Many of you reading this are familiar with the backstory of how Berkshire Hathaway came to be the chosen investment vehicle that built Warren Buffett’s vast fortune. Buffett noticed that the price of Berkshire tended to bump in price every time there was an announcement of a mill closing, and he thought there was a gap in value between the $7-$8 prevailing price and the $20-$21 stated book value of the stock.
Because Berkshire’s stock price was so low compared to the book value, patrician CEO and Chairman Seabury Stanton would use the liquidated proceeds from the mill closings to buy back its stock. Although this may be obvious, it is useful to keep in mind the premise—anytime a smallish company wants to repurchase a meaningful percentage of its stock, it needs to locate shareholders willing to part with the stock lest the business end up bidding against itself or—even worse!—run afoul of SEC rules and congressional laws on stock price manipulation.
After a mill closing, Warren Buffett contacted Seabury Stanton and indicated that he would be willing to sell the 200,000+ shares of Berkshire that he controlled on behalf of his partnership’s investors. Stanton agreed to a $11.50 per share price. When the paperwork for the offer eventually arrived in the mail, Buffett found that Stanton’s “official” offer was only $11.375, or 11 and 3/8 as stocks traded in those days.
This enraged Buffett, as he had an extreme aversion to being taken advantage of because his ego would never allow him to be the loser in a business transaction. Not only did he not accept the proposed tender offer, but he began purchasing more and more shares of Berkshire stock so that he could vote himself seats on Berkshire’s board and eventually oust Stanton. And that is exactly what happened, though Stanton resigned before he could become a victim of activist defenestration.
In short, Warren Buffett controls Berkshire because of a challenge to his ego and notions of fair play rather than any detached, mathematical reason. In fact, the $11.375 offer was so close to the $11.50 offer that a purely rational evaluation of his partnership’s best interests should have turned Berkshire into a footnote as small as Buffett’s foray into the Kohlberg department store.
I was thinking about Buffett’s feud with Stanton when I saw the recent news that Sally Smith and the Buffalo Wild Wings Board of Directors had taken to releasing a deck of slides to investors on May 16, 2017 that criticized Marcato Capital’s activist suggestions and took shots at Mick McGuire specifically, calling him a loser in the boardroom with no successful track record and made fun of his tenure on the board of Border’s Books because of its bankruptcy.
When I saw that slide, I knew that Sally Smith’s days as CEO of Buffalo Wild Wings were numbered. I also expected other resignations to come, though I had no opinion on the specifics of the other would-be casualties among Buffalo Wild Wings’ insiders.
My view is that it is terrible advice to engage in ad hominem attacks against an activist investor, and it is much better to focus on the merits of the arguments being propounded rather than to make personal insults that animate the ego for vengeance.
I am surprised that the advisors to Buffalo Wild Wings executives encouraged such a scorched earth approach. First of all, when you become an insider at a business, you owe two fiduciary duties to your owners. The first is the duty of reasonable care—you must follow reasonable process and make substantially reasonable decisions that are in the best interests of the business. And the second is a duty of loyalty—you are not allowed to take actions that are adverse to the business which can sometimes extend to the treatment of its owners.
Legally, Sally Smith probably did not breach the duty of loyalty to Buffalo Wild Wings shareholders as a class because she can fairly argue that Mick McGuire’s suggested actions would harm the corporation, and so she made the statements that she felt necessary to act in the best interests of Buffalo Wild Wings shareholders as a collective.
But politically, the advice she received was a nightmare. The moment she took shots at Marcato in general and McGuire personally, she guaranteed that they were not going away. It was no longer just about the money and the philosophy. It became about the ego, and I suspect even if Marcato did not win the most recent Board fight, it would continue to accumulate shares until it would win. That is the political risk of making people hate you. They may choose to redefine their self-interest as conquering you rather than, say, engaging in rational investment decisions that would maximize wealth.
If I were Sally Smith’s advisor, I would tell her to focus on the deficiencies in Marcato’s arguments. Marcato has argued that wealth will be created for shareholders by switching from having 49% of its locations franchised to having over 90% of its locations franchised.
The best response would have discussed the differences between franchising from the ground-up as part of an expansion effort compared to franchising as part of a conversion of existing stores effort. When you franchise from the ground-up, you put out a small amount of capital and then receive a fee for hundreds of thousands of dollars and collect a 5-10% sales override. It’s all about creating a synthetic income stream out of nothing.
The conversion of stores via franchising isn’t as lucrative. If you have a location worth $2 million making $400,000 in annual profits, your franchising efforts will get you a lump sum payout plus a perpetual right to, say, $40,000 of those profits. In other words, it’s an exchange of nearly equal value. You’re giving up $400,000 in annual net profits on your balance sheet in exchange for a lump sum plus the right to receive $40,000 per year.
When you franchise a new location, you’re getting an income stream created out of thin air. When you convert an existing store to a franchise, you have to subtract something. You are trading 100% of something for 10% plus the lump sum and hoping that the lump is sufficient compensation for the 90% of profits that you will no longer receive.
A better argument would be this—we have made 1,700% returns for investors since we’ve been public in 2003. We know what we’re doing. We will franchise new locations, and we will make sure that our pre-existing locations will engage in coordinated deals that are well-known in the community to re-establish Buffalo Wild Wings as the place to watch Monday Night Football. We will launch a $10 deal that covers X number of wings and a beer to become the cost-effective way to watch sports in a fun setting with your friends.
I will be interested in watching to see whether the tactic of insulting activist investors catches on. It flirts with the gray area right before violating the duty of loyalty, and it seems likely to trigger ego and personal considerations that will make activist investors likely to stay longer than is rational to hasten your corporate demise.
Notice: Per Missouri requirements on discussions that involve the law, I must include the following: Nothing in this article is intended as legal advice, and is intended for general informational purposes only.
Originally posted 2017-06-03 19:11:44.