Buybacks, Investor Communication… and Bad Small-Cap Lawyering
As I wrote about recently in an American Bar Association corporate governance publication, my firm’s small-cap clients regularly change law firms due to bad advice (i.e., not because of fees, staffing, or responsiveness).
As a former large-firm lawyer and institutional investor, I see two principal culprits:
- Capital markets and corporate finance issues are not fungible. Since many large law firms spend considerable time advising larger public companies, assumptions are too often made that the same advice applies equally to more nascent public companies.
- Today’s capital markets are virtually unrecognizable fr om 10 years ago, particularly for small-cap companies. Boardroom legal (and business) advice needs constant recalibration in light of the changes.
Unfortunately, there are many examples in this regard. Recently, I’ve seen attorneys give small-cap companies terrible advice regarding two subjects in particular. I’ll be discussing these and other examples in more depth during the webinar on September 27, 2017.
Mid- and large-cap companies routinely repurchase stock. By reducing the number of outstanding shares, earnings per share rise, and, theoretically, so too will share prices. In the S&P 500, for example, literally trillions of dollars have been spent on buybacks in the last 15 years (for better or for worse, mind you).
Buybacks undertaken by large public companies tend to have several things in common: (1) these companies are materially (and historically) cash flow positive; (2) the buybacks authorize millions – if not billions – of dollars of stock to be repurchased (e.g., Apple has repurchased ~ 20% of its stock since 2012); (3) these companies are widely covered by leading sell-side research analysts; and (4) these stocks are predominantly traded/owned by large institutional investors.
Small-cap companies also transact share repurchases. Unfortunately, too many large-firm lawyers, who advise both large and small public companies, don’t realize that many small-cap buybacks are viewed by the buy-side as meritless publicity stunts.
Particularly in companies with market capitalizations below $500 million, there is a swath of exchange and OTC-listed companies that are cajoled by short-term focused and/or unsophisticated investors and advisors into undertaking stock buybacks. Believing that buybacks are acceptable (even positive) corporate transactions for all sized companies, counsel often acquiesces to (or even recommends) the same.
Why does the buy-side view some small-cap buybacks as a sign of naiveté instead of acumen? Unlike in the large-cap ecosystem, many small-cap share repurchases are undertaken fr om positions of weakness: (1) companies are marginally profitable (or not profitable at all); (2) the stocks are not covered by credible research analysts (so the characteristically small change in share count is akin to a tree falling in the woods); (3) most of the companies are retail-owned and traded (and retail investors historically are less focused on valuation ratios and more focused on revenue growth); and (4) most of the companies are nascent growth companies that should be using any cash they have to further catalyze growth (or, simply returning it directly to shareholders if they can’t find a prudent corporate use for it).
In the most egregiously value-destructive situations, there are small public companies that use cash to repurchase stock, and shortly thereafter transact equity or debt financings because they are on the verge of running out of money.
When advising small-cap companies, attorneys need to be mindful that capital markets are not one-size-fits-all. If a client company is diminutive and historically cash-starved, authorizing any stock buyback (much less one in tiny increments) is going to signal to savvy investors one thing, and one thing only about that company: it likely shouldn’t be publicly traded.
In the not too distant past, it was anomalous for investors to actively (and successfully) seek out board members of public companies to speak directly with them. Correspondingly, it has historically been “Prudent Lawyering 101” to advise client board members not to speak directly to investors.
Today, however, in the large-cap marketplace, investors speak with board members (in carefully choreographed settings) daily. And, investors are also seeking out direct communications with board members much more regularly in smaller public companies (remember, 78% of shareholder activist campaigns in 2016 were in small-cap companies).
Unfortunately, far too many corporate counsel haven’t gotten this memo. I regularly still hear lawyers advise their clients that board members have no obligation to speak directly to investors, and… they shouldn’t do it.
It’s a great example of the difference between Delaware law… and reality. Ultimately, legal advice premised exclusively on the fact that the arbiters of corporate governance efficacy are the judiciary is bound to fail. In actuality, the real judges of boardroom excellence aren’t judges – they are institutional investors.
Investors are wise to engage directly with board members in order to assess firsthand whether directors are appropriately suited to oversee management on behalf of shareholders. This is particularly true in the small public company environment wh ere many directors lack appreciable governance experience, and CEOs can exert undue influence on board composition.
As alluded to earlier, director-investor engagement needs to be carefully orchestrated. Directors need to be educated about what they can and can’t say pursuant to Regulation FD, and they need to be conversant with a company’s strategy, risks, corporate performance, and messaging. Succinctly, not every board member will be appropriately suited to speak directly with investors, and, as is the case with most things in life, preparation is everything.
That said, when lawyers rigidly counsel boards not to speak directly with the buy-side they are ensuring an ominous future – one that doesn’t include investors.
A lawyer’s primary role is, of course, to provide legal advice. That said, what they don’t tell you in law school is that lawyers are routinely asked to opine on business issues, particularly in boardroom settings.
If I were a law school professor, I would have a brutally frank admonishment for future corporate lawyers: “When it comes to capital markets, you’re either really an expert – or you’re not.” Attorneys who aren’t experts should simply stand down in favor of those with more experience. Such deference is particularly important in small-cap boardrooms wh ere companies are often only one bad capital markets decision away from disappearing.
No advice is better than bad advice… every time.
The author, Adam J. Epstein, is a former institutional investor, and now an advisor to CEOs and boards of pre-IPO and small-cap companies through his firm, Third Creek Advisors, LLC. He speaks monthly at corporate governance and investor conferences and has appeared internationally more than 100 times since 2012. Mr. Epstein is a key contributor to Nasdaq’s new Amplify small-cap content initiative, and a distinguished National Association of Corporate Directors (NACD) Board Leadership Fellow, and faculty member. He is the small-cap contributing editor for Directorship magazine, author of The Perfect Corporate Board: A Handbook for Mastering the Unique Challenges of Small-Cap Companies (New York: McGraw-Hill, 2012), and contributing author to The Handbook of Board Governance: A Comprehensive Guide for Public, Private and Not for Profit Board Members (New Jersey: Wiley, 2016). In June 2017, The Perfect Corporate Board was the #1 ranked corporate governance book on Amazon.com, and, in June 2016, The Handbook of Board Governance was the “#1 New Release” in corporate governance on Amazon.com. Connect with Adam on LinkedIn or learn more at https://adamjepstein.com/.