As shareholders with minority stakes in a business, we often place ourselves in the hands of insiders to act in our best interests as the stewards of our capital. Proper corporate governance practices go hand in hand with strong fundamentals in creating an attractive investment, with conflicts of interests between those in control and outside shareholders as a potential red flag.
In my previous article on Acacia Research Corporation (ACTG), I summarized some of the positive developments that I believe could benefit Acacia from a fundamental business perspective. In light of the recently initiated shareholder activist campaign, this article will serve as an addendum to my previous article on Acacia, with a focus on issues related to corporate governance - namely insiders' incentives and capital allocation policies. Much of the discussion below centers around issues brought up by or relevant to the activist campaign, especially ones that I found of primary concern as a shareholder of Acacia.
Timeline of Events Leading to the Upcoming Proxy Battle
To give the reader some background, the following is a summary of events that have transpired with respect to the activist campaign:
- March 20, 2018: Sidus Investment Management and BLR Partners ("Activists"), who collectively own ~4.1 percent of ACTG shares, issued a press release outlining their concerns regarding Acacia's leadership and strategy. The Activists formally nominated two candidates for election to ACTG's board of directors at the 2018 Annual Shareholder Meeting - Clifford Press and Alfred V. Tobia Jr.
- March 21, 2018: Acacia issued a press release defending their board and Management team against the Activists' allegations. The Activists swiftly countered with their own press release indicating dissatisfaction with the Company's responses to their initially stated concerns.
- March 23, 2018: The board nominated two candidates to serve as additional board members, Joseph Davis and Paul Falzone. The candidates were claimed to have been identified from a search process that the Company conducted over the course of the past year.
- March 30, 2018: The board decided that neither of the Activists' proposed board candidates offered the desired background or experience, and appointed their nominees (Davis and Falzone) instead.
- April 5, 2018: Activists filed a preliminary proxy statement with the SEC, expanding on their earlier concerns with Acacia's leadership and strategy.
- April 10, 2018: Activists issue a letter to the board, summarizing earlier concerns regarding entrenchment, and noting new concern regarding cancellation of previously scheduled annual meeting date.
After reviewing the Activists' allegations, the historical actions of Acacia's board, the Company's capital allocation policies and their implementation of the disruptive technology investing - I believe that there's a strong case that Acacia is in dire need of electing outside, independent board members.
Questions Regarding Board Independence and Incentives
The following is a list of Acacia's current board members taken from Acacia's proxy filing:
As the Activists point out, four of the current eight board members were not elected by shareholders, instead they were appointed by the board, and two of them allegedly at the recommendation of the Executive Chairman.
Notably, both of these board-appointed directors have long-standing ties to Mr. Graziadio. Since 1998, Mr. Sanders has served as secretary and general counsel of Boss Holdings, Inc., a company of which Mr. Graziadio serves as Chairman and Chief Executive Officer and is the controlling stockholder. Mr. Sanders also serves as a Trustee of the Graziadio Family Trust. Mr. Walsh's ties to Mr. Graziadio include serving together on the board of directors of World Point Terminals Inc. (where they both continue to serve as directors today)... We believe the appointment of Messrs. Davis and Falzone, who each lack any record of public company board experience, was a defensive and reactionary response to our nominations and public criticisms.
- Preliminary Proxy Statement filed by the Activists
The lack of shareholder involvement in electing these directors calls into question the independence of these directors and their incentives to govern the Company in accordance with the best interests of equity holders. The remaining four Directors have been with the company for over ten years, with two of them serving since the 1990s. Given the considerable evolution that Acacia has seen as an organization, originally founded as a technology incubator company in the 1990s then moving on to IP monetization in the 2000s and now recently engaging in disruptive technology investing, it's surprising to see the lengthy tenure of some of Acacia's directors.
Another indication of misaligned incentives is the creation of a subsidiary known as AIP Operation LLC (AIP) and the profits interests plan entered into by Acacia and AIP. As an early investor in Veritone, Acacia was awarded additional warrants as a sweetener to the deal after Veritone's IPO. Acacia then put these warrants into AIP, and split the ownership interest in AIP 60/40 between Acacia and certain members of management and the board as compensation for their services rendered to AIP. It's questionable that Management should need a further 40% upside incentive as reward for their work related to Veritone, even if it was approved by a compensation consultant. The additional incentive seems unnecessary given that management's number one priority should be focused on increasing the value of Acacia's stock.
Another concern is the presence of the "tax benefits preservation plan" (i.e. poison pill) that was unanimously approved by the board in March 2016. Such plans are enacted in the name of preserving net operating loss carryforwards from elimination stemming from ownership changes. Often times, poison pill tactics serve as a means for entrenched management to suppress non-controlling activist shareholders. In fact, low ownership change trigger levels (such as the 4.9% threshold set by Acacia) are pointed to as evidence that insiders are motivated to insulate themselves from proactive outside shareholders rather than hostile acquirers (I refer readers to this Columbia Law School article).
In addition to the poison pill, the staggered board terms add to the difficulty for outside groups to gain a voice within the company, as only two director positions come up for election each year. Taken with the cancellation of the investor Q&A sessions during Acacia's earnings calls beginning in Q4 2016, which appears to be a clear act of disregard for shareholder transparency, we see a compelling case that insiders are not shareholder-oriented.
The National Association of Corporate Directors published a document titled "Key Agreed Principles to Strengthen Corporate Governance for U.S. Publicly Traded Companies" that lays out corporate governance best practices and recommendations based on input from shareholders, managers, and directors nationwide. Acacia's board unfortunately fails to check the box on a majority of these best practice principles, including corporate governance transparency, protection against board entrenchment, shareholder input in director selection, and shareholder communications.
The executive turnover at Acacia has also been a cause for concern, with CEO Matthew Vella's abrupt resignation in December 2015, followed by his successor Marvin Key's resignation thereafter in April 2017. No doubt this may have been influenced by the collapsing patent enforcement industry around them. Since then, the CEO position has remained open, with the board appointing Robert B. Stewart (a Senior Vice President at the Company) to serve in the role of "President" until a new CEO could be appointed. The board's Nominating and Governance Committee, whose stated purpose is to review succession plans and make recommendations to the board regarding senior executive positions, has failed to find a new CEO for over two years - a sign of ineffectiveness that does not inspire investor confidence.
Capital Allocation Policies
Despite having over $100M in cash and marketable securities on the balance sheet over the last few years, the board cancelled the annual cash dividend of $0.50 per share in February 2016. Between then and early 2018, there was no cash returned to shareholders. In February 2018, the board authorized a stock repurchase program of up to $20M of stock, expiring in February 2019. While it would be great to see this level of cash allocated to buy backs, it's at the board's discretion how much if any repurchases actually occur.
During the two year gap between the dividend cancellation and the repurchase program, insiders thought it would be a better use of capital to invest in Veritone, Miso Robotics, and Bitzumi before allocating that cash to reward shareholders. Presumably this indicates the board's confidence that Acacia's efforts in disruptive technology investing are likely to produce a higher rate of return on capital for shareholders than share buybacks. I wouldn't take issue with this assessment in the case that Acacia's leadership had articulated some sort of repeatable process that gave them an investment edge. As a consequence this investment strategy gives investors a potential upside that seems indiscernible from gambling.
There has been virtually no disclosure regarding what benchmarks will be used for determining a successful outcome, what the timeline is for making these investments, or what market/technological insights the company has and wishes to pursue. Unfortunately, this lack of communication and transparency makes it difficult for market participants to attach much value to this investment strategy. Until Acacia can convey a methodical process for successfully generating returns through early stage investing, it seems that the market will continue to assign a large discount to the value of its investment portfolio.
While pivoting into a new business model of early stage investing may very well generate shareholder value, it's difficult to see how Acacia's implementation to date fits with traditional venture capital style of investing. Specifically, Acacia is holding a very concentrated portfolio of early stage investments. Acacia's fair value of the Veritone interest was last reported at ~$105M. Relative to a total cash and investment balance of ~$244M (this includes the fair value of Veritone and the equity method investment in Miso Robotics), we see that the Veritone interest alone makes up ~43% of Acacia's current "portfolio," even more if we assume some portion of the cash will be used for patent monetization, buy backs, etc. Typical practice in early stage VC investing is to spread risks through a diversified portfolio. In this case, much of our outcome appears to be linked to the success/failure of one company.
A sum of the parts analysis of Acacia's balance sheet reveals great potential for the stock. However, my concern is that this value may not materialize unless corporate governance practices are modified to produce greater accountability and transparency toward outside shareholders. There are a number of actions and policies that raise questions about insiders' incentives and whether or not conflicts of interests exist between them and the shareholders of Acacia.
To be clear, I do not believe insiders are intentionally acting against shareholder interests and I acknowledge that they've taken a number of positive steps in managing Acacia against industry headwinds. I do see a number of practices that are indicative of poor corporate governance which I would like to see rectified. If the Activists' nominees are elected to Acacia's board they will still constitute a minority, but they bring a valuable perspective that will help course correct some of the practices that led to the situations outlined above. I'm optimistic that with a new set of voices at the board level, Acacia shareholders will find their interests protected and their equity values maximized.
Disclosure: I am/we are long ACTG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.