One of the most complicated issues in the junior exploration business is how to best align the interests of all stakeholders involved with the exploration process. These stakeholders include everybody from the retail investor on down, with a specific focus on management.
It is always a big checkmark for investors to see management pay personally for a big equity interest in the company they run. Unfortunately, for a number of perfectly valid reasons, this rarely happens. Not everyone has the capital to be a large equity player in their own company; and, oftentimes new management teams are brought in at a later point in the story where it is difficult to provide them with a “seed” position. To compensate for this, a rolling stock option plan is put in place where every year a certain number of options are allowed to be issued based on a percentage (often 10%) of the current outstanding share capital, minus those already in existence. In order to calculate the cost of these option plans to shareholders, the Black Scholes method is applied, which is, in short, a fairly simple statistical estimate of the expected value to the option holders.
At a first glance this process appears to make sense, as management and insiders are compensated through share price appreciation in a quantifiable and controlled manner. A closer look however exposes a massive underlying issue with this system which lies at the heart of the other major problem with the junior exploration model—shareholder dilution. The rolling stock option plans simply place the burden of previous errors onto shareholders by mitigating for management the previous mistakes and applying it to future success. This results in a direct conflict of interest between the two groups.
The options themselves are of course dilutive; however, that is not what is being referred to here. The issue at hand is the type of behavior that the classic options structure endorses and the conflict it creates with the best interests of shareholders. Being a capital intensive, cash flow negative business by nature unfortunately means junior explorers will always be at odds with the dilution machine. How this battle is managed is one of, if not the, most important key(s) to success in the exploration business. Without going into too much detail: a company that manages dilution well is a company that manages risk well.
If you take on too much risk too quickly you will end up with a nine digit share count in the blink of an eye (except for the extreme minority who get lucky). The argument is often brought up that in order to find a deposit you must spend money, and lots of it. This is true, but it can also be argued that with $10 trillion in exploration funding, someone with nothing but good permitting skills could single handedly make the next big gold discovery. All they would have to do is grid drill the entire State of Nevada with 500-meter holes at 50-meter centers. Not too many geologists would argue that it would be highly unlikely to find nothing under that scenario. The problem is of course it’s completely inconceivable that you would get a positive return on capital. With this in mind, why is it that so many companies run by very competent management teams drill projects that should not be drilled or take on too much risk by drilling a project that should be partnered?
Some will argue that it is a unique business where the companies are run by risk hungry individuals who want to gamble and have no understanding of how to run a company. However, since we are only referring to “competent management teams” in this case, this does not entirely add up. Firstly, as mentioned earlier, rarely do you see management put up their own money– which is often because they are too risk averse. Secondly, an important trait of a good management team is intelligence and, considering that basic corporate finance theory is far from rocket science, it is hard to believe they are all just missing the big picture. A large part of the answer lies in the incentive structure employed by juniors and the perspective it creates in the minds of the individuals at the helms of these companies.
From a management team’s perspective, a rolling stock option plan is insurance against dilution and therefore an incentive to take larger risks. For a shareholder, the risk of being diluted for purposes that are not accretive on a dollar per share basis is ever present. Every time a drill program fails, the next one must be funded with more dilution; and each time this happens the current shareholders own a lower percentage of any future success the company may have. Consider for a second that 99.9% of juniors could not receive a cash payment anywhere near equal to their market cap on sale of their properties. What this means is that exposure to possible future success (i.e. future production from management) makes up that difference and is the single biggest asset these companies have. As a consequence, being diluted from this exposure is the biggest single risk shareholders take. For management however, the story is different.
Although they too are diluted from their equity interest, it is backed with the knowledge that options are issued based on a percentage of the total share capital. It insures that for management, previous mistakes do not take as much from future success and places their best interest in direct conflict with that of shareholders. This is not to say that management teams are evil but only that they are human and, as a result, their decisions are highly susceptible to a position of conflict.
The next question of course is how to address the issue and that, unfortunately, is far more complicated than the problem itself. Many possible alternatives can be presented but in the end there are problems with all of them. For instance if options are issued based on a fixed initial number and not as a percentage of the company would this help? Management teams would lose interest in the company as their equity interest was diluted and eventually leave altogether, but is this really that much worse than the status quo? Perhaps the most obvious solution is to approach management compensation on a more case by case basis just as would be done with any other business decision, instead of always applying it from the mold of another company. As a retail investor, it is of significant value to simply understand these conflicts so as to aid in your own decision making process.
In the end, a proper incentive structure for a management team will of course have an integral focus on capital gains as their path to profit. This however must be combined with a higher level of accountability for previous mistakes, thereby helping to instill a more entrepreneurial spirit and paternal level of care for the company’s future (an “I built this company out of my garage” mentality).
Disclaimer: Mr. McLean is employed as an Investment Advisor at Haywood Securities Inc. The views and opinions expressed by Mr. McLean are his own and not necessarily those of his employer and are provided for information purposes only and not as investment advice.
This piece was originally published March 25, 2012 in Brent Cook’s Exploration Insightsnewsletter. To quote Rick Rule, founder of Global Resource Investments,
”Serious mineral exploration speculators should “employ” Brent Cook… Brent is a no nonsense “boots on the ground” geo, not one of the “desk explorers” who cost the investment community so many millions. He can make you serious money with his buy recommendations, and save you much more, by counseling you on what to avoid. Most newsletters are written by journalists, if they researched publishing investments, maybe they would be credible. Brent is an exploration geologist, writing about exploration geology, what a wonderful, novel idea. Do your portfolio a favor, subscribe!”
Rick Rule, Founder
Global Resource Investments