What is corporate governance?

The purpose of this document is to enable founders, CEOs, management investors, shareholders, board of directors, and advisory boards to create a shared understand of their company’s corporate governance.

You may download a PDF of this article from:  What is corporate governance

The challenges of understanding corporate governance.

Discussion around governance is often very silo based and depends upon the specific background of the governance advisor e.g.

  • Lawyers often start with the Business Corporations Act.
  • Regulators often start with financial risk management guidelines.
  • Accountants often start with quality of financial statements.
  • Consultants have a variety of different points of view.
  • IT (Information Technology) governance advisors have an IT-centric perspective.

Etc.

What then results is a deep, detailed, siloed discussion without a broader context or showing the relationship with related points of view. After the stakeholders have heard from several different advisors, there is a confusing and disjoint picture of governance with limited shared understanding.
What is corporate governance?

“Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders.  Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. “1

Corporate governance is built on a foundation of relationships.  This requires knowing who the relationships are with and managing those relationships.

This definition has 4 other components:

  • Decision making i.e. setting objectives and approving action plans.
  • Action plans i.e. means of attainting those objectives.
  • Performance monitoring of the objectives, action plans, and communications.
  • Two-way communications and understanding among stakeholders, regarding objectives, action plans, and other information.

What is the purpose of the corporation?

Is the purpose of the corporation to maximize money for shareholders? Is the purpose to make as much profit as possible?

Larry Fink, in his 2018 letter to CEOs, said “To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate…..Without a sense of purpose, no company, either public or private, can achieve its full potential…..And ultimately, that company will provide subpar returns to the investors.”2

 The purpose remains fixed while operating practices, cultural norms, strategies, tactics, processes, structures, and methods continually change in response to changing realities. 3

 What is the purpose of corporate governance?

The purpose of corporate governance is to enable the achievement of the purpose of the corporation.

Corporate governance manages the broad set of conflicts of interests which arise. The OECD governance definition starts with relationships: within corporate leadership, as well as stakeholders and third parties.  Any relationship has the potential for conflict of interest, because parties may have different or conflicting interests.  For example, how should both profits and costs be allocated among: CEO, C-Suite, shareholders, employees, other stakeholders, and third parties including society, especially in cases of poor profits or losses.

Perhaps the greatest conflict of interest is deciding the degree to which the corporation extracts value from society versus creating value for society. An example is the decision on whether to whether to replace employees with lower-cost offshore staff which may benefit the off-shore communities or retain the employees in order to sustain local communities.

A common understanding of values, morals, and ethics is needed, to enable decision making.

The Corporate Governance Journey

I outline some of the corporate governance concepts and challenges by an illustrative journey, starting with three founders and ending with a large publicly listed company. Every company will have a different journey, and none will be the same as this illustration.

The initial objectives include;

  • Targeting a large marketplace with customers that are willing to pay for a solution.
  • Delighting revenue generating customers and users by enabling them to achieve significantly more value than the current situation or competitors.
  • Having the right roles and right talent at each point in time to successfully carry the business forward for the next 24 months.
  • Honesty, integrity, and transparency of the founders.

The action plans are focused on achieving the above objectives.

Performance monitoring includes:

  • Constantly validating the number of customers who have a need they are willing to pay for. Needs may be changing. E.g. at one point in time, most people needed cell phones with keyboards.
  • The revenue generating customers and users delight in the solution and value they are achieving. The degree to which customers obtain more value from the company’s solution than from the competition.
  • The value that roles provide and the value that people in those roles provide. This includes: investors, advisors, coaches, mentors, board directors, management, staff, partners, and suppliers.
  • Morals, values, and ethics – including honesty, integrity, and transparency.

Two-way communications of objectives, action plans, and performance monitoring occurs among all the stakeholders, thus enabling a shared set of facts, knowledge and beliefs.  Every stakeholder knows how they are contributing to the value achieved by customers.

The way to read the following journey is that any governance behaviours at a stage, continue in following stages unless other stated.

Three founders have an idea.

  • They decide to work together. The purpose of the company is to solve an urgent need of hundreds of millions of people, especially in the third world.
  • The founders agree that all decisions will be unanimous. This is documented in the decision-making document. This decision-making document may be included as part of a founders agreement.
  • The initial objectives reflect the purpose. The assumptions are that meeting the objectives and moving towards the purpose will enable revenue growth and financial success.
  • Plans are largely oral.
  • Each founder knows what the others are doing, because they are communicating throughout every day.

The founders incorporate under the Canada Business Corporations Act.

  • Some or all of the founders become board directors. Directors need to be elected by shareholders. The founders decide to split equity equally 1/3 each.  There is a unanimous shareholder agreement which clearly defines which decisions are made by shareholders. The decision-making document is revised to reflect which decisions are made by shareholders and which by board directors.  All other decisions continue to be made by the founders.
  • The founders decide whether the social purpose of the corporation requires them to become a B corp.

The founders create a website

  • The website describes the team. One of the founders is described as the CEO. Other founders are also described.  The decision-making document is revised to reflect which decisions continue to require unanimous approval.
  • Plans are written down, using project management software and other tools.

The founders get money from their friends and family

  • Some money is provided as covenant free loans. Some money is provided as equity, but voting rights are constrained.  There may be a voting trust. The unanimous shareholders agreement is revised. The founders begin to focus in different areas and make decisions on their own. The decision-making document is revised.
  • The founders send a monthly communications update to all investors, who are family and friends at this point.

The founders get money from AIs (angel investors)

  • The founders are still focused on the purpose. AIs agree with and support the purpose. The founders communicate documented action plans and objectives to AIs. AIs have made information reporting requirements (including tacking of actual results to plan) as part of their investment.
  • Objectives are set for customer satisfaction. The main objective is to have a small group of revenue generating customers who are delighted with their initial version of the solution. There may be an AI on the Board of Directors.  Decision making at the board becomes more complex.  The personality of directors has major impact on decision making – a strong personality with limited equity may be able to drive the board.  AI investors may have certain decisions under certain conditions. The decision-making document is revised to reflect the current situation.
  • Angel investors only invest if they believe in the founders honesty, trust, and integrity.
  • The unanimous shareholder agreement may be updated or replaced.
  • The founders send an enhanced monthly communications update to all investors.
  • The founders decide whether or not to bootstrap growth or obtain funding from VCs (venture capitalists). This decision is reflected in the 24-month cash flow forecast, by month with monthly milestone assumptions.  There is a supporting forecast for years 3-5, by year.

 The founders get money from VCs (venture capitalists)

  • The VCs are focused on making money by enabling the company to grow its revenue substantially. Understanding the long-term market potential is key. The purpose of the company is unchanged.  Many people in the world who need the solution but who would not make material profit for the company are excluded in the short-term objectives.
  • The VCs objectives focus on ensuring the company leadership has the right skills and experience. Coaches and mentors are put in place as well as an advisory board to assist the CEO.  New talent is brought into leadership.  Some of the founders may exit or assume supporting roles.
  • VCs will also provide advisors and board directors who have skills, experience, networks the founders lack.
  • The VCs have certain decision-making rights and veto powers. There will be a VC on the board of directors. VCs are deeply involved with management. 63% of VC funds will interact with the company at least once a week.4 Decision making often occurs outside of board meetings. Significant, ongoing reporting requirements to VCs.
  • The decisions which require shareholder approval or board approval are clearly documented. All other decision may be made by the CEO, who may in turn delegate decision-making authority.  The leadership team members will be making decisions, as will managers and staff.
  • There may be debt financing. Covenants may provide lenders with information rights as well as decision-making rights, in certain circumstances.
  • The CEO begins to send a monthly communications update to all potential investors.
  • The CEO puts in place two-way communications plans with a broad set of stakeholders, including all employees and contractors.

The founders get money from PE (private equity)

  • PE is focused on maximizing exit value in 5-7 years time. Every major decision is focused on maximizing this value.  PE still has a very long-term focus on total market size. The company will only be attractive to future buyers if there is still major growth potential at the exit time.
  • PE must approve the major decisions.
  • Every three months PE assesses whether there is the right CEO in place. The exit in 5-7 years allows little time for a poor performing CEO.
  • PE provides advisors and board directors with skills, experience, and networks the CEO and management team lack.

The company does an IPO and is listed on a major stock exchange

There is a 50% chance that this new S&P 500 company will disappear within 10 years.5  What governance changes have occurred which have put the company on a path to failure?

  • The founders have exited. Professional management and professional directors have joined. The original purpose of the company is forgotten. The purpose of governance has been forgotten.
  • The objectives are now focused solely on financial returns and shareholder value. There is no longer a focus on enabling customer perceived value.  There are no objectives regarding the value that roles and people provides.  Morals, values, and ethics objectives are secondary. E.g. the code of conduct, and all other company policies are written to minimize legal liability of management and the board directors.
  • Two-way communications with many stakeholders are very limited.

The following are some of the specific governance changes.

  • The planning process driven by meeting customer needs of a large number of customers is dropped and replaced by a traditional strategic planning process. (e.g. Vision, mission, objectives, strategies).
  • Performance reporting has dropped all customer satisfaction metrics and all metrics regarding the value customers are achieving from the company. There is little knowledge or understanding of the customers.
  • The two-way communications with shareholders and other stakeholders have collapsed. 95% of employees are not aware of or do not understand the strategy.6 An even greater percentage of employees have little understanding of how they help meet customer needs and provide value to customers.
  • The director selection process is flawed. The majority of directors do not understand the company’s strategy, marketplace, or how it creates value.7 The directors no longer have skills, experience, and networks which the company leadership lacks. “Directors are not liable if they exercise the same degree of care, diligence and skill that a reasonable, prudent person would exercise in comparable circumstances.”8 The director decision with the greatest impact on company value is the succession planning, appointment, and termination of the CEO.  No director has this experience.  The directors rely on recommendations from outside consultants and the HR leader to make CEO decisions.
  • Board of directors mandate specifically excludes customer focus, value creation, and any board accountability for the board’s performance or the company’s performance. The directors as advised to carry out their fiduciary duty, which is interpreted to mean maximize profits and share prices.
  • The initial focus on honesty, integrity, and transparency has changed. The culture of the board of directors, especially values, morals, and ethics permeates down through the company.
  • Shareholders no longer make material decisions, have little two-way communications with the company. Majority of the shares are held by ETFs, pension funds, sovereign wealth funds, and family offices. Shareholders have a wide variety of expectations and are no longer aligned.
  • Governance was previously driven by experienced leaders and advisors who were focused on growth and talent. Governance is now driven by a variety of advisors, each with their own point of view, with few advisors focused on solving urgent needs of a large number of revenue generating customers.

Your next steps

Your next steps depend upon the stage of your company.

Step #1 Document the current understanding of governance.  This requires asking a number of stakeholders, which may include: founders, CEO, leadership team, employees, the board of directors, the advisory board, investors, and shareholders. Do not just refer to existing documentation.  Asking people reveals what people actually understand.

  • What is the purpose of the company?
  • What is corporate governance?
  • What is the purpose of corporate governance?
  • What are the key objectives and plans to achieve the purpose of the corporation? Do these objectives include the skills, experience, and networks required for board directors, advisory board members, and investors?
  • Who makes the decisions as to what the key objectives and plans should be?
  • What is the two-way communications process with which stakeholders regarding the above 5 points?
  • What is the performance monitoring process regarding the achievement of objectives, plans, decision making effectiveness, and effectiveness of the two-way communications?

What are the results of the current performance monitoring process?

Step #2 What are the implications of your findings from Step #1

Step #3 What needs to change and what is the value of making those changes?

 Footnotes:

1 Based on “G20/OECD Principles of Corporate Governance”, 2015  I added the concept of third parties, https://www.oecd.org/daf/ca/Corporate-Governance-Principles-ENG.pdf

2 https://www.blackrock.com/corporate/investor-relations/2018-larry-fink-ceo-letter

 3Page 17 The five most important questions you will ever ask about your organization (20008)   Book Summary   by Peter F. Drucker,  Jim Collins et al, I adapted

4 How do venture capitalists create value? https://koorandassociates.org/selling-a-company-or-raising-capital/how-do-venture-capitalists-create-value/

5 https://www.innosight.com/insight/creative-destruction/

 6 “Creating the Office of Strategy Management”, Harvard Business School; paper 05-701, by Robert Kaplan and David Norton

 7 Eric Kutcher, “Corporate Boards need a facelift”, McKinsey May 4, 2018, https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/the-strategy-and-corporate-finance-blog/corporate-boards-need-a-facelift

8 Government of Canada, Corporations Canada website https://corporationscanada.ic.gc.ca/eic/site/cd-dgc.nsf/eng/cs06643.html

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