Weekend thoughts: Not then, not now, and probably not tomorrow (incentives, procrastination, and insider ownership)

Different investors look for different things in their investments. Some investors might prefer fast growth, some investors might want a lower multiple, some investors might focus mainly on capital returns, etc.

But, no matter their style, every investor likes to see a good amount of insider ownership in their company. In fact, outside of one or two edge cases¹, I can’t think of a reason an investor would say something like “man, I really like this business but I sure wish management owned less equity!”

Unfortunately, most companies don’t have a ton of insider ownership. The simple fact is most companies are run by “professional management” who have risen up through the ranks or been hired externally to run the company, and those types don’t have huge insider ownership. So it’s entirely normal for companies to have CEOs who own limited amounts of stock; most board set ownership limits that require their top executives to own 3-5x their salary in stock… but that’s honestly not that much and given the ownership limits often phase in over a number of years and can be met by simply holding on to equity grants it’s a pretty small ask for executives.

Anyway, this week I was talking to a friend about a company we were both looking at where the CEO owns a “normal” amount of stock, and my friend was bashing the CEO as just completely incompetent. His take kind of surprised me; I didn’t think the CEO was going to get elected into any corporate hall of fames or anything, but I thought he was a perfectly fine CEO who was doing a perfectly fine job running the business. I followed up by asking my friend questions about why he didn’t like the CEO so much, and a lot of his answers came back to “he doesn’t own a lot of stock and I don’t think he’s operating with any urgency.”

That interaction got me thinking: I know a lot of times when I’m looking at a company where management doesn’t own a lot of stock I’ll take a much harsher eye / lens to them than I would where the company / board owned a ton of stock. In fact, I’d go so far as to say my tendency (and I suspect many value investors share this tendency) is to assume incompetence for any board / management team that doesn’t own a lot of stock.

And I’m not sure if that’s completely fair…. there’s nothing about owning a lot of stock that makes a management team more or less incompetent than a team that doesn’t own much stock / management teams with a lot of equity ownership can be just as incompetent as management teams that own no equity. In fact, management can be more incompetent if they own a ton of equity because their stock ownership prevents an activist or shareholder from replacing them (it’s one of the few edge cases where you’d prefer less insider ownership!).

So I don’t think a management team is more competent than another simply because they own a lot of stock (though often management teams own lots of stock because they started the business and grew it massively, which is certainly at least a signal of some skill!). But I do think there are a few areas where stock heavy management teams will tend to be much better than stock light management teams.

Some of these areas of incentive divergence are obvious. For example, the most well known area of incentive downside relates to M&A. Company executives tend to make more the bigger their company is regardless of how the company got there, so equity-light management teams will be much more incentivized to pursue M&A (as an acquirer) even if it’s value destructive. Consider a simple example: say the average CEO gets paid $1m for every $100m in market cap. If you’re the CEO of a $200m market cap company, buying a $100m competitor with all stock will push your market cap up by ~$100m, which means you’ve got a reason to push your board for a 50% salary bump (from $2m to $3m) regardless of the underlying shareholder return on that acquisition!

Will the management team want the acquisition to be good? Sure! But the acquisition working out well or poorly for shareholders really doesn’t matter that much to management’s personal bottom line. Earlier I mentioned most boards require their CEO to own 3-5x their salary in stock ownership; let’s say our hypothetical $2m/year CEO was at the high end of that range and owned $10m of stock (5x his $2m/year salary). Even if the stock price dropped 10% on an acquisition announcement, the CEO comes out way ahead: he’s lost $1m of equity value, but he’s gained a $1m/year annuity in the salary bump…. Not a bad trade!

So big M&A (as an acquirer) is an obvious area of incentive mismatch, and there are plenty of other well known areas…. but I’ve increasingly come to view one area of incentive mismatch as the most value destructive for companies with low insider ownership, and it’s one that I seldom hear talked about.

That mismatch? Procrastination.

I honestly don’t believe most boards are full of imbeciles or people trying to rob shareholders (there are, of course, exceptions!)…. but if your board and management team doesn’t own a bunch of stock, the simple fact is delaying and procrastinating benefits them in almost every circumstance.

Let’s go back to M&A, but this time considering the company as a seller. Most companies realize it if they’re too subscale and need to sell…. but, if insiders don’t own any stock, selling will result in all of the insiders losing their paycheck, so it’s easy for insiders to convince themselves that now isn’t the right time to sell.

There are a handful of companies that I’ve been talking to for the past five years that clearly should not be standalone companies….. insiders know the company shouldn’t be standalone, but they'll always have an excuse for why now isn’t the right time to sell. The excuses would look something like this:

• In 2021, they’d say they needed to get more visibility on the effects of COVID reopening, or that private market bidders weren’t willing to bid up to their peer public multiples

• In 2022, they’d say interest rates were rising too quickly for buyers to lock in attractive financing

• In 2023, they couldn’t sell because of SIVB destroyed the financing market in the first half of the year and inflation and interest rate uncertainty (as they waited for fed cuts) made financing difficult in the back half of the year

• In 2024, they couldn’t sell because of election uncertainty.

That’s 4 years in a row of excuses on why the timing wasn’t the right to sell! And, for some of these companies, I’ve seen their board decks and I think the company honestly believes that they’re doing right by shareholders in waiting for a better time to sell…. never mind that they’ve been waiting for 4 years and the stock price has flatlined over that time period!

It’s tough to get a man (or, in this case, a board) to believe something that goes against their incentives. And, in many cases, these boards own no stock and are collecting low six figures/year for their board seats. In addition, board seats are a kind of chicken and the egg thing; it’s hard to get invited to a board if you’re not already on another board, but once you’re on one, you’re more likely to get invited to other boards, so there’s some added incentive to hold on to ones you already have as they make you a better candidate for other board seats. Every year that the board decides “now is not the right time” is another year where their directors take home six figures and keep the prospects for more director gigs! So yes, I’m sure they believe it when they say “now is not the time”…. but their incentives are demanding they believe now is not the time!

Companies selling themselves is obviously the most visible example of this procrastination, but you’ll find plenty of others if you talk to enough boards and put their decisions, particularly around capital allocation, through this incentive lens. Another one that will frequently come up is stock buybacks; I’ll see companies invest in risky organic growth all the time when it seems clear to me stock buybacks would be a much better use of capital. When you talk to the management team / boards, a lot of them will be very open to stock buybacks, but they’ll be insistent that now isn’t the time. “The economy is too uncertain”, “interest rates too high”, etc. Plus, how can the company turn down these attractive growth organic growth opportunities in favor of share buybacks? And, from their insider seat, that decision to lean towards organic growth makes sense: a stock buyback shrinks the company, which eventually leads to less money to go around for salary, while organic growth grows the company, which should lead to more salary / board fees in the long run.

From the board/management standpoint, investing in organic growth makes sense…. even if the math doesn’t make sense for shareholders! A fast example: I’ve had several restaurant / retail companies walk me through the math of investing in new store growth and found that they’re underwriting new stores at a ~6x EBITDA multiple (and ignoring risks of cost overruns, stores underperforming, time value of money, etc) while refusing to buyback their stock at 4x EBITDA right now (and stock buybacks come with no risks of overrun or store failure; you’re buying your existing base!).

So I’ve kind of come around to a new approach when talking to companies: do what makes sense now, no excuses except for real crises. If a company is too small to be a standalone, the time to run a process and sell the company is today. It’s not to wait for comps to stabilize in the back half of the year, it’s not to wait for regulatory clarity, it’s not to go from 100 units to 150 units so that you can get a better multiple as a bigger business. Run a process and take the best bid now. The only exception would be if financing markets are truly closed / we’re in a panic (i.e. GFC, first wave a COVID, maybe the week or two after the regional banking crisis started).

Or consider non-core assets: I can’t tell you how many companies I talk to have an asset that’s clearly noncore, and they’ll say “yeah, we ran a process for it, but we didn’t like the bids so we held on to it.” This is particularly true with companies with commodity exposure; if the commodity price changes at all when the process is happening, management teams will always point to that as a reason for not selling (if oil goes down, they’ll say they’re waiting for oil to go back up…. if oil goes up, they’ll say bidders had designed their bids around the lower oil price and weren’t willing to update). That whole line of “bids weren’t where we wanted them so we didn’t sell a noncore asset” thinking is pretty insane to me; unless there’s a real reason to think the process was flawed (i.e. a panic started during the process), bids short of your expectation should tell the company their expectations were too high! Sell the asset and rationalize the company.

Again, I don’t think boards or managements are lying or being unethical when they say or do any of this. In almost all cases, I think they truly believe that shareholders will be better off waiting for a brighter tomorrow…. but the thing about tomorrow is it’s always a day away. Increasingly, I’m of the opinion that if there’s something that makes sense for a company to do (sell a noncore asset, buyback stock, sell the whole company), shareholders should push management to do it and do it now, excuses and environment be damned.

1. The edge cases would generally relate to companies where insider ownership is so high they’re effectively entrenched, and the insiders use that entrenchment to either enrich themselves or keep themselves employed despite incompetence.