Incentive stock grants — Not what you may think

As it is the case for all postings in this blog, my standard disclaimers apply for this posting.  However, since this posting discusses investments, I urge you to review the disclaimers laid out in the About section with extra diligence. Moreover, even if you have already reviewed these disclaimers in the past, you need to review them again, as they are subject to change without notice.  Do it now, and remember that whatever I say in this blog posting is simply my opinion — it is not science, it is not advice, and it is not an attempt to make you act in any way whatsoever.

8d20979vI hold an investment in ClickSoftware, an Israeli based software company traded on Nasdaq under the ticker symbol CKSW.

ClickSoftware, with annual revenues is excess of $100 million and strong competitive advantages, is an interesting and intrinsically very valuable company with the potential to greatly grow over the next years.

Overall, I quite like what the company does and how its management team and Board of Directors moves forward with a long term outlook, rather than a quarter-by-quarter outlook — even when the market disagrees and quarter-after-quarter assigns CKSW a low per share price.

There are, however, areas where I disagree with the approach of ClickSoftware’s management team and Board of Directors. Two of these areas are the issuance of excessive amount of incentive equity to the company employees and the the issuance of incentive equity to the company’s CEO, Dr. BenBassat, in the form of options grants of CKSW stock.

Year after year, the company has experienced an aggressive dilution rate because of its regular grant of incentive equity to its staff. This dilution is particularly problematic because of the fact that the per share price of CKSW effectively has moved very little since the company’s IPO in June of 2000 — where the company’s equity was priced at $7 per share — in spite of an enormous growth in annual revenues and one of the strongest balance sheets around.

Although the per share price has from time to time gone higher than its current level and although the company has paid out a small (but consistent) dividend since 2011 and in spite of the company’s acquisition of three small companies for cash, it is my opinion that the performance of the company’s per share price over the years since the IPO is unacceptable and is adversely affected by a mostly unnecessary annual dilution of the common shareholders.

The sting of this dilution, which I consider almost completely unnecessary given the company’s current revenue level, projections for growth, stability, and excellent compensation (at this stage, the company is hardly extending options as sweat equity or to compensate for any risk,) is aggravated by the company’s consistent issuance of incentive equity to Dr. BenBassat, at a level that effectively has kept him immune from the dilution that he, as the company’s CEO, is the prime mover behind. Naturally, no such dilution offset has been offered to the common shareholders.

I wrote about the direct impact of this issuance of equity incentives to Dr. BenBassat (dilution) and the indirect impact (increased risk of financial hijacking) in a previous post (here,) saying that:

[T]he company’s Chief Executive Officer and other parts of the company’s management team control approximately 20% of the outstanding shares, a significant number of options are outstanding at an exercise price vastly below the current per share price of $8, or so, and the company continues to issue stock based compensation at a high pace in spite of the fact that the company’s net performance, measured in earnings per share, has deteriorated over the last years.

There are, of course, other forms of financial hijacking, including consistent issuance of diluting incentive equity to senior employees who does not need it. For ClickSoftware, for instance, Mr. BenBassat — in one form or another — controls close to four million shares, amounting to 12%, or so, of the total number of outstanding shares, and, yet, the company’s Board of Directors, lead by Dr. BenBassat, insists on issuing more than 100,000 options on an annual basis to … you guessed it… Dr. BenBassat.

Should the company be sold at some point in the future at a per share price of $15, Dr. BenBassat’s shares (or, rather, shares controlled by Dr. BenBassat) will be worth a staggering $60 million. On this scale of compensation, I, for one, do not see how the addition of 100,000 options annually really increases Mr. BenBassat’s incentive to achieve such outcome.

Generally, I am subject to a lot of criticism when I point out that incentive equity is not the panacea that is it made out to be in the business and investment writings — particularly when it comes to stable companies with limited risk and well-compensated staff, and, in fact, can be contrary to the interest of the common shareholders. The idea that incentive equity — in particular when issued to CEOs — is a necessity and an absolute good is as ingrained in the common business and investor culture as is the notion that growth companies should not pay dividends (a ridiculous and inherently value-destabilizing notion that was most recently repeated by Warren Buffett,) and any attempt to counter this notion has traditionally let to ostracizing.

I was, therefore, pleasantly surprised when I read a recent working paper from some pretty smart fellows at University of Cambridge, University of Utah, and Purdue University (you can find it here,) which concluded that there was evidence that (I hope you are sitting down for this one, dear reader):

… CEO pay is negatively related to future stock returns for periods up to three years after sorting on pay. For example, firms that pay their CEOs in the top ten percent of
excess pay earn negative abnormal returns over the next three years of approximately -8%.

The effect is stronger for CEOs who receive higher incentive pay relative to their peers. Our results appear to be driven by high-pay induced CEO overconfidence that leads to shareholder wealth losses from activities such as overinvestment and value-destroying mergers and acquisitions.

Whoaaa!!!!! Let me translate: Higher incentive pay leads to lower performance.

The study (hat off to a Yahoo Finance message board poster, vo2macs, who pointed my attention to the study,) which has a basis of 1,500 companies (largely the S&P1500 firms) over the period from 1994 to 2011 period, is complex, but the gist of it is that there is a problem with incentive equity in that it stimulates overconfidence. While incentive equity do work as an incentive, it also attract individuals that are willing to take too much risk with the company’s money.

This may be a surprise to most readers, but it is quite in line with the fickle nature of incentives as described in a recent article by Dr. Barry Schwartz, a Professor of Psychology at Swarthmore College (you can find it here, courtesy of LinkedIn) who in his article concludes:

Thinking of “smart” incentives as magic bullets is virtually guaranteed to demoralize activities, and practitioners, and eventually, whole practices. Incentives are meant to be a substitute for having people who do the right thing because it’s the right thing. They aren’t.

The finding of the working paper is consistent with my issue with the regular issuance of incentive equity to Dr. BenBassat. First, the study establishes that there is no proof that such issuance promotes performance (au contraire, it appears that it impedes performance,) and, second, it implies that there are significant risks associated with constantly increasing the size of the ownership position held by Dr. BenBassat at the expense of the common shareholder — something that is intuitive, but nevertheless constantly disputed by business and investment demagogues.

It is nice to be vindicated — in particular when you find yourself exiled.

For the record, other substantial investors in ClickSoftware has, I believe, argued pretty consistently against the number of options issued to Dr. BenBassat by the Board of Directors, albeit with a different twist.

In particular a long term investor located in the Pacific West has argued for years that the issuance of share options to Dr. Benbassat has no real incentive value, and, in fact, acts as a demotivating force on the rest of the ClickSoftware Staff, because it creates, and a I paraphrase, two different classes of employees within the company. This investor has also argued that rather than just not issuing these options to Dr. BenBassat, the options should be reallocated to other ClickSoftware staff.

I understand the first point, but I don’t agree with the derived, second point for the reasons that I highlighted above and has written about in the past: (1) At this point in ClickSoftware’s life-cycle when the company is mature, growing, stable, and profitable and the company is compensating its staff at the market level or better there are no pay-equivalency or risk reasons to provide a large number of incentive options to the staff, (2) the level of incentive equity issued is value-destroying, deflating or depressing the earnings per share, even when the company’s net income increases, effectively paralyzing the company’s per share price, and (3) in an almost perverse irony, the incentive equity, which is priced at the deflated or depressed market value, is effectively in-the-money if the company would simply stop issuing vast amounts of incentive equity, and, therefore, it does not truly act as an incentive and, in fact, introduces a cultural hazard.

The third point may not be intuitive, but it is nevertheless true. Effectively, the company is significantly undervalued — something that anyone working at any higher level of responsibility within the company is aware off, and, therefore, there is surely an ingrained sentiment that whatever happens and whatever effort is expended by the recipient of the incentive equity (whether big, small, or just average,) there is going to be an incentive rewards at some point in the future. This not only neutralizes the options, but, also, creates a cultural hazard with (a) a very real risk that complacency will set in, and (b) the company’s value increase being determined not by the company’s actual operational performance,but, rather, by a Board of Directors’ and executive management team’s decision to issue or not issue options, effectively shifting control from the owners to an inside trigger-man.

Simply put, for incentive equity to work is must be a stretch, and for incentive equity to be justified, it must not materially and consistently depress or deflate the earnings per share.

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