Skin in the Game Explained

There’s an old saying: “a good captain always goes down with his ship.” This sentiment can extend to other fields and situations. When you are a leader, the best way to earn the trust of those working for you is to be relatable. Putting yourself in a similar position or putting something personal on the line insinuates that if things go downhill, the leader will be affected, too. This idea can be found in the world of financing under the name ‘skin in the game.’

In business, there are winners and losers. One of the key factors that separate the two is when decision-makers have real skin in the game. Put simply, they — and not just their stakeholders — will suffer a direct impact financially should they be wrong.

What does it mean?

‘Skin in the game’ is a phrase that was coined by the famous investor, Warren Buffett. He was referring to when high-ranking insiders use their own money to purchase stock in the company they run. The aphorism is commonplace in the world of business and finance, as well as gambling and politics.

In terms of business and financing, skin in the game typically refers to owners having a significant stake in an investment vehicle. To elaborate, it is usually when outside investors are approached to invest. The “skin” in the phrase is merely a figure of speech for the person or money that is participating. Or, more appropriately, what is on the line. The “game” is the metaphor that applies to actions on the field of play under discussion.

Having real skin in the game is proving itself to be an excellent motivation tool in making strategic decisions. Ones that allow us to work effectively within a specific environment. The environment in question is one where independents are squeezed out thanks to margin compression. Moreover, due to the scarcity of distribution options regarding their investment products.

Understanding the details

It is not uncommon for an executive to earn stock as reimbursement. Alternatively, to exercise stock options in order to purchase a stock at a discount. However, what is less common is for an executive to put their own money on the line. Whenever an executive puts skin in the game, it indicates good faith or is a sign of confidence in the company’s future. Furthermore, many outside investors interpret it as being a positive sign.

If owners or principals invest their own money into the investment vehicle, investors – both potential and existing – will notice it and translate it as a vote of confidence. Additionally, skin in the game (aka. ‘insider ownership’) tells investors that the company will do its best to generate returns.

The idea of executives putting their skin in the game ensures that corporate management is in the hands of like-minded individuals. Put simply, those who actually share a stake in the company’s well-being. Executives can talk all they want, but it is their actions that matter most. The best indicator of confidence is putting one’s own money at risk just like outside investors.

Requirements for the game

There is a specific requirement from the Securities and Exchange Commission (SEC). It states that funds must annually disclose how much money each portfolio manager invests in the fund. Advocates use this information to help make the argument that fund managers putting their money where their mouth is can be beneficial. To elaborate, it is a reliable method of identifying fund managers who could potentially beat the market over the long-run. ‘Skin in the game’ proponents contend that capital commitment is crucial to aligning the interests of investors and managers.

Another SEC requirement is that companies must report on insider ownership or trades of a company’s securities. This is mandatory because trades by directors, executives, and officers can influence the company’s stock price. There are an array of form types that the executives need to file with the SEC. These insider ownership reports are accessible to investors. With them, they make a more calculated decision regarding if they should or should not invest in the company.

Notable limitations

Naturally, there are limitations to owners and senior management executives investing their own money in a security. Several banks and other financial institutions do not allow employees to have “skin” where client capital is managed. This restriction addresses the problem regarding front running. This is when an executive enters a trade prior to an event or announcement to acquire an economic advantage. Specifically, when they enter the trade with inside information.

There are also restrictions concerning commingled funds, which is the pooling of resources. Alternatively, it is the mixture of private funds as well as corporate resources into the company’s stock or bonds. Sometimes, it is imperative that the executives’ decision-making be objective and prohibited from investing in the company they are managing.

Let’s look at investment entities as an example, including hedge funds, private equity, and mutual funds. These are legally under the limitations of minority investment positions ranging from 0.5% to 2%.

It’s all about trust

In his article about the phrase being used as an investing indicator, Luqman Abdi asks the following question:

Would you rather trust someone at the helm of a company who has a sizable amount of shares or someone who hasn’t?

Abdi states that he would choose the latter option because money is in a risky position as an investor. Let’s take a look at four individuals as an example: Bill Gates, Elon Musk, Jeff Bezos, and the creator of the phrase himself, Warren Buffett. Each of these men has a common denominator in the way they operate. That being having ownership of shares pertaining to the companies they lead or led.

There are also companies such as Gillette where you can’t say at the top of your head who the person at the helm is, and they still perform well. Therefore, it’s always recommended to look at a company and see the amount of insider buying stock as a confirmation.”

Abdi also talks about how actions speak louder than words, especially when those words are coming from a company head. This evidently ties into the matter of trust. You are basically gambling if you go by what they say rather than what they do. Or, in this case, whether they deliver on their promises. According to him:

If I see someone who is the head of a company talk positively about its future but doesn’t own shares or sells all their shares that feels contradicting. For most of us, actions speak louder than words. Sometimes it’s already planned that an owner or employees sell a part of their share options at a fixed interval. This is something to keep in mind.”

Having a stake in the game

More often than not, we want to know if those who are leading a company have a stake in it. If they do, it is easier – or more logical – to trust their decisions. They are putting their wealth on the line, so why wouldn’t you trust them even a little? Be that as it may, some successful companies have leaders whose identities are unknown.

There will always be challenges to face for every company. However, not all of them possess the proper management and skills to successfully face them. Experts typically have skin in the game when they lead a company. Moreover, they look for this quality in other companies that they want to invest in. To quote Buffett about this phrase:

To be successful in business and investing, you’ve got to have skin in the game, a stake in the company.”