million
John Sheridan, CEO of Ballard Power; ~58,000 shares, all of which were received for services rendered as a Director, worth about $300k — if he had more than 15 months on the job as CEO he might be more suitable for the category below
“Non-shareholder executives” (including up to ~$100k in value as at most recent circular):
John Caldwell, President and CEO, SMTC; zero shares owned
Richard Carlson, CEO, Wireless Matrix, 69,000 shares owned worth about $75k
Francois Cote, President & CEO, Emergis; 14,322 shares owned worth about $100k
Peter Strom, President and CEO, March Networks; 9,000 shares owned worth about $100k at the time the circular was filed
These are merely representative samples of hundreds of TSX senior executives. If I had more time, I’d dig up additional examples of both categories (but we have a bunch of term sheets on the go this month and there are, believe it or not, better things to do than blog at 6am!). In the VC world, a major red flag would be raised if the CEO had little, if any, skin in the game. No VC wants to back someone who appears to be the hired gun, and not a fellow owner of the business.
Why does the buyside not feel the same way about public market executives? I’m not advocating activism, just common sense. The next time one of these folks comes to see you on a roadshow at, for example, AGF, AIM, C.I., Fidelity, Gluskin & Sheff, Jones Heward, Mackenzie, Scotia Cassels, etc., ask they why they don’t directly own much, if any, stock in the company they are pitching you to invest in.
It’s one of the first questions a VC will ask during a pitch, and it’ll serve you portfolio managers well.