MicroCap executive compensation is a topic that is discussed repeatedly in our members forum on MicroCapClub. Unfortunately, it is a topic that always seems to be brushed under the rug by many investors. I’m not an executive compensation expert, but I have invested in over a hundred microcap companies over the years. As a full time microcap investor, there have been plenty of instances where I have completely passed on making an investment primarily due to executive compensation amounts and/or structures. In its truest form investors want to know: Is this management team in it for the salary or in it for shareholders? In this article, I will give my subjective viewpoint on this topic, and I hope it will spur conversation amongst investors and corporate officers.

Executive compensation is made up of Cash Salary + Stock Option/Restricted Stock awards + other perks. Let’s focus on the cash salary first. The main reason cash salary levels are so important to microcap investors is that over 90% of microcap companies are unprofitable. Salaries can greatly influence the health, longevity, and eventual success or failure of a microcap company. For example, if a small microcap company is losing money, and the CEO is raking in $500,000 what message does that send me? Not the right one, and I will pass on making an investment or buying the stock.

So what metrics do I use to determine if a cash salary is too high? To be honest, I never really put down a formula before for this article. It’s always been common sense + my gut. There are many variables that come into play, but I believe the most important is the size and financial performance of the underlying business. Here is my subjective opinion on what peak cash salaries are acceptable given the financial performance of the underlying business. My annoyance meter or red flagdar goes off when salaries go much above these figures:

• Company is unprofitable — $1 million EBITDA per year: $200,000
• Company produces $1 million -$5 million EBITDA per year: $250,000
• Company produced $5-10 million EBITDA per year: $300,000

I stopped at $10 million in EBITDA because quite frankly I don’t take initial positions in companies that are larger than that. Also, the figures above are for microcap companies only, as there are obviously plenty of billion dollar market cap companies that are unprofitable.

In some rare instances, I’m willing to accept a higher cash salary such as when the CEO is a serial success story. One of our members on MicroCapClub calls these CEOs repeat offenders in a good way, an executive that has built up and sold several companies to the benefit of shareholders. Examples of this would be Shimon Alon of Attunity (NASDAQ:ATTU ), Mark Libratore of Liberator Medical Holdings (NYSEMKT:LBMH ), Manuel Villafa of Kips Bay Medical (OTCQB:KIPS ), but these individuals are few and far between in the microcap space. Even in these circumstances, I’m okay with the CEO getting a little bit more but not a lot more. A successful CEO like this should be smart enough to take most of his compensation weighted in stock in the first place. I’ve also given leniency to corporate officers with higher-than-acceptable salaries that are consistent buyers of stock in the open market. But even in this situation, why not have a lower salary, let the company keep the cash and do a buy back and decrease the outstanding shares.

Outside of these outlier circumstances, I find management teams that draw large cash salaries above and beyond the norm aren’t aligned with shareholder interests. Smart investors know this too, and they will completely pass on buying a stock if the salaries are too high. I could give you a bunch of real examples of companies that trade today that I passed on because of bloated management salaries, but the point of this article isn’t to be a bash session. Bloated cash salaries are a disease that affects many microcaps. The great thing is over 2/3 of publicly traded companies are microcaps, so you can cross them off the list and move onto the next one.

I will give you an example of a company that I invested in in spite of high management salaries. I’m an investor in Noble Roman’s (OTCQB:NROM ), a company I wrote about a while ago [HERE]. Over a year ago, I was conducting my due diligence, and the biggest red flag I could find was the aggressive salaries of the CEO-father and COO-son in a combined $700,000+ on a company that did 2.5 million in EBITDA in FY 2011. After some digging, I found that a few years earlier they actually reduced their salaries. YES, they actually reduced their salaries from even higher ones, but at least it was a step in the right direction. I flew out to visit the company and met with the management team, and I got a comfort level with them and their motivations. I ended up investing in the company in spite of the high salaries mainly because the CEO owned 15% of the company, and he made it known they weren’t planning on increasing salaries anytime soon. I tell you this real life example to better illustrate the complexity of situations, but I would like to make note that even though I made an investment, the high salaries did impact my position size.

Corporate officers are incentivized with stock options and sometimes restricted stock grants. The use of stock options and restricted stock can be very productive for microcap companies in recruiting top talent where they cannot afford to pay the normal going rate in all cash. Certain industries like Biotech and Pharma use these means of compensation more so than others. In 2011, the average microcap biotech/pharma executive compensation consisted of 50% cash and 50% stock options (source ). Companies will often say that the stock options better align the corporate officers with the shareholders, but they can be very dilutive to microcaps. If a company has a $10 million market cap and total salaries are $2 million per year, and half of that compensation is issued in stock options, it illustrates my point.

These options and stock grants can be quite destructive to a company’s capitalization table. Just like a large cash salary, a huge stock incentive plan can also turn away professional investors if it’s not structured correctly. I’ve seen companies that issue options that dilute 10%+ of the company per year, which is ridiculous. Restrictive stock grants are even worse because the company is just giving stock away. I believe that most corporate officers need to reward employees and management but not to the detriment of shareholders. As an investor be careful and really dive into the executive compensation structures of microcap companies.

Stock options should be granted in reasonable amounts and should be based on performance metrics that enable stock appreciation. In a perfect world, I believe every microcap executive officer would have a modest base salary and be highly incentivized with bonus awards for hitting predetermined business milestones, financial milestones, and stock milestones.

• Business Milestones: Predetermined events the board and management feel are important for the year ahead. Ex: Product XYZ rolled out by August, Two licensing deals accomplished by year-end, etc.
• Financial Milestones: Auxilio (OTCQB:AUXO ) is a good example of a management team incentivized by financial milestones. In their case, they receive option bonuses if the company achieves $2 million in EBITDA in 2013, $6.3 million in 2014, and $9.2 million in 2015.
• Stock Milestones: This one might be a bit controversial, but I believe it is a public company management team’s fiduciary duty to be public and let investors know they exist. I would love to see bonus awards granted for stock price and volume milestones. I certainly don’t want management teams doing unscrupulous things like [THIS ], but I believe it does make sense to tie some level of management compensation directly to stock performance. The goal would be to encourage microcap CEOs in particular to get out and tell their stories.

Executive compensation is one of the first things I look at as a full-time microcap investor because it quickly tells me how the management team is motivated. I hope this article has given a general overview on how evaluating executive compensation is important to microcap investing. I believe this topic has been brushed under the rug for years. I’ve tried to give a general outline about how one full-time microcap investor, myself, looks at executive compensation. My hope is that at the very least, this will start a dialogue amongst investors and amongst corporate officers. I welcome any comments.

In a follow-up article, I will talk about insider ownership and insider buying.

Disclosure: I am long OTCQB:NROM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.