When you own your own business you can make sure that any managers working for you are acting in your interest. It is different for public companies, where management is not directly answerable to shareholders. In corporate governance terms, this is called the agency problem. How can a shareholder be sure management, who acts as the shareholder’s agent, is acting in the shareholder’s interest? In theory this is done through the Board of Directors.
For the board to be an effective guardian of shareholder interests, it should strive to mitigate conflicts of interest between stakeholders, and in particular between management and shareholders. Managers left to pursue their own agendas unchecked can grant themselves excessive pay, use shareholder funds wastefully, engage in nepotism and do many other things that could potentially be harmful to the shareholders.
Long-standing best practices and recent regulatory changes under the Sarbanes-Oxley act require that the board be independent from management, have the appropriate expertise to evaluate management performance and have the authority to act independently from management when necessary. However, independence can be subjective and difficult to judge. McEnally and Kim (CFA Institute, 2006) suggest that factors indicating a lack of independence include:
- Former employment with the company
- Business relationships
- Personal relationships
- Interlocking directorships (serving on multiple boards together, particularly if executives of one firm serve on the compensation committee of another board member’s firm)
- Ongoing banking or other creditor relationships
Based on these criteria, we have concerns over the relative board independence at Silicon Laboratories (SLAB). Of eight board members, three are company executives or founders. Of the five classified as independent, four are either venture capitalists or investors, three were former executives at companies ultimately acquired by Hewlett Packard (and thus likely have personal relationships outside the Board of Directors) and 2 attended the Massachussetts Institute of Technology.
Any particular one of these relationships would not necessarily be sufficient cause for concern. Furthermore, it is possible that the ownership stakes held by the investor and venture capitalists make them treat their board responsibilities more like shareholders. All told, board members and executives hold more than 11% of the shares outstanding, which itself serves to link their interests to those of shareholders. However, according to the Silcon Labs proxy statement:
Silicon Laboratories believes that the backgrounds and qualifications of the directors, considered as a group, should provide a diverse mix of experience, knowledge and skills.
As diverse as any collection of venture capitalists can be, we suppose.
The other concern we have also relates to the share ownership, much of which is derived from option grants. Each director is granted 30,000 options upon joining the board, and each year every non-executive board member receives an automatic option grant of 5,000 shares and a discretionary option grant of 5,000 shares (which has always been granted.) Our concern is that, since responsibility for granting the discretionary options appears to fall to the CEO and one of the co-founders, these board members have reason to believe that they work for management rather than the shareholders.
While companies ignored any cost for options until recently and Silicon Labs still reports their value as the amount they are currently “in the money” (have exercise prices below the current share price) in the proxy statement, all one needs do is call up a quote to realize they are quite valuable. For example, as of yesterday’s close the July 2007 call options with a $35 exercise price (slightly out of the money) closed at $5.10 each. With 10 years to expiration and issued at-the-money, Silicon Labs directors options are clearly much more valuable than those quoted. Still, even at $5.10 each the directors receive a discretionary grant worth $25,500 each year (about the same as their cash compensation.) This is on top of an equal-size grant that is automatically awarded. In all, between cash and options the directors receive compensation worth at least $90,000 per year (equivalent to $10,000 for each board meeting attended.) And that is not counting the initial option grant, which is worth hundreds of thousands of dollars.
To be sure, some boards pay far more than that. But Silicon Labs is a relatively small company, with less than $500 million in annual sales. For example, newsprint manufacturer Bowater (BOW) only offers 1,500 shares of restricted stock (although it pays slightly more in cash compensation.) Bowater has annual sales of $900 million. Apparel retailer Buckle (BKE) has approximately $500 million in annual revenue and pays only $22,000 in cash compensation and 3,000 stock options. The level of director compensation at SLAB in comparison is another indicator that their interests are not completely independent from management.
The last bit of concern we have over the governance being provided results from their high level of CEO turnover recently (3 CEOs in as many years.) The initial candidate hired to replace the founders, Dan Artusi, was let go after a relatively brief stint. While it is true that things sometimes do not work out, his separation package allowed him to collect $165,000 in cash plus immediate vesting of options he was able to cash out for $2 million. These options, purportedly issued as “long term incentives” ended up rewarding a very short term indeed.