Good governance is essential to maintaining a strong, financially healthy company. Simply put, corporate governance is the system of rules, practices, and processes used to direct and control a business. Many startups pay scant attention to corporate governance as they are in the day-to-day crises of running a new business. But implementing good corporate governance practices is the business equivalent of building a strong foundation for a house–by the time you realize you should have done it, it may be too late.
Beyond maintaining efficient and effective company operations, good governance is crucial to the health and stability of nations. According to the G20/OECD Principles of Corporate Governance, produced by the Organization for Economic Co-operation and Development, the purpose of corporate governance is “to help build an environment of trust, transparency, and accountability necessary for fostering long-term investment, financial stability, and business integrity, thereby supporting stronger growth and more inclusive societies.”
Corporate Governance Models Within the U.S.
Below are brief descriptions of various styles of U.S. corporate governance and the businesses that use them.
Family-controlled corporations include:
- family offices, privately held companies that handle investment management and wealth management for wealthy families, some of which control billions in assets;
- closely-held corporations such as the Murdoch family’s New Corp; and
- thousands of smaller companies whose assets are controlled by a single family.
According to McKinsey & Company, families control a surprisingly large sector of the global industry: 30 percent of large corporations in the U.S., 40 percent in Europe, and 60 percent in emerging markets.
The upside of having a founder or one or more founding-family members maintain a strong presence as shareholders, directors, or managers is that their large ownership position aligns their interests with those of minority investors. They tend to have a long-term orientation rather than focusing on quarterly profits, and they maintain vigilant oversight of all aspects of the operations.
But founding-family members can also exert disproportionate control relative to their ownership stake. They might also extract private benefits at the cost of minority shareholders, knowing the board will not object.
According to Stanford Business School’s Corporate Governance Research Initiative, family-controlled companies show superior long-term performance in comparison to other companies and have better employee relations and a stronger culture. But they are also prone to less transparency in decision-making and more insider trading. They are less likely to plan for succession, and when they do, they often make worse selection choices.
Venture-backed companies provide initial and early-stage capital to small, high-growth companies. They focus on rapidly changing industries that offer high risk and high potential rewards. Venture-backed companies spread their risk by investing in highly diversified portfolios, counting on a few highly successful investments to offset significant losses.
Venture-capital funds are structured as limited partnerships, with each partner committing to a ten-year investment. Investors profit whenever an investment target is sold or goes public.
Venture-capital boards tend to be small and tightly controlled, with half of the directors being firm members. They don’t bother with formal audits, compensation, or governance committees until the run-up to an IPO. After the IPO, the board remains closely involved with its investment target. They may contribute to the professionalism of the new company’s governance by replacing founders with outside CEOs, introducing stock options, and influencing HR policies. They tend to encourage innovation and investment in research and, as a result, demonstrate higher earnings than other public companies.
Private Equity-Owned Companies
Private equity companies are privately held investment firms that invest in businesses for the benefit of retail and institutional investors. They tend to target mature companies that generate substantial cash flows, sometimes launching hostile takeovers. If a takeover is successful, they sell the company to a strategic or financial buyer or back to the public.
Private-equity firms tend to have small boards filled with insiders. They are closely involved in strategic and operating decisions, so board membership requires a considerably larger investment of time than public boards. Investments may become more lucrative for board members than other stakeholders as performance objectives shift from company performance to profitability measures.
Private equity owners have an uncertain impact on the firms they invest in. They tend to outperform public companies, but this may be due more to increases in leverage and tax deduction than to improvements in company operations.
Regional Systems of Governance
There is no standard one-size-fits-all system of governance: Governance styles vary based on the nature and purpose of the business, its ownership, its size and stage of development, legal and regulatory requirements, and the availability of resources (both financial and human). Corporate governance styles also vary by geographic region.
Internationally, there are three dominant systems of corporate governance: the Anglo-U.S., the German, and the Japanese. Each is a product of its culture and financial system. The Anglo-US model is oriented toward the stock market, while the other two focus on the banking and credit markets.
Most Americans are familiar with the American system of corporate governance, where the board of directors governs major decisions, held in check by the shareholders. Corporate officers and managers report to the board. This system of governance is oriented toward stock markets and will change course based on their rise and fall.
The German model also called the European or continental model, is based on two governing bodies: the supervisory council and the executive board. The executive board oversees managers and administrators. The supervisory council controls the executive board. Company employees and shareholders choose its members.
Government and national interests play a more prominent role for companies governed under this model than under the U.S. system. There is more consciousness of the need for corporate responsibility, including achieving government objectives and improving society.
The Japanese model is more rigid than the Anglo-U.S. or German models. It entails a set of intertwined relationships between (1) shareholders, customers, suppliers, creditors, and employee unions; and (2) administrators, managers, and shareholders.
All stakeholders share a sense of joint responsibility toward the company and its managers. This sense of loyalty sometimes leads to an unhealthy tendency to cling to longstanding business relationships, with a corresponding reluctance to embark on new ventures.
Unlike the other two systems, Japanese government officials are major stakeholders in this model. The central banks and the Ministry of Finance (comparable to a hybrid of our Treasury Department and Federal Reserve) review and control business negotiations.
There is notably less transparency under the Japanese model than in the U.S. or German models. Shareholder needs are placed behind those of other businesses, government agencies, and trade unions.
Louis J. Licata, Esq. is a managing partner at Gertsburg Licata. He can be reached at email@example.com or by phone at (216) 573-6000.