Skin in the Game: Understanding Risk & Accountability

“Skin in the Game” is a phrase popularized by world-famous investor Warren Buffet signifying a condition in which high-ranking insiders buy the stocks of the company they are a part of using their personal money. It is a common saying in business, gambling, finance, and politics.

Summary

• “Skin in the Game” is a common saying in business, finance, and gambling that involves high-ranking insiders buying the stocks of the company they are a part of using their personal money.
• The goal behind executives putting skin in the game is to create a corporation that is managed by like-minded individuals whose goal is to improve the company.
• The disadvantage of skin the game is a conflict of interest between the management and the client. Hence, certain rules allow financial institutions to only own 0.5% to 2% of their portfolio.

Understanding Skin in the Game

In the finance and business world, the phrase refers to when high-level executives in a company acquire a significant stake in the shares of the company, which aligns their personal risk/reward with that of other shareholders. The word “skin” is a figure of speech that describes a person involved risking their own hide or skin in winning or losing in gambling or business.

It is common for an executive of a company to exercise stock optionsEmployee Stock Option (ESO)An employee stock option (ESO) is a form of financial equity compensation that is offered to employees and executives by their organization in order to buy stocks at a discount or receive stock compensation; however, it is not common for executives to invest their personal money in the company they are working for. It shows a sign of confidence or good faith when an executive puts “skin in the game,” as it portrays that the company is moving in a positive direction and the share price will rise in the future if the company plays all its cards correctly.

The goal behind executives putting skin in the game is to create a corporation that is managed by like-minded individuals whose goal is to improve the company.

Requirements for Skin in the Game

The Securities and Exchange Commission (SEC)Securities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges requires an organization to disclose how much money executives have invested in the company. It is especially true for portfolio managers that have invested their personal money in a fund, and the public uses the information to either invest their money with the fund manager or not.

Furthermore, the SEC requires that an organization disclose any insider trades or ownership of an organization’s securities. It is required to disclose the information because any trades made by directors and executives can influence a company’s share price since upper-level management will trade in millions of dollars’ worth in stocks.

There are several forms that executives need to file with the SEC. Investors can use the reports to make knowledgeable decisions as to whether to make an investment or not in the organization.

The Disadvantage of Skin in the Game

There are limitations to skin in the game when executives and directors are instructed to invest their personal money in the organization’s share. Many financial institutions like banks prevent executives from having skin in the game, as the financial institutions manage the capital of their clients.

The restriction is implemented to prevent conflict of interest and address the problem of front running, which is an illegal activity that involves an upper-level executive executing a trade using insider informationInsider InformationInsider information, also called inside information, refers to non-public facts regarding a publicly traded company that can provide a financial advantage in the markets. In other words, insider information is knowledge and information on the operations, products/services pipeline or non-public information to gain financial advantage.

There are limitations to commingled funds, which involves combining corporate resources and private funds. For example, investment institutions, such as mutual funds, private equity firms, and hedge funds are legally limited to investment positions that range from 0.5% to 2%.

Real-World Scenarios of Skin in the Game

Investors usually want higher-level executives like the CEO and CFO to have skin in the game. A good example is Mark Zuckerberg, the co-founder of Facebook (FB). His performance and public image will have a significant impact on the company’s share price, as he owns a majority stake in the company.

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