Recently, the Manhattan Bridge Capital, Inc. (LOAN) board recommended that one million restricted shares be given to its CEO, Assaf Ran. Their reasons for this include issues involving expensing of options, the company’s reliance on Ran for continued day to day operations, and an argument that such an investment made by shareholders will better align Ran’s interests with those of shareholders. Any rational investor will only agree to this if such a loss of equity, being an investment, would yield expected returns exceeding the cost of capital. I will show that given today’s market conditions, the only manner in which this can make sense is if somehow Ran becomes someone else.
To begin with, the reasons given by the board for issuing one million shares to Ran should be explained by them directly:
- The shares of Common Stock underlying the options are not subject to any restrictions. Mr. Ran could exercise the options and immediately sell those shares. The Restricted Shares cannot be sold, transferred, pledged, liened(sic) or disposed of in any way until they vest, which may not be for 15 years with respect to 1/3 of the shares, 16 years for an additional 1/3 of the shares and 17 years for the final 1/3 of the shares.
- Mr. Ran could exercise the options and then terminate his employment with the Company without forfeiting his shares. The Restricted Shares are tied to Mr. Ran’s continued employment with the Company. If he terminates his employment voluntary, he would forfeit the shares.
- Under the existing program of annual option grants to Mr. Ran, the Company incurred amortization charges of $46,920 in 2010. Assuming the continuation of this program into the future and the trading of the Common Stock at an assumed price of $1.50 per share, future amortization charges would range from $68,044 in 2011 to $122,136 in 2015 and thereafter. Under the proposed grant of Restricted Shares and related option forfeitures after first year amortization charges of $67,155 annual amortization charges would substantially decline to $26,097.
- Mr. Ran has no right to vote the shares underlying the options and no right to dividends with respect to those shares until he exercises the options. On the other hand, he has a right to vote the Restricted Shares immediately upon their grant giving him greater power in the election of directors and other matters submitted to shareholders which is expected to increase his willingness to personally guaranty borrowings by the Company. He also has the right to receive dividends on the Restricted Shares giving him a greater financial stake in the Company.
It must be noted that the annual growth in issued and outstanding shares over the period beginning in 2005 through the end of 2010 is 1.2%. The board portrays the issuance of the restricted shares as something to be earned over the 17 year period. Under this perspective, these restricted shares amortize over the 17 year period such that the issued and outstanding shares grow at a rate of 1.53%. The dilution rate has been increased when compared with the historical figures provided in the annual reports. These restricted shares give Ran voting rights and entitle him to any declared dividends immediately. Obviously, the restricted shares are substantially more valuable than options. The shares are his and he enjoys full rights as a shareholder, with the only restriction being placed on when he can sell his shares with the business maintaining a going concern status. If LOAN closes its doors and liquidates tomorrow, the equity is his. Thus, the equity is already transferred and the equity investment is more appropriately viewed as being made in full up front, rather than being amortized over time.
To begin analyzing the board’s investment decision for shareholders objectively, the opportunity cost of capital for shareholders needs to be pinned down. The S&P 500 Index provides a convenient alternative investment to the Assaf Ran investment, through a basket of shares weighted to match the index, and seems perfectly reasonable to use as the cost of capital figure. LOAN is far riskier than a basket of S&P 500 shares, but it is safe to say that this is one alternative use of capital for shareholders making it a candidate for the opportunity cost. The restricted shares represent a transfer in equity of $1.833 million. For LOAN’s shareholders to rationally choose to invest this with Assaf Ran rather than a basket of S&P 500 shares, they should expect to earn no less via the Ran investment than they would earn through the basket of shares, net of capital gains taxes 17 years from now.
Ran has not acquired additional human capital for himself, to my knowledge, that suggests he will continuously generate new innovations in hard money, factor, or any other type of collateralized short term lending. In fact, from the recent 10k, his biggest selling point as CEO is “22 years of senior management experience leading public and private directories businesses”. Unlike shares in a basket at the 17 year mark, the investment in Ran has a finite life. Whatever skills are uniquely his cannot be sold off once he retires or dies. He is 45 years old as of March 16, 2011, making him 62 to 63 years of age 17 years from now. So even if Ran suddenly becomes a rare innovator in collateral lending, the flow of innovations will die when he retires or dies and barriers to entry are sufficiently low as to presume his innovations will not be protected through monopoly. Also, shareholders cannot be expected to sell his old brain or its ideas to someone else to liquidate this investment. The return for LOAN shareholders will logically be realized entirely through LOAN earnings, requiring not only a recovery of the $1.833 million but also the gain shareholders could have acquired otherwise through a basket of S&P 500 shares.
Currently, the S&P 500 Index is valued at 1159, with earnings of 87 and book value of 579. This provides a return on equity figure of 15.04% and a price to book ratio of 2.00. For a $1.833 million investment in a basket of S&P 500 shares with the implied equity and earnings yield held over a 17 year period, the expected 17th year earnings are $698 million. Selling at the same price multiple of earnings, 13.3, this basket can be resold 17 years from now for an expected $17.246 million. Assuming a capital gains tax of 20%, the investment nets an expected annual return equal to 12.78% over the 17 year period. These numbers are summarized below.
For a LOAN shareholder to be indifferent between the S&P 500 basket and Assaf Ran investments LOAN must earn at least 12.78% per annum on the equity invested with Ran plus get their equity back. Recent ROE figures show roughly an average of 3.74% earnings yield for LOAN. Assaf Ran must somehow create an additional 7.22% return on equity for shareholders creating a total annual return on equity of 10.96% over the next 17 years. Such an increase in performance over this period will make LOAN shareholders no worse off. These numbers are summarized in the chart below, for the 77% of shares that are non-restricted with the firm’s corresponding total earnings following this.
None of the above makes use of discount rates for cost of capital. The board’s reasons for recommending these restricted shares, as noted above, really involve nothing more tangible to earnings than a change in amortization charges. Ran already owned 1.802 million shares prior to this, so he had plenty of incentive to maximize profits and market value of this company. The board’s specific reasoning is insufficient to make up the increase in return on equity as noted above. Under the assumed price of $1.50/share the best case scenario described by the board of directors in the DEFA14A filed 08/09/2011 adds at most $1.633 million to the bottom line over this period. Assuming this best case scenario, the amortization savings only reduce the minimum required return on equity by 0.52%.
As far as the tax treatment comments the board makes in this filing, the shares’ only requirement to be vested boil down to either dissolution of the company or Ran’s decision to continue with the company over the 17 year period. I have not bothered thinking about the tax treatment of options over this period compared with the compensation expense at the vesting periods. The return on equity figures should be assumed to include these issues seeing as the historical return on equity has included this and any savings captured by the reduction in stock options for Ran are incorporated in the marginal earnings generated by the Ran investment. Suffice it to say his performance includes these changes whether they are favorable or unfavorable to him. The bottom line, is that Assaf Ran must somehow improve the earnings performance of LOAN relative to equity by 193% to justify this decision and keep shareholders happy.
For another article on this topic read Saj Karsan's piece here.
Disclosure: I am long LOAN.