Investing in SmallCap world – the importance of understanding the influencers

Since 2007 my directorship career has included eleven companies (six listed and five unlisted) where a real risk existed of competing interests between an influential shareholder/controller and the wider investor-base. In each case, the duty of a director to act in the best interests of the company required me, and all my board colleagues, to temper any adverse effects of that influencer’s competing interests. In some cases the influencer was an executive officer or founder. In others he was an activist investor. In most (but not all) cases, as a shareholder he held less than 50% of the voting rights.

At what level does the influence of such a person enable him to exert de facto control over board decisions and render him a “controller”? I see two scenarios.

In the first, the controller was the founder and is a board member. Typically, the board comprises his chosen allies. Here the action is more likely to take place in the board room rather than in general meetings of shareholders. The controller might stand to gain through direct contractual reward – remuneration, success-based profit share, share options or share warrants. Or his “gain” might be indirect – financial reward from the company to a third party in a way that works to the controller’s advantage.

In the second, the controller is a shareholder with a substantial minority holding, but not a director. My experience of SmallCap world is that investors with insubstantial holdings are passive, typically do not vote, and, generally, will follow the fortunes of an activist substantial shareholder. Beware, however, the risk that the substantial shareholder may have interests competing with other shareholders’ interests. A seasoned and enquiring director can sense that risk. Even if all investors possessed the same information, how many would react?

In either scenario, it’s all down to voting on the day of course. A holding of around 18-20% has a strong chance of carrying a majority vote at a general meeting of shareholders, for example on a resolution calling for board changes. Shareholders own the right to vote, and do not have to exercise voting rights to benefit anyone’s interests except their own.  For the board to resist the determined wishes of a controller can, in my experience, have a negative outcome. A board initially acting as one, in knowing the right thing to do for the company, can be split by one or two telephone calls to selected board members. That can leave whichever director is perceived as the architect of resistance to be vulnerable to ousting by his board colleagues to satisfy the controller’s wishes, or via shareholder requisition calling for a general meeting of shareholders to vote on a resolution for removal of the director. For the targeted director it can be a matter of “Thy Will be done”, or you’re out!”. I have been through the full spectrum.

In a simple world, showing the controller that your experience and ability can add value to an outcome would be enough. Ultimately, though, added value from the perspective of directors’ duties means in the best interests of all those with a stake in the fortunes of the company, but for the controller it means only in his own best interests. Fairness and openness should always prevail, but how should a director go about achieving that? Therein lies the difficulty for the director.

So not all my roles had happy endings. However, I learned by far the most from those that didn’t.

If you choose to invest in a SmallCap company, first decide who you think are the controllers. Is it the board, or is it a substantial shareholder? Do your research and learn what you can about their other interests. Then research all the directors and decide if the company looks to have strong governance independent of controlling interests, and capable of always acting in the interests of the company. Do the directors look suitable for a role as custodians of your money? In case that alone is not enough, form your view on whether the controllers’ interests are sufficiently aligned with yours to mean you can safely follow their fortunes.