I’ve seen some people argue that management’s incentives must be aligned with shareholders because insider ownership is high. I think that this is a dangerous idea. Insider ownership tends to be fairly high in fraudulent stocks and stocks with bad management teams. Scams and frauds involving the sale of shares at inflated prices often begin with the perpetrators owning almost all of the stock.
Fundamentally, there will always be conflicts of interest between management and shareholders in publicly-traded companies. The problem is that insiders own 100% of their personal bank accounts versus some smaller percentage of the publicly-traded company. The insiders will always have an incentive to transfer money from shareholders to themselves. Here are some methods:
- Excessive salaries and other forms of compensation (travel, entertainment, special defined benefit pension plans not available to rank and file employees, etc.).
- Related party transactions.
- Run away with the money. This has happened with at least one Chinese reverse merger.
- Insider selling. Insiders may sell stock at inflated prices. Sometimes they do this secretly.
Shareholders should really be asking: is management honest? One way to answer this question is to look at whether or not management tried to avoid conflicts of interest. In particular, shareholders should ask these questions:
- Are there related party transactions? If so, are they fair?
- Has management tried to avoid unnecessary conflicts of interest? In practice, many related party transactions could have been avoided. They almost always reflect poorly on management.
- Does management own private companies that compete directly with the public company? Honest people would avoid creating such a situation.
- Has management tried to align their interest with shareholders?
- Has management tried to create a situation where their equity stake in the company is more important to them than their salary?
- Is management selling shares? Is their reason legitimate? (There are legitimate reasons for insider selling.)
On the other hand, honest and skilled managers with low insider ownership will still work hard at making money for shareholders. While incentives drive behaviour, the owners of that company will often impose an incentive structure that creates the right incentives. At almost all publicly-traded companies, compensation is linked to performance. Insider ownership often doesn’t matter as managers will often work hard without it. Conversely, there is no incentive structure that will solve the problem of unethical management. CEOs will always own more of their personal bank accounts than their equity stake in the public company.
When insider ownership correlates with good things
Insider ownership tends to be high if the founder is still running the company. In general, I believe that the founders of publicly-traded companies tend to be more skilled than the average CEO of publicly-traded companies. In the initial public offering process, there is some skewed selection that occurs. Poorly-managed retailers tend to stay extremely small- too small for an IPO to be worthwhile. This generally means that only well-managed retailers will be IPOed. For this and other reasons, it is possible that insider ownership correlates with management’s skill. Stocks with high insider ownership may outperform simply due to this correlation.
At the end of the day, looking at insider ownership is a distraction. Often what really matters is management’s skill and integrity.