Why Small-Cap Investors Often Aren’t Keen on Large-Cap Board Members

I regularly spend time in boardrooms providing buy-side perspectives on many of the unique challenges that small-cap directors face. Occasionally these boards contain directors who are new to the small-cap world, having spent their careers exclusively operating, governing, or advising large-cap companies. These board members, and their colleagues, are often surprised – and not in a good way – to learn that many small-cap investors don’t always view their large-cap experience in a positive light.

Here is the good, the bad, and the ugly in this regard through an investor’s lens.

The Good 

Small-cap companies are often operated and governed by those who, intelligence and sophistication notwithstanding, are new(-ish) to the public company realm. Accordingly, those who have operated, governed, or advised large-cap companies can provide tremendous insights about boardroom best practices, and the policies, procedures, and corporate culture which need to be cultivated for smaller companies to successfully scale. Moreover, many from the large-cap world also are able to expertly counsel CEOs about how to more effectively communicate with and utilize boards, and vice versa. It’s also often very helpful to have a board member who is more experienced and comfortable with speaking to institutional investors, particularly since the majority of shareholder activism takes place in small-caps. 

The Bad

Unfortunately, experienced small-cap investors have learned the hard way that the positives can be outweighed by the negatives. 

• Form over substance. If a large-cap company is akin to an aircraft carrier, many small-caps are more like speedboats. The former takes dozens of people and extended periods of time to change speed or course, while the latter can take one or two people and happen in a matter of seconds. When you try and operate a speedboat the same way as an aircraft carrier, it’s pretty easy to hit other stuff… or sink. Every small-cap investor has a story about a portfolio company that sunk – or came needlessly close to it – because a newly-appointed board member from the large-cap world unconsciously redirected the board’s attention away from key existential threats to never-ending boardroom box-checking.
• Misplaced emphasis on proxy advisors. Large-cap companies are typically more than 80 percent owned by large institutional investors. Those investors, in turn, can place a high degree of emphasis upon third-party advisors that educate institutional investors how they should consider voting on various annual proxy proposals. These so-called proxy advisors (e.g., ISS, Glass Lewis, etc.), can be highly impactful on board appointments and director compensation, among other things, and large-cap board members can get transfixed upon remaining within the good graces of ISS, et al. Regrettably, many large-cap emigres assume that their small-cap colleagues should be equally concerned about proxy advisors, despite the fact that many small-caps are majority owned and traded by retail (i.e., nonprofessional) investors who don’t care one iota about what any proxy advisor says… about anything. The result isn’t pretty, because when small-cap boards lose primary focus on strategy, innovation, culture, and capital formation, and instead become enamored with proxy advisors, bad things tend to happen.
• Consultants aplenty. Not surprisingly, there are large-cap boards that spend more on a single board member, than small-cap boards spend on their entire corporate governance infrastructure. Large-cap boards also can spend millions of dollars annually to retain consultants that assist with everything from compensation benchmarking and risk management, to cybersecurity and board performance. But many small-cap investors, officers, and directors bemoan the fact that their new large-cap board appointee’s answer for every issue upon arrival is: “let’s hire a consultant.” While this learned behavior is understandable, it presents huge problems for small-cap boards that often don’t have the resources – or the time – to hire consultants.

The Ugly

It gets a bit worse, unfortunately.

• Low capital market IQs. Large-cap companies are typically valued based on how profitable they are. Correspondingly, large-cap folks are often inclined to view unprofitable public companies less favorably, and, in so doing, can dangerously misdirect a small-cap board’s focus to the detriment of shareholders. Now, to be sure, there isn’t a small-cap company that doesn’t want to grow like a weed, and be wildly profitable. But, many of those companies aren’t “small-cap” for long. Most small-cap companies instead are either growing fast and aren’t yet reliably profitable, or they are growing slowly and modestly profitable. While reasonable people will differ, the former are always going to be valued much higher than the latter. Uber was recently valued by the market at $60 billion, and Amazon recently eclipsed a trillion-dollar valuation; the former has never been profitable and is a serial capital raiser, and the latter was marginally profitable for 10 years after its IPO. Many large-cap professionals new to the small-cap world have one-track minds: never mind the growth, get profitable now. Be careful what you wish for though, because public companies tend to be less interesting… when they have no investors.
• Unrealistic homework assignments. Large-cap boards are sometimes supported by extensive governance staffs, and they are accustomed to dozens, if not hundreds, of senior officers, in-house lawyers, and finance teams. Small-cap boards, on the other hand, typically have no governance staffs, their companies often don’t have a single in-house attorney, and you can sometimes count the senior officer ranks and finance department ranks on two hands. The problems occur when large-cap board members forget the austere limitations of their new surroundings. For example, small-cap CEOs with large-cap board members regularly confide in me that they are tasked with providing voluminous data to the board – at the request of the large-cap board member – that literally grinds their officers, finance teams, and outside lawyers to a standstill. When CEOs ask me for an antidote, I tell them: you need a really experienced, independent chairperson who is from the small-cap world, who can make sure that such requests are right-sized for the company’s resources.   
• Corporate finance disasters. Large-cap companies rarely need to access the equity capital markets, and when they do it’s almost always from a position of strength and leverage – strong balance sheets and extremely liquid stocks. On the other hand, many small-caps are serial capital raisers, and often transact financings from positions of weakness and vulnerability – everyone knows they are running out of money and their stock is illiquid. Here’s the rub: when I was an institutional investor, many of our portfolio companies either waited too long to raise “must have” capital, or they turned down “market terms” all because a large-cap board member noisily applied big company corporate finance sensibilities to a marketplace they didn’t understand – at all. This problem is exacerbated by the fact that “other” board members are often overly deferential to the new board member who operated, governed or advised famous companies. Just because someone works on an Indy 500 pit crew, doesn’t mean they are the best person to change the brakes on your Lexus.

Small-caps that are considering onboarding a large-cap board member should consider a handful of things to increase their chances of success: (1) if your board is convinced that the prospective board member is the best person for the job, then, by all means, appoint them; (2) given the concerns many experienced investors have in this regard, it’s a good idea to make sure your largest shareholders get an opportunity – sooner versus later – to meet the new board member; (3) at a minimum, make sure that the relevant subsequent proxy disclosures are plainly and transparently worded to best convey the board’s appointment rationale; (4) don’t assume that your new board member understands the unique issues your company faces just because they’ve overseen a large enterprise; (5) look for early warning signs that existing board members are being overly deferential to the new appointee’s viewpoints; and (6) if the appointee isn’t quickly acclimating to their new surroundings, make sure the board’s leadership communicates the same quickly and constructively.

Though it perhaps goes without saying, there are some large-cap cognoscenti with no small-cap experience who make incredible small-cap board members – full stop. But, by the same token, there is a reason why many veteran investors have trepidations about this fact pattern. 

The best approach for all concerned parties is: eyes wide open.

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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 private corporate events, and corporate governance and investor conferences, and has appeared internationally more than 150 times since 2012. Mr. Epstein is a key contributor to Nasdaq’s Amplify small-cap content initiative, a mentor at the Nasdaq Entrepreneurial Center, and he is chair of Small-Cap Institute's editorial advisory board. He is the author of The Perfect Corporate Board: A Handbook for Mastering the Unique Challenges of Small-Cap Companies (New York: McGraw-Hill, 2012). In June 2017, The Perfect Corporate Board was the #1 ranked corporate governance book on Amazon.com, Connect with Adam on LinkedIn or learn more at https://adamjepstein.com/.