What About Those Pesky Shareholders?

TABLE OF CONTENTS Essential Knowledge 1. What is the Purpose of Your Business? 2. Avoiding the “Kiss of Death” 3. Managing the Stock Price Side of the Business 4. Overhang and the Risk of Stock Price Catastrophes 5. What if You Ignore the Second Side of Your Business?



1 2 3 5 6

Best Practices and Trade Secrets 6. How to Analyze and Understand the Shareholder Base 7. Moving Stock From Weak Hands to Strong Hands 8. Why Investors, Not Traders, Are Desirable Shareholders 9. How to Identify Shareholders 10. Methods for Communicating to Shareholders 11. Methods for Marketing to Desirable Shareholders

10 11 11 11 13 15

Organizational Structure that Supports Both Sides 12. Bet on the Jockey 13. Musical CEOs 14. The Compensation Debate 15. How Many Millions Are Enough? 16. If Senior Management Compensation is Wrong 17. How to Get Yours 18. How to Recruit the Right Board 19. Conclusion

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1. What is Your Purpose in the Business? I am not looking for your marketing spin here. I don’t want your grand vision of how you are transforming your product or service and I could care less about your elevator speech. I am looking for that lackluster but essential answer that lurks in the first chapter of every financial accounting textbook. What is the purpose of a business? Why does it exist? The maxim states that the primary goal of a business is, to add value for the shareholders.1 If adding value for the shareholders is the purpose of the company, then, ipso facto, it is also the goal of Senior Management. So, what is this “shareholder value?” I am asking a little tonguein-cheek, but consider that private companies with a limited number of shareholders have the luxury of being able to decide what maximum shareholder value means. They might be non-profit companies formed to serve a cause which might be social, personal, political or even altruistic. Public companies on the other hand (or private companies with a trading shareholder market) only deliver maximum shareholder value in one way—by increasing their stock price.

It is a simple, universal, value per share formula. The transition a company goes through from before it has significant number of shareholders (or more specifically a trading shareholder market) to the time when it has a base of shareholders is fraught with the desperation and heads-down operational execution that are the hallmarks of a company in the midst of rapid growth. The obligation of a new shareholder focus tends to sneak up on these teams and is easy to miss. It may not be part of the company’s DNA or even a blip on the radar of Senior Management. What’s more, Senior Management tend to be unaware that there is another side to their business, are resistant to admitting its importance and are reluctant to embrace the added responsibility. In fact, if you have read this far, you are already ahead of most of your peers. The first key to success in leading a growth company with a shareholder market is to recognize that you are running two sides of the business. It is like you are running two companies with linked but separate goals—and neither one can really succeed without the other. First, you manage the business you are used to—the revenues

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and earnings side that comes from solid execution and smart decisionmaking. Leadership teams may be already adept at this. After all, this is part of the reason they attracted the shareholders in the first place. Second, you manage the shareholders and the stock price. Why is the second side so critical? Success in managing the stock price means you have fulfilled the purpose of your company (add value for shareholders) and increased the value of your company. Senior Management likely do not even understand that this side of the business exists, let alone how to execute their obligations to it. Familiar or not, Senior Management must embrace the fact that they have this dual responsibility or else reap the weighty and unpleasant consequences of ignoring it. Reluctance is understandable. If you are one of the reluctant ones, read on. I have included all the critical information necessary to get you started on the right track. 2. Avoiding the “Kiss of Death” Now, let me indulge in one example for the sake of the understandably skeptical. To those of you who say, “Wait a minute. Shareholders, certainly the early ones, bought stock in our

company because they believed in our business. We won their confidence by executing on our business plan, by meeting the needs of our customers and by driving earnings and revenues. Our job isn’t to influence the stock price. If we look after earnings and revenues, the stock price will take care of itself.” The market is full of people preaching that stock price is not part of the responsibility of Senior Management teams.2 In ignorance, CEOs steer clear of anything resembling an attempt to impact stock price fearing regulatory misconduct. But, this is not an area where business leaders can afford to remain ignorant. I have seen many many companies led by individuals who professed the attitude that somehow “the stock price will take care of itself.” I call this the “kiss of death.” Of the many examples we could cite, perhaps none is more illustrative than that of Robert L. Nardelli. Bob Nardelli, was a talented executive who joined GE in 1971 and climbed the ranks to become the President and CEO of GE Power Systems. He was mentored by famed GE CEO, Jack Welch, and was even referred to as “Little Jack.” When Jack Welch retired as CEO, Bob

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Nardelli was one of a threesome on the shortlist to be Jack’s successor. In the end, Bob came in as a runner up. Being passed over for the top spot at GE, however, was anything but a career killer for Nardelli. Bob was a man in demand, and was almost immediately extended an offer to take the helm of The Home Depot (for a paltry $38 Million, plus bonuses). The Home Depot was struggling, but Bob was off and running. He was righting the Home Depot ship operationally and turning it into a real money maker. Under his leadership, The Home Depot doubled its sales and profits between 2000 and 2005 (revenue jumped from $45.7 Billion to $81.5 Billion, while profits leapt from $2.6 Billion to $5.8 Billion). Operationally, Nardelli was a rock star. But, what about Bob’s other business? During the same period, share price fell 6%. By contrast, shares at Lowe’s had grown by 200%. Pressure from shareholders forced the board of directors to push for Nardelli to alter his compensation package in order to tie his salary more closely to stock price performance. Nardelli countered complaining that “share price was outside his control.” He was not without support in this

position with many crying that his charge was to run the company, not the stock price. The shareholders disagreed. Their scrutiny may have been attracted by Bob’s generous compensation package—CEO compensation is a favorite bone to pick with shareholder activists. Truthfully, his pay wasn’t the key issue, theirs was. The shareholder’s value wasn’t growing despite increasing profits and revenues, and Nardelli was forced to resign. Now there will probably be few tears shed for Nardelli’s fall from grace. After all, an estimated $210 Million in severance has made him the poster child for golden parachutes. It appears Nardelli will continue to swim in deep water. In 2007, after his departure, Bob was offered the job of CEO at Chrysler (where, incidentally his pay is tied to a successful turnaround after the Daimler Benz divestiture), and he spent much of the end of 2008 before Congress alongside GM and Ford requesting a Federal bailout of the auto industry. The moral of the story is that once Bob declined his responsibility to increase shareholder value, it was the kiss of death and no matter how stellar earnings were, it could not save

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him from the repercussions of not shepherding the share price. It is easy to see why CEOs of growth companies might resist the idea of tackling an entirely new dimension of their business. It is the basic psychology of human nature. We resist change and fear the unknown. For these executives, the revenue and earnings side has been their whole focus. To get to this point, they must have already mastered many of the critical skills necessary to drive this side of the business. To suggest that they take on an another side of the business—about which they know nothing—is uncomfortable. It is like telling a child who has learned to ride a bike that that is all well and good, but what really counts is how good they are at rowing a boat. If you feel this, acknowledge it and discipline yourself to learning the other side of your business. Like it or not, Senior Management actually run two companies and they bear the twofold responsibility to manage both sides of the business: revenue and earnings and stock price. 3. Managing the Stock Price Side of the Business Another thing most Senior Management teams do not understand, is the relationship between the

shareholders and the value of the company. In fact, they may know very little about their shareholders. Shareholders drive the value of the company! The behavior of the shareholders directly affects the value of the company whether you have ten shareholders or ten thousand. Managing your shareholders directly affects the stock price and your ability to raise money and grow the business. What is the mechanism for this relationship? The value of a company is a function of the price and volume of its stock. The behavior of your shareholders—past, present and future—affects the supply and demand3 of your stock, and ultimately the value of your company. Do they buy? Do they sell? What are their intentions? Notice how price is affected as the volume of supply or demand goes up. The goal of the Senior Management team should be to increase both the volume and price of the company’s stock. Rapid fluctuations in volume, however, yield disastrous results on price. Managers need to grow the stock with as little volatility as possible. So, the aim should be a steady increase of both price and volume, keeping in mind

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Demand

Supply

Supply

Demand

Demand

Price

Price

Price

P-2 P-1 D-2

D-1

Volume / Quantity

Volume / Quantity

P-1 P-2 S-1

S-2

Volume / Quantity

Figure 1

the balance, the equilibrium between supply and demand that dictate price. There are a lot of choices when it comes to buying stock. Why does someone buy a particular stock? Well, if a stock is on the S&P 500 or the DOW 30, people will buy it just because it is on the index. What about companies who aren’t on an index? What if your company isn’t on an index? Increasing the value of the company depends on someone buying your stock. Well, let’s just get everyone we can, any way we can, and crank up the shareholder base, right? Not so fast—not all shareholders are created equal. Companies do things in order to make their stock desirable to potential shareholders. If a company is careless or does not understand what type of shareholder it wants to attract, it could easily end up

beholden to a shareholder it does not want. Your shareholder base4 should not spring up by accident. Companies need to understand who their ideal shareholder is and tell a story that attracts that type of shareholder. Whether intentional or not, Companies are recruiting new shareholders and the Senior Management needs to understand how to attract and market to the right ones. This is impossible if you do not know who they are! In the end, Senior Management needs to understand who its shareholder is if it is to have any chance of influencing its stock price and ultimately the value of the company.

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Supply

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4. Overhang and the Risk of Stock Price Catastrophes Not only do most Senior Management teams not understand the relationship between shareholders and value—they often don’t understand their shareholders at all. In my years consulting with dozens of growth companies, I found that Senior Management could usually tell me a lot about the company’s customers. I mean they practically knew what each customer had for breakfast: they know the detailed profile of their target customer and what the key demographics are. They can tell me about the psychographic profile of their customers, about their lifestyles and about their interests, attitudes, and opinions. They have crunched the numbers and know what it costs to attract that customer and how much they expect to earn from each transaction. Then I ask them to tell me about their shareholders. I hear crickets. These competent and skilled executives look at me with blank stares. A few start grasping at straws, but most don’t even know how many shareholders there are, or what the average number of shares per shareholder is. Somehow, they are entirely ignorant of how the

shareholder relationship will impact the success of their business. So what? What are the risks of this kind of ignorance? For starters, there are what I call stock price catastrophes. Remember supply and demand? A stock price catastrophe is typically the result of a flood of supply—someone is unexpectedly selling large amounts of stock and the price plummets in a very short time frame. If Senior Management does not understand what is happening within the shareholder base, they are unprepared to mitigate stock price catastrophes that otherwise could have been averted. On the other hand, management teams who understand their shareholders will notice precipitating events, or catch the warning signs that are the fruits of some basic and simple analysis. Underlying any analysis of the shareholders is the concept of “overhang.” What is overhang? To understand overhang, you need to understand some things about the psychology of how individuals think about their stock. One of the irrationalities of people buying and selling stock is that they often weigh a stock’s current price against the price

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originally paid, not whether or not the stock is worth its current price.5 As the difference between the current price and the price paid grows, so does the psychological pressure to sell. For example, let’s say that an individual bought $1,000 of stock in a growth company at $1 per share. Then the price starts going up. It goes to $1.50, then $2.00 per share. The investor is thinking he is pretty savvy to have made such a great return, but in the back of his mind he knows that the general market average only delivers returns of just less than 8%. He has beaten the average by ten times already. Then the stock goes to $3.00, then to $5.00 per share. He starts to get nervous. This might be too good to be true. What if the price goes back down? Where is this stock going to peak? If I have already made 500%, can’t I be happy with that? And so it goes. As the difference between the price paid and the current price grows, especially as that growth outpaces the market, so to does the itch to sell. If the pressure to sell motivates a sale of any inordinate volume, you have the perfect conditions for a sale that is likely to cause a drop in stock price. With that in mind, overhang can be defined simply as cheap stock.

Shareholders who bought stock at a cheap price should be a red flag for Management because these shareholders represent a threat that stock could suddenly and unexpectedly come onto the market. And of course, a sudden influx of shares will most often cause a drop in price. What’s more, since many investors get their investment advice from other investors around them, a move to sell by one could bring a flock of imitators6 and cause a full-blown stock price catastrophe (remember our supply and demand curves). 5. What If You Ignore the Second Side of Your Business? Here are two typical examples– stories I see all the time; one represents individual shareholders and the other represents institutional shareholders. Both illustrate the reason why it is a fatal mistake not to manage your shareholders: Example 1. An aggressive young and growing company makes its Initial Public Offering. To raise the cash necessary to bring the company to this point, the company used its equity and sold stock to an individual investor looking for big returns on ownership of a pre-

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IPO company, but who cares little for the company. The CEO and founder of this company is focused on execution. He is in his stride driving revenues for the company and making his dream for the company come true. Raising money and even the IPO are only stepping stones in his company’s growth. The individual shareholders forgotten, he gets up every morning and checks the stock price. He has been working tirelessly and has led the company to stellar earnings and takes great satisfaction in watching his stock price climb accordingly. It’s up to $14 per share!

Then one morning he stares at his screen in disbelief. The stock has fallen to $8 per share overnight. What happened? The individual investor dumped his shares onto the market as soon as his six month holding period expired. He is allowed to do this, right? YES, and the entrepreneur just saw his stock price (ie. his company’s value) drop by 43% overnight because this flood of shares is equal to ten times the daily trading volume of his company’s stock. This is almost exactly what happened to Lululemon. Lululemon Athletica made its IPO in July of 2007 at $18 per share. Existing shareholders

Figure 2

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were under a 180 day lockup agreement which would have expired around mid November. Over the next four months, successive volume spikes cause the price to tumble from a high of around $60 to a low of around $20 per share. Example 2. Here is a company that has been courting individual shareholders, but along the way has attracted one or two institutional buyers. They might form a “fat tail” (which we will discuss a little later). They don’t really fall within the normal shareholder distribution, and since they are an outlier, Senior Management ignores them. Like our previous example, Senior Management has managed—through extraordinary effort and drive—to generate earnings that represent a 20% return! The company is riding high and individual investors love it. Then the day after earnings are reported, the institution sells in bulk. Stock price drops and instantly erodes the hard won gains. Why did they sell? The company was generating stellar returns! Understanding this example requires a closer look at the differences between individuals and

institutions as shareholders.7 These two behave very differently. Purchases by institutional shareholders are often made by investment managers. Institutional managers are not as interested in growing their personal wealth, or even the wealth of the institution, they tend to act more interested in keeping their jobs and avoiding blame. The ideal investment for them would consistently return a few points over the market in general—no more, no less. They are like Goldilocks. They want their stocks not too hot and not too cold—they want them just right. These managers may purchase on the recommendation of internal or external analysts, who are focused on calculations like Earnings per Share (EPS) or PE Ratio or even world events. Analysts issue reports that may recommend investors buy, hold or sell certain stocks. The manager needs the opinions of the analysts, in case an investment goes bad or does not yield as expected, so he can claim that he has made his decisions using the best advice in the industry. They manage to mediocrity and follow the safety of the herd. As a result, they set up criteria that govern their purchases. Institutional managers have an incentive to play it safe.

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Individual buyers, on the other hand, don’t read analyst reports as often and don’t usually use the same type of rigid criteria that institutional buyers use. They may care more about the background of the management team or the company’s position in its industry or any of a number of other investment data points when they make their purchases. So, why did the institution sell? The institutional manager looked at earnings growing more than double the general market. While superb for individuals, this falls outside his established criteria and he regards the growth as unsustainable. It has fallen outside his safe zone and even though it seems like good news, he sells. (It’s not like it’s his money anyway.) Other reasons the fat tail institution/investor could unexpectedly sell is that someone in the company did something that disappointed or angered an analyst. The analyst retaliated with a bad report. Or maybe he had bad information and published a negative analysis. Remember, institutions live and die by the analysts because their managers live and die by blame. Net result—your company loses value which it could take years to recover. Both of these stories are oversimplified to make the point that

Senior Management must understand its shareholders. Institutions may hold the company to a higher or stricter level of performance than an individual investor or use different criteria altogether in deciding to buy or sell. The principle is not one of endorsement for or against institutional or individual investors, but an endorsement for understanding your shareholders, and understanding them in-depth. The industry saying goes, “You live by the institutions; you die by the institutions.” This means that if you have, or more importantly try to attract, this type of investor you need to understand the way they play the game. And it’s no different with individuals. If you want to be able to meet your obligations to increase shareholder value and to head off the catastrophes that may be lurking within your shareholder base, you absolutely must understand them. There is no shortcut. For example, within each of these groups there are subgroups. There may be investors in your space who only buy companies that are preearnings. Others only buy companies after they produce earnings. Either of these types of shareholders may be ideal or flat wrong for the company,

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but Senior Management needs to know which. By understanding the shareholders—more specifically, by understanding the shareholders who are overhang and represent a significant number of shares either in or entering the float8 (trading shares of your stock), you can take steps to head off stock price catastrophes and fulfil your obligation to increase shareholder value.

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6. How to Analyze and Understand the Shareholder Base Understanding the shareholders starts with some basic analysis. Senior Management should look at the shareholder base just as they would their customer base. Basic analysis starts by collecting statistics and demographic information and, at a minimum, answering the following questions: How many shareholders are there? Is the number increasing or decreasing? How long do shareholders typically hold the stock? What are the demographics of the shareholder base (institutional vs. individual, investors vs. traders, old vs. young, etc.)? How many shares does each shareholder own? With this information, shareholders can be segmented and some simple statistics can be applied.

What does the distribution look like? Is it normal? Is there more than one peak? Are there any fat tails? Are there restricted shares out there? How many? When do they become tradable? Who owns them? At what price do they own them? What are their intentions of holding or selling? How many shareholders are in each standard deviation from the mean? If we consider three standard deviations (σ) to be the base, how many outliers are there? Who are they and how many shares do they own? Are there warning signs or positive indicators showing up in the data? Outlier clusters and fat tails are indicative of potential overhang. In this image, we are showing shareholders on the Y-axis and number of shares on the X-axis. The graph on the left shows a normal distribution—high at or near the mean, with a bell-curve sloping off to

Figure 3

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the two tails on either side. Everyone is accounted for. However, the graph on the right has most of the shareholders within a normal distribution, but a shareholder cluster or “fat tail” exists which needs to be analyzed. This likely represents a risk of overhang. If it does, a plan needs to be put in place to buffer the impact of an unexpected sale. 7. Moving Stock From Weak Hands to Strong Hands While it is illegal to manipulate your stock price, it is not to orchestrate it. In fact, Senior Management has an obligation to be strategic about orchestrating its stock in order to create the most value for the shareholders. When overhang is owned by an investor who may sell unpredictably, these shares are in “weak hands.” As long as this investor holds the shares they are outside the free float where market forces keep the price in equilibrium with supply and demand. As long as there is overhang, the firm is at risk of a stock price catastrophe. One way to mitigate the risk of the overhang is to work on “patriating”9 the overhang into the float. By getting these shares into the freely trading circulation at an acceptable volume, the risk of an artificial price

fluctuation shrinks. This also means that shares tied up in any fat tails are absorbed into the normal distribution. Note that the “weakness” of a shareholder holding overhang, is a way of describing the unpredictability of their behavior. By understanding the shareholder base and what shareholders intentions are, Senior Management works to minimize risk. A shareholder could own a great deal of cheap stock, but if the Senior Management knows he is holding the stock out of a belief in the long-term success of the company and that he has a longer investment horizon—if this was an investor whose behavior was predictable and acceptable—his stock would be considered to be in “strong” hands and not a risk. Senior Management should be vigilantly looking for weak hands and making efforts to move those shares to strong hands. 8. Why Investors, Not Traders, Are Desirable Shareholders What is the difference between an investor, or newer investment criteria, and a trader? These two buyer types are operating from different paradigms. Traders are not primarily interested in your company. They are interested in the ebb and flow of your

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stock price. They are trading to make money on the fluctuations. They watch for the momentum in your growth to fall off, and then they sell. Because of this, they can create instability and become overhang. They don’t invest because they believe, they are just playing the numbers. Investors, on the other hand, are betting on your company for the long haul. Because they believe in your company they are more predictable and less panicky. The moral of this story is that you want to develop shareholders who are investors instead of traders. 9. How to Identify Shareholders The first step in understanding your shareholders is to know who they are. Understanding the shareholder base is essential to influencing stock price and protecting the firm from unexpected fluctuations like those mentioned above. By profiling your shareholder base, you will start to have the information you need to anticipate what your shareholders are thinking and what their actions will be. Typically, it is not very challenging to make a list of the shareholders classed as “insiders.”10 These are members of the Board of Directors, officers & Senior

Management, directors, key employees (control persons), or shareholders with over 10% of the issued shares. Before a company goes public, it is also fairly straightforward to get a list of shareholders. A great practice for pre-IPO companies is to review their financial statements for the “Records of Certificate” that show stock has been sold. Private companies keep their own records (they can, but usually do not, use a Transfer Agent, defined below). They keep a shareholder list or can extrapolate one from their cap sheet. The original filing will indicate the original shareholders and subsequent filings should provide a paper trail for what stock has been issued and to whom since that time. What if you are public? Things can get a little more complex. Public companies are required to have a third party who handles the transferring of shares of stock. The third part is called a Transfer Agent and the Transfer Agent is responsible for keeping the transactions out of the company’s hands. Each company can only have one Transfer Agent at a time, and part of what the Transfer Agent gets paid to do is keep a record of all the Shareholders.

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Resources are also available through The Depository Trust & Clearing Corporation (DTCC).11 The DTCC was formed in 1999 as a holding company to combine the Depository Trust Company (DTC), and the National Securities Clearing Corporation (NSCC) which had been formed initially to handle the needs of the New York Stock Exchange (NYSE), the American Stock Exchange, and later the NASDAQ. DTCC now serves the needs of all US and many foreign stock exchanges. The DTCC is owned by those who use it and is regulated by the Securities and Exchange Commission (SEC).12 The DTCC is basically the framework upon which all trading happens; it is a warehouse for public companies which facilitates transferring between brokers and dealers electronically. They record and secure all the transactions. All trades in the US go through the DTCC. A guide published by the DTCC, Following a Trade, which outlines the mechanics of what happens as shares are traded, is available from the DTCC web site. The DTC is the actual legal owner of the shares, but has no “beneficial interest” in them.13 The shares, while “legally” owned by the DTC are “beneficially” owned

by the participants14 or clients of the participants. Beneficial ownership gives one voting rights and the right to dispose of the shares. The names of beneficial owners are pseudonyms or “street” names in order to keep the owners anonymous. In order to penetrate the street names and determine who really owns the shares in your company, you need to request a list of the “Names of Beneficial Ownership,” or a NOBO list. The DTC is the only entity who can penetrate the street names via the NOBO list. NOBO lists are typically used for preparing an Annual Report. After collecting the names of all your shareholders, what next? 10. Methods for Communicating to Shareholders How do you communicate with your shareholders (other than a dutiful entry in the Annual Report)? Some companies truly understand this and have become experts at communicating with their shareholders. One example is BASF.15 With a tagline like “we don’t make a lot of the products you buy. We make a lot of the products you buy, better,” their ads are clearly not targeting consumers. Try buying anything from BASF at any retailer; you can’t. They are

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Figure 4

not speaking to consumers of their products; they are speaking to people considering what their 401ks and their mutual funds are invested in. This is an unusual example of a firm who knows that it needs to speak to its current and potential shareholders. So, where do you start developing your communication? The key to communicating with your shareholders is to recognize that you want to build a relationship with them.

Shareholders need a little TLC. Investors are news junkies. They want any crumb of news about the companies they own. So ask yourself, are you giving them the news that they need? How often are your press releases going out? People within the company possess nauseating levels of information about what’s happening, but investors are often starved of even the most trivial morsels of information.

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Do you have a mailing list? An e-mail list? Are you sending anything out? Do you have an Investor Relations department? In my consulting, I often ask a firm to tell me about their investor relations department. They say, Oh, we hire that out. What!? If you understand that investor relations is more than just a department (and is in fact more than merely “investor relations”), that it truly is the second half of your business, if you understand that it is like the Yin to the Yang of serving your customers in order to create revenues and earnings, then you have to ask yourself, does it really make sense to subcontract out such a vital part of your company’s success? Would you try to hire out your company’s ability to generate earnings? Of course not. The shareholder side of the business is at the heart of the strategic vision Senior Management has for the company. It must be done right in its totality. Which means that it simply requires too much care and attention to allow someone else to do it for you. Another question I often ask is, how much do you spend on marketing and selling your product or service? Answers vary, of course. Then I ask, Now tell me what your budget

is for improving your stock price— how much are you willing to spend to market your stock? Consider a company with 10 million shares. If they could get the stock price to go up even $1 per share, it would be worth ten million dollars in valuation. But, how many companies dedicate even $50,000 or $100,000 to this side of the business? Very few (almost none in the micro cap sector) even have budgets allocated for marketing their stock. Executives have to remember that if they don’t find a “home” for every share of stock, every single day, then the value of the company is going to go down. Demand has to exceed supply to keep the price moving in the right direction. How can management know what demand to generate if they don’t even know how fast their float is turning over? The CEO has to understand and be able to champion the Investor Relations effort. I often ask, where do investor relations and public relations fit on your org chart? This tells me something about where IR fits in the list of priorities. Think about it. If you do not give your shareholders information about you, where are they going to get it?

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11. Methods for Marketing to Shareholders If you don’t reach out to the right shareholders, how will they find you? The relationships you build with your current shareholders are a great vehicle for reaching out to others. What really drives anyone to buy stock in a company anyway? People buy stock because they perceive an opportunity. The psychology is simple. Almost universally, they believe that, at some point, the value of the stock they purchase will go up. In order for a company to attract the right shareholders, they need to tell a story that resonates with their target shareholder. It has to be very compelling. The target audience should feel like they will struggle with a lifetime of regret if they don’t make the purchase. So, what makes a story this compelling? Senior Management needs to communicate to their shareholders that they have vision. They need to be enthusiastic, but grounded in the facts. They need to represent that they are executing on growth strategies, which could include: uses for the cash they are raising by selling stock, expansion into new products or new markets, merging with or acquiring another

firm. They may strategically acquire private companies at private valuation and converting them at their public valuation. Wrapped inside of that story is a reason to believe—a rationale that answers the question: how can I make money. The message should be communicating authentic value. Ultimately, management needs to pull this together in a way that communicates potential.

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12. Bet on the Jockey Over the past twenty years, I have seen company after company come through my door looking for funding or help in executing their growth strategy. I am a believer in the sentiment, “Bet on the Jockey, not the Horse.” Experience has taught me this lesson over and over again. The Leadership within the company is more critical than the elements of the company itself and a great company with weak leaders at the helm is a recipe for failure, no matter how good the company looks on its own. Senior Management teams who understand both sides of the business are critical, but we know that most do not. How can companies encourage the types of leadership and execution that support both sides of the business when all or part of the Senior Management is ignorant or reluctant to embrace both sides? Management compensation is a critical component to successfully managing both sides of the business. Your key executives are smart individuals who understand exactly which side their bread is buttered on. The right compensation structure is essential for them to be successful. Likewise, the wrong comp structure creates a huge risk that you need to be

able to recognize before it comes back to bite you. Just like shareholder base, you can identify and take the first steps to mitigating the risks of the wrong executive compensation structure by understanding it and its implications. 13. Musical CEOs Senior Management and the Board of Directors are not always on the same page. Often the first CEO of a growth company is the founder. He or she is entrenched in the history and roots of the company. Entrepreneurs are, by nature, control freaks. They have brought the company to its current state by sheer force of will. Sometimes that same strength of personality that created the company starts holding the company back— oftentimes there comes a point when a company is ready to grow beyond its roots, but the CEO is not. It’s a tough road. Entrepreneurs are required to navigate many transitions. One of these is the transition from owning all the stock at a low value to owning a portion of the company and working to increase value. This can get a little ugly. So, the simple truth is that a lot of CEOs get fired or otherwise transition out of the CEO job (maybe to take seats on the board or provide a consultative

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role) shortly after a company raises its first equity financing and hits the throttle on growth. Finding a great CEO is not easy and often companies go through two or three generations of management trying to find the right fit. In the end, it is not uncommon for the board of directors, tired and desperate to get the company on solid footing, to become focused on one side of the business: the earnings and revenue side. They typically end up with management who are operations experts, but who know nothing about stock or financing, or the relationships on the investment side of the business. In other words, they just hired themselves the “Kiss of Death.” 14. The Compensation Debate I am going to outline the secret to compensating your executives in a way that incentivizes them to create the most value, but I would be remiss not to acknowledge that there is a furor raging in public discourse over this issue. On the one hand, market forces dictate the going rate for CEOs in any industry. On the other, shareholders are asking tough questions about the justification for big salaries and they are wielding increasing power. Needless to say,

executive compensation is a hot and divisive topic. Earlier I cited Bob Nardelli as an example of a high profile CEO whose compensation package was a sore point for shareholders, but Bob is not alone. Disney, and the NYSE have all had high-profile CEO fires where compensation was an issue. Currently CEO compensation (and particularly severance packages) are one of the issues at the heart of the mortgage crisis.16 Shareholders are raising eyebrows at CEOs exiting businesses with very large severance deals at a time when these firms are in real jeopardy ostensibly because of the leadership decisions of the departing executives. Shareholder activist groups, like AFL-CIO, are increasingly organized and able to garner enough votes to force decisions from the board of directors. Often executive pay is the issue that causes them to pick up the torches and pitchforks. Shareholder activism has gained popularity as management compensation at publicly traded companies and the rising cash balances on corporate balance sheets have risen.17 Some of the recent activist investment funds include: Icahn Management LP, Santa Monica Partners Opportunity Fund LP and Relational Investors, LLC.18

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Where many of the large cap companies may have gone too far with their activism, small and micro caps need to be increasingly aware of the issues surrounding this debate. The issue has grown in interest to the point that during his time in the Senate, President Barak Obama, even sponsored a bill that would require a non-binding vote on CEO pay by shareholders: the Say on Pay19 bill (S. 1181/H.R. 1257).20 He has since pressed the issue of executive compensation as part of his economic policy. 15. How Many Millions Are Enough? Senior Management is the group responsible for running the company. The Board of Directors and the Shareholders are responsible for managing the Senior Management. The Board of Directors has a responsibility to establish a compensation plan for management that ties the self-interest of executives to increasing shareholder value and harnesses their drive in a way that motivates them to achieve that goal. Here is a textbook reference that starts to outline the issues at work in establishing appropriate and effective management compensation. “Managerial goals may be different from those of shareholders. What goals

will managers maximize if they are left to pursue their own, rather than the shareholders’ goals? “ . . . managers obtain value from certain kinds of expenses. In particular company cars, office furniture, office location, and funds for discretionary investment have value beyond that which comes from their productivity. “. . . Corporate wealth is that wealth over which management has effective control . . . . Corporate wealth is not necessarily shareholder wealth.”21

My point is that this is not an issue that naturally resolves in a way that supports both sides of the business. So, what is the right strategy for establishing executive compensation? How do you align management goals with investor goals? To start with, the Board needs to establish a Compensation Committee.22 Compensation Committees are often organized with a charter and they develop certain principles as guidelines for their objectives in making recommendations about executive compensation. The core principle is that bonuses and stock are the two elements over and above a straight salary that tie in to the two sides of the business. This much is pretty straightforward. Bonuses tie to earnings and revenue goals, while ownership of the business through stock or options create an

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incentive for executives to increase shareholder value because they are numbered among the shareholders. In practice this can be more complex. For instance, a CEO who was the original founder has to make the transition from owning all the shares to owning only a portion of them (and seeing that a smaller percentage of a bigger pie is the more valuable of the two). It may be foreign for this individual to think of his or her compensation plan from the perspective that the ownership element is worth more than the salary and bonus element. It may never have been considered that salary and bonus were the minority players in the compensation plan. Here are some elements to consider... 16. If Senior Management Compensation is Wrong Senior Management, and particularly CEO, compensation that is aligned incorrectly begins to show signs of the mismatch. As the saying goes, the fish starts to stink at the head, so CEOs with the wrong compensation package start showing symptoms that they are set up with the wrong compensation package For example, if management does not have a significant ownership

stake in the company, they tend to look for other means of compensating themselves besides increasing the stock price (ie. shareholder value). These could be wages, perks, travel, entertainment, cars, side deals, etc. Even if they have high salaries, small or no ownership equates to no incentive to grow the stock price. 17. How to Get Yours It is an unfortunate fact that very few entrepreneurs can execute their business plans completely. Research shows that most entrepreneurs want two things: to make a lot of money, and to call the shots in their business. The same research shows that less than 25% of entrepreneurs are still CEO by the time their company makes its IPO.23 It takes a different set of skills to get your company off the ground than it does to manage it through the phases of growth. With that in mind, demonstrating that you can develop and execute on a growth strategy is one of the best ways to ensure your stake stays strong. Showing that you are a management team that can execute is the same as demonstrating that you are worth the ownership stake.

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18. How to Recruit the Right Board Why do you have a Board? Who do you want on your Board? What do you want out of them? Board members provide several things to a growing company. Having members who are experienced and can provide mentoring and leadership to the Senior Management team is a real strength. Board members also help the company raise money and make key introductions and forge relationships that help expand the business. In effect, Board members bring their network of contacts, their experience and their clout to bear in evening out the roadblocks that companies face in their path to growth. Board members should not just be a rubber stamp for the aims of management. They need to understand that they have a fiduciary responsibility to all the shareholders. Members need to be recruited who will ensure the best interest of the shareholders. Prior to Sarbanes Oxley, it was common for Board selection to be a process of dipping into the “Good Old Boys,” throw in some nepotism and take a devil-may-care attitude to independence. SOX changed all that. In order to be SOX compliant, you need to have an independent Board.

The company also needs to provide for Directors and Officers Insurance. Board members take on significant risk. Growing companies are by their natures involved in the risky business of being in business. When something goes wrong and a growing company has to declare bankruptcy or gets involved in a lawsuit, the members of the Board are exposed to significant liability. Often Board members come to the board as successful officers from other companies—which means when things go south, they represent the deep pockets for litigators. Remember, the average business person is sued every three years—this is a real concern that can be mitigated by proper D&O Insurance. 19. Conclusion Entrepreneurs and Senior Management teams are usually illequipped to realize the impact of the stock price side of the business. As I consult with growth companies in many industries, I find that rare is the company who really understands the impact of the investment side of the business. What that means is that there is a great opportunity for growing companies to create an advantage for themselves through competing

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along both fronts. How much would it mean to you to receive funding when your competitors do not? How much would it mean if you drove the value of your business by dedicating resources to increasing stock price and to marketing to your current and ideal shareholders? By embracing the responsibility of increasing shareholder value and by equipping yourself with the essential skills and strategy necessary, not only to do it, but to be wildly successful at it, you will rise above your peers. Even better, they won’t know why you are growing when they are shrinking (because they don’t know about the second side of their business either). Finally, by focusing on both sides of your business, you will be creating real value in the company as the stock price increases as well as understanding and capturing the best terms for yourself. You will understand the mechanics of how companies increase in value and gain the skills necessary to turn that into a winning growth strategy for your company. 

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Kirby Cochran is an educator, speaker and thought leader in the field of management and

finance and is a leading expert on capital structure and shareholder value. He has been teaching new venture financing and entrepreneurship to graduate students for over a decade. Kirby currently serves as an adjunct professor in the Finance department of the David Eccles School of Business at the University of Utah. A veteran of the venture capital industry and a pioneer of emerging approaches to raising capital, Mr. Cochran has been at the forefront of the growth company financing and management trends for over twenty-five years. In his new series of articles entitled Leadership Insight, Mr. Cochran reveals secrets used by entrepreneurs and CEOs to drive growth in their companies. This information has always been difficult and painful for Senior Managers to acquire, found only in the ruthless university of experience and obtained through costly tuition at the school of hard knocks. North Point Advisors, the firm founded by Mr. Cochran, advises growth companies on the implementation of the best practices discussed in Leadership Insight for increasing shareholder value.

ACKNOWLEDGEMENTS Chad Jardine, my close associate and friend, was responsible for much of the leg work and physical writing of this article. His contribution allowed the principles and practices of my consulting process to come to life in written form and bring my insights, personal experiences and unique “voice” to a new audience via the printed page.

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Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe. 2005. Corporate Finance, Seventh Edition. 15. New York: McGraw Hill/Irwin. 2. D&O Diary blog, The. http://dandodiary.blogspot.com/2007/01/executive-pay-shareholder-activism-and. html. 3. Note: Price is directly affected by the equilibrium of supply and demand. 4. Note: Shareholder base is all the shareholders cumulatively. 5. Armstrong, Robert, and Jacob Ward. 2008. Money Minded: How to Psychoanalyze the Stock Market. Popular Science, February. 6. Ibid. 7.  Note: Institutional investors are typically hedge fund, mutual funds, insurance companies, etc., and they typically make large buys or sales (compared with individual investors) and are managed by a professional manager. 8. Wikipedia. Float (finance). 2008. http://en.wikipedia.org/wiki/Float_%28finance%29 (accessed July 15, 2008). Note: The “float,” “free float,” or “public float” is usually defined as being all shares held by investors other than insiders and shares that are not “restricted.” 9. Note: Patriating refers to the process of moving shares from risky overhang into the free float where their price is determined by the market for the stock. 10. Wikipedia. Insider Trading. 2008. http://en.wikipedia.org/wiki/Insider_trading#General_Information (accessed July 15, 2008). Note: Corporate Insiders are members of the Board of Directors, officers & Senior Management, directors, key employees (control persons), or shareholders with over 10% of the issued shares. 11. DTCC: The Depository Trust and Clearing Corporation. 2008. http://www.dtcc.com/ 12. 2007. The US Model for Clearing and Settlement: An Overview of DTCC. 1. DTCC. 13. Goodman, Amy L., John F. Olson, and Theodore B. Olson, editors. 2001. A Practical Guide to SEC Proxy and Compensation Rules, Third Edition. 12-6. New York: Aspen Publishers. 14. Ibid. Note: Participants are the member organizations of the various national stock exchanges, such as Merrill Lynch, Goldman Sachs, etc. 15. BASF. Print Advertising. 2007. http://www.basf.com/corporate/printadvertising.htm 16. AFL-CIO. 2008 Executive Paywatch. 2008. http://www.aflcio.org/corporatewatch/paywatch/ 17. Wikipedia. Activist Shareholder. 2008. http://en.wikipedia.org/wiki/Activist_shareholder 18. Ibid. 19. CRO: Corporate Responsibility Officer. “Say on Pay” Gets Its Day. 2006-2008. http://www.thecro.com/ node/462 20. AFL-CIO. 2008 What You Can Do. 2008. http://www.aflcio.org/corporatewatch/paywatch/what2do/ index.cfm 21. Ross, Stephen A., Randolph W. Westerfield, and Jeffrey Jaffe. 2005. Corporate Finance, Seventh Edition. 14. New York: McGraw Hill/Irwin 22. Note: Compensation Committee information is readily available. Here are links to the Compensation Committees for Microsoft (http://www.microsoft.com/about/companyinformation/ corporategovernance/committees/compensation.mspx), Dell (http://www.dell.com/content/topics/ global.aspx/corp/governance/en/compensation?c=us&l=en&s=corp) and Dow (http://www.dow.com/ corpgov/board/comp.htm). 23. Wasserman, Noam. 2008. The Founder’s Dilemma. Harvard Business Review February, 2008. 1.

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