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Microcap Executive Compensation

Something I have been paying a lot more attention to is microcap executive compensation. I believe there is a correlation between executive compensation and shareholder return. My opinion is based on a few microcap companies that I have invested in. Executive compensation gives investors a glimpse into the motivation of management. Is the compensation package shareholder-friendly or is the CEO in it for the salary and perks. Does the compensation package promote long-term sustainable growth or does the compensation package promote short term strategies to meet quarterly numbers?

Ian Cassel On MicroCap Executive Compensation

Ian Cassel photo
Ian Cassel, Founder of MicroCapClub

Very little is published regarding microcap executive compensation. The only article specific to microcap executive compensation was written by Ian Cassel (founder of MicroCapClub and full-time microcap investor).

Cash compensation, stock-based compensation and other perks comprise executive compensation. Ian Cassel says that cash salary is very important because many microcaps are not profitable. A CEO who is making an exorbitant salary can greatly harm a microcap company that has minimal resources at its disposal. With little cash on their balance sheet, excessive compensation can lead to dilutive equity raises.

Ian came up with a very simple and straight forward set of numbers to start with using US dollars:

  • Company is unprofitable to $1 million EBITDA per year: $200,000
  • The company produces $1 million to $5 million EBITDA per year: $250,000
  • The company produced $5 to $10 million EBITDA per year: $300,000

Ian published his article in 2013. According to the Bureau of Labour Statistics Consumer Price Index, today’s prices are 10.22% higher than in 2013. To account for inflation I will increase Ian’s numbers by 10%:

  • Company is unprofitable to $1 million EBITDA per year: $220,000
  • The company produces $1 million to $5 million EBITDA per year: $275,000
  • The company produced $5 to $10 million EBITDA per year: $330,000

The extra 10% changes the number only minimally. Ian does not strictly follow these numbers but uses them as a guideline. When compensation is above these numbers it raises a red flag. Ian will give leniency to a CEO that is a “serial success story”. For a CEO that has built up and sold several companies benefitting shareholders, it is reasonable to think they would be paid a premium.

Stock-Based Compensation

The other major component of compensation is through stock options and restricted stock grants. The efficient use of stock options and restricted stock is an important tool microcap companies can use to recruit the top talent they cannot afford to pay with cash. Stock options should be granted in reasonable amounts and should be based on performance metrics. Ian described business milestones, financial milestones and stock milestones as metrics that should be used when issuing stock options.

Ian`s article is not very long I encourage you to give it a read.

Microcap Executive Compensation: What I Look For

I’ve only been investing in microcaps for a little over a year but I’ve become more familiar with management compensation and how it compares to other microcaps. I think Ian`s guidelines above are very reasonable however there are many companies that greatly exceed them.

The question then becomes is their compensation reasonable for the success of their company?

Salary

Let’s look at both good and bad examples of executive compensation.

The Bad: Good Life Networks (GOOD.V)

I’ve written about Good Life Networks in the past and discussed their executive compensation in this post. Good Life Networks is a Canadian programmatic digital advertising company. I noticed some red flags with the business and management but couldn’t convince myself to sell the stock until I looked at their executive compensation

Good Life Networks Executive Compensation
Good Life Networks 2018 Executive Compensation

There are two major offenders in this compensation table, the CEO and CCO. At the beginning of 2019, GOOD’s share price was $0.19 and a market cap of $16 million. For the full year of 2018, GOOD lost $2.3 million and added millions in debt. Needless to say, CEO Jesse Dylan did not earn his compensation. His $375,000 may seem reasonable but after looking at the overall success of the business his salary does not align with shareholders. Add in the enormous bonuses they were awarded and you have an egregious level of payment. The numbers above are only cash compensation and do not include any stock-based compensation.

How did GOOD turn out? GOOD’s share trade at $0.01 and are halted by the TSX Venture (they have recently begun trading again but the company is out of cash with no real business model). There are other issues with GOOD but after looking at their compensation I knew I had to sell. This type of compensation makes it very clear to investors that the CEO and CCO are in it for the money. Building wealth for shareholders is not their number one priority. Almost $1 million in bonuses is absurd for a cash strapped company that had to return to the market to raise money. The massive bonuses awarded to management were not consistent with the overall performance of the company.

The Good: Xpel Inc. (XPEL)

Xpel Inc. is in the business of automotive paint protection film. They are also expanding their products to include films for large glass buildings. Xpel has had massive success in recent weeks, months and years. Over the past five years, Xpel has grown net income from $1.32 million in 2013 to $8.71 million in 2018.

One of the reasons is because of very reasonable executive management compensation.

Xpel Inc. Management Compensation
Xpel Management Compensation

As you can see the CEO earned $323,436 in 2017. This is a very reasonable amount as Xpel is a wonderfully profitable company with excellent growth. CEO Pape continues to execute and we are seeing his compensation climb mostly through cash bonuses. Xpel has had tremendous success and CEO Pape’s bonuses reflect that. If a company is faltering and management receives a large cash bonus or stock options it’s time to reassess management allegiance to shareholders.

Cash Bonus Compensation

A cash bonus is a great way to incentivize management. A clearly defined bonus package sets concise goals for management to strive for. A strong board can steer management by instituting a bonus structure that emphasizes long term goals. The goals set out in the package should reflect the same goals that the company is presenting to investors and not empire building.

I also look for a bonus package that is not overly complicated. As a novice investor if a compensation package has too many moving parts it is difficult to assess. A good bonus structure should clearly outline what the goals are and what the compensation is if the goals are achieved. An investor should be able to read the proxy statement or management information circular and understand what goals have been set for management.

The Bad: Seven Aces Limited (ACES.V)

Seven Aces Limited is a Canadian microcap company that operates amusement and gaming machines in the state of Georgia. I was previously a shareholder but could no longer accept their management compensation package.

Seven Aces Limited Executive Compensation

CEO Sekhri was paid $3,011,953 in 2018. Ian Cassel suggested $330,000 at the higher end for microcap executive compensation. Sekhri’s pay is 10.9x higher. CEO Sekhri was paid over $2 million in bonuses and other compensation alone. Seven Aces is generating a substantial amount of cash from operations but most of it goes to executive compensation.

So how is CEO Sekhri’s compensation package structured?

Seven Aces Sekhri Agreement
Seven Aces Sekhri Agreement

So what goals are CEO Sekhri incentivized to achieve? If the company makes an acquisition that has a trailing six-month EBITDA of at least $1 million Sekhri receives $200,000. If he does not complete an acquisition of a profitable company he receives $150,000. So if Seven Aces acquires a company he gets paid. If Seven Aces does not acquire a profitable company he gets paid.

If Seven Aces makes a significant acquisition of a company with over $2.5 million in EBITDA Mr. Sekhri is entitled to $1 million in consulting fees. And after all of that pay just to make acquisitions he gets a cut of the total value, 2% of the total value of all forms of payment. CEO Sekhri is incentivized to acquire companies. Even if the multiple he pays to acquire them is detrimental to the business and shareholders.

More of the Bad: Good Life Networks (GOOD.V)

Good Life Networks Bonus
Good Life Networks Bonus

CEO Jesse Dylan earned a large cash bonus by growing gross revenue. There is no mention of growing profitability. This type of bonus encourages CEO Dylan to make acquisitions even if they are not in the long term interest of shareholders. This bonus structure resulted in CEO Dylan getting massive bonuses as seen above by spending shareholders’ money. And to add a nice cherry on top CEO Dylan was given two months of vacation.

Something Better: Crescita Therapeutics (CTX.TO)

Crescita Therapeutics is a holding of mine. I appreciate how Crescita breaks down bonus calculations. Although their bonus structure below isn’t as transparent as it could be it is a vast improvement over bonuses that are awarded at the sole discretion of the board, or something similar.

Crescita Therapeutics 2018 Bonus Compensation Structure
Crescita Therapeutics 2018 Bonus Structure

Crescita’s executive bonus is then calculated using Adjusted EBITDA to come to the final number. I appreciate that the company is telling investors what management goals were for the year in plain language. I’m sure there are better examples of transparent bonus structures than Crescita but this was the best one I could find from the microcaps I am familiar with.

Stock-Based Compensation

Stock-based compensation is a complicated topic. I struggle with trying to understand what the true value of issued stock options is. One thing I do know is I don’t like my share of a company being diluted. When a company reaches profitability I prefer that they increase cash bonuses and limit stock-based compensation.

One of the best podcasts I’ve heard was by Meb Faber. Meb interviewed Albert Meyer, the founder and President of Bastiat Capital. Here is a link to the transcript. I’ll try and summarize the meaningful lessons from the podcast.

Stock Options

Albert Meyer is against investing in companies that have excessive stock-based compensation and have a large stock-options overhang.

The overhang is the number of options outstanding divided by the number of shares outstanding. So if it’s 28%, it basically tells you that even if Merrill Lynch were to grow its earnings by 28%, by the time the options of this are exercised their earnings growth would be zero. So you’re basically diluting shareholders in a massive way. And so I stayed away from companies with option overhangs of more than 5%, and that means that I avoided a lot of pain in 2008 and 2009. And I still, to this day, if it’s more than 5% overhang, I just pass on the idea.”

Albert went on to explain that he is more of a proponent of restricted stock units (RSU’s) due to their simplicity.

Restricted Stock Units (RSU’S)

“And restricted stock units, the accounting is basically simple and there’s no smoke and mirrors. You issue the stock at the market value, you grant it at the market value, and you expense the market value at the date of the grant. Whereas, with options, it’s the Black-Scholes and the binomial method, and 110 other different ways to understate the true expense.”

Albert’s opinion is that RSU’s are superior to stock options because of their simplicity. The true cost of the RSU’s is clear at the time of issuance while the true cost of stock options is very complicated to calculate. I can understand that some investors may turn their nose up at RSU’s. The person receiving them does not have to pay any money to exercise them however generally much fewer RSU’s are awarded then stock options. The true value of RSU’s is easy to understand and calculate.

The Bad: Seven Aces (ACES.V) and Good Life Networks (GOOD.V)

Again we revisit Seven Aces. In November of 2019 Seven Aces management awarded themselves a generous stock option award.

Seven Aces November 14th, 2019, Stock Option Award

The 3,686,522 worth of options add 4.5% to the fully diluted share count. At the same time, Seven Aces spent $2.4 million to buy back shares over the past nine months. The $2.4 million doesn’t even come close to covering the 3.7 million shares that are added to the fully diluted share count. Like Albert Myers explained by the time all the options are exercised Seven Aces is wiping out 4.5% of earnings per share growth.

Another red flag for me in terms of stock-based compensation is when options are issued below the market price. Here we see it with Good Life Networks.

Good Life Networks Stock-Option Issuance

On December 27th, 2018, Good Life Networks issued 830,000 stock options to executives and directors. These options were issued at $0.15 while the stock price closed at $0.20, a 25% discount. I see no reason for this to happen. Although this is allowed by TMX I see it as unnecessarily greedy by management as investors can’t purchase shares on the open market at such a discount. The options have an expiration date of five years. This should give management ample time to grow the business and share price, therefore, increasing the value of their options.

The Good: Xpel Inc (XPEL) and Namsys (CTZ.V)

Xpel Management Compensation
Xpel Management Compensation

Again let’s look at Xpel Inc. as a good example. They do not issue stock-based compensation. This is great for shareholders. The portion of the company that you own is not diluted by stock-based compensation. This has resulted in a very steady share count year over year.

Xpel Inc. Share Count
Xpel Inc Share Count

Referring back to Ian Cassel once again, he believes that dilution is a microcap investor’s biggest enemy. Reasonable stock-based compensation is a very important factor when assessing possible dilution.

Namsys is one of my newer holdings. Namsys is a software as a service company in the cash management business. One of the big reasons I like the company is they have no options or warrants outstanding. They also are not issuing any options as compensation.

Namsys Executive Compensation
Namsys Executive Compensation

Similar to Xpel, Namsys’s share count has not increased.

Namsys Share Count
Namsys Share Count

This creates an environment where increases in net income also increase earnings per share. If a company were to continually dilute by issuing stock options it becomes more difficult to grow earnings per share.

Microcap Executive Compensation Conclusion

So what does the ideal microcap executive compensation structure look like to me:

  • A reasonable base salary similar to the guidelines suggested by Ian Cassel;
  • A cash bonus structure that is simple to understand with goals that are aligned with creating shareholder value;
  • Minimal stock-based compensation, restricted stock units are acceptable but should be issued sparingly.

These three points seem so simple but trying to determine if a CEO’s compensation is reasonable is much more difficult. A company that is just reaching profitability will likely have higher stock-based compensation as they continue to build their business. As the company becomes profitable I like to see a corresponding increase in cash bonuses and a decrease in stock-based compensation.

Microcap executive compensation is something that I am paying much closer attention to. The structure and amount of compensation paid to management say a lot about the board of directors and management. It gives investors a glimpse into how management views shareholders and the money shareholders have invested in the company.


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This Post Has 2 Comments

  1. Kevin M

    Hi Blair – Nice summary and I agree with most of your conclusions. How deep did you dig on this? Did you solely select a few of the companies that you’re most familiar with and look at the compensation models? Or have you looked at a broader cross section of companies. I know many investors who reference Ian’s article on exec comp and both his and your article make complete sense, but I still wonder how much selection bias is there. ie: who are the examples that would make the counter argument that high comp pays for itself, or possibly exec comp structure doesn’t matter? Thanks for posting your stuff

    1. Blair

      Hi Kevin, thanks for visiting the blog.

      My observations are based on my experience in microcaps and does not include a large cross section of companies.

      I view my post as a framework to start assessing compensation and not hard and fast rules. If a company has an excellent balance sheet, growth and wonderful profitability and the CEO is responsible for achieving these results than I would expect them to be compensated accordingly.

      For large cap companies that have established balancd sheets the compensation paid is not as big of a factor in the success of the company because their balance sheet can absorb largercompensation packages. Microcap companies often cannot absorb large compensation packages without harming the company somewhere else.

      Again my thoughts are how management pays themselves is a reflection of how the board and management think of investors.

      Thanks again for the feedback.

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