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Column

Gary Sutton
Columnist, “Sutton’s Laws”
Directors & Boards

Whimsies, Fads, and Lipstick on Pigs
Stay focused, and stick with what’s important.

By Gary Sutton

Comp committee chairmen: You’re now the most likely to be sued. And proxies will be withheld for your re-election if ISS doesn’t like your decisions. Audit was the hot seat yesterday. Today it’s you in the crosshairs.

Just like sales commissions, there’s never been a perfect executive comp plan. Penalties and rewards will never be absolutely fair. And so, executive comp plans are always fluid and subject to the fads du jour.

Restricted stock units are the latest fad. RSUs are in vogue for three reasons:

Execs like them because they get rewarded by RSUs even if the stock price drops. That’s great . . . but only if you believe your top people should be free from the pain that your shareholders suffer.
Boards like RSUs because they can be made to vest over time, like options. That’s great . . . but only if you want to retain disgruntled managers who might otherwise bail out.
Many like them because the cost to the company is more straightforward than today’s requirements for expensing stock options. That’s a reasonable but underwhelming advantage.

Knocks on Your Stock
Stock options linger. They’re not so bad, since management works for the shareholders. The problem is that they don’t always relate to performance. For example, when your stock drops, it could be from any of seven reasons:

1. A major shareholder has a liquidity crisis, and starts dumping shares every quarter.

2. Your respected IR professional leaves.

3. A couple of analysts guess that the healthcare bill is going to ravage your earnings.

4. Business Week sees that your earnings dropped, but missed that you’re writing off an acquisition that doubled your cash flow and boosted revenues by 50%. They offer to print a letter from the CEO explaining this, but have no room to print until three issues later.

5. Your numbers are all up but the market drags you down with it.

6. Foreign exchange rates go against you.

7. A short seller, not knowing that your major customer has doubled its commitment to you, whispers that you’re losing that business.

These and other whimsies of the market can pop your stock up, but with the same level of deep irrelevance.

Your Stock Gets Gamed
Stocks, by the way, vacillate because institutional investors game them. An institution may hold your stock for many years. But the institution’s manager gets bored. He sticks with you through those years, but he sells some every time you hit 100 and buys every time you drop to 80. That cures his boredom. He’s never entirely in or out. But he noticed this range, and it works for him, and the net effect is that he turns over his holding 100% every year.

This is called “trading around the core.” Most do it. And what’s more, as more do it, this practice actually defines your trading range. That is, of course, until some unforeseeably huge change smashes through that floor or ceiling, which puts the institutional investors into a deep rage, whether up or down, since they stayed in their range.

That’s why exec comp shouldn’t depend on options. Some, yes. Everything based on options, no. When it’s all about the stock price, hallway conversations turn into glee at uncontrollable price spikes, and depression when some totally uncontrollable event depresses the price. Morale is driven by silly things. And it distracts from business.

The Only Thing That Proves Something
Stick with the only thing that proves the business is doing well. Cash flow. Make that real cash flow: spendable dollars after investments. But don’t even reward that if it came from an asset sale, or a profitable acquisition that destroyed your balance sheet.

Forget EBIDTA. That’s a formula for “Earnings Before . . . costs we simply cannot reduce without bankruptcy.” Forget pro forma earnings. That’s Latin for “in your dreams.”

EBIDTAs and pro formas are great lipstick for pigs, but if you use them, don’t fall into the trap of believing they mean much except to naïve investors.

Stick with cash flow.

Gary Sutton has been a CEO and director of a number of private and public companies in his career as a specialist in startups and turnarounds. He writes the “Sutton’s Laws” column for Directors & Boards.

He is the author of two books on business, “Corporate Canaries: Avoid Business Disasters with a Coalminer’s Secrets,” which has been translated into six languages, and “Six-Month Fix.”

He can be contacted at garysutton@san.rr.com.