The Role of a Corporate Governance Structure
Corporate governance can take on many meanings and look different for each company. At its foundation, corporate governance consists of the structures and processes by which a company is directed and controlled.
A company utilizes a framework of corporate governance to provide accountability, transparency, and representation to all stakeholders. A company’s stakeholders —which can consist of shareholders, executives, management, employees, suppliers, customers, and sometimes regulators —have their own interests and priorities. Each stakeholder holds an expectation that it will be adequately represented or considered regarding significant decisions of the company.
Through the establishment of an effective corporate governance structure, a company ensures that the various stakeholder groups are appropriately represented in decisions that impact the company and its ability to meet strategic goals. Additionally, an effective and diverse corporate governance structure can be instrumental in assisting management in evaluating and assessing risks, including adequately mitigating risks, ensuring the company operates effectively, and providing value to outside investors and lenders.
Companies should find this publication helpful for evaluating their current corporate governance structures, as well as strategically preparing for the future, including corporate governance considerations for going public.
The Importance of Effective Corporate Governance
Over the life of a company, and often by necessity, the corporate governance structure will change. For a start-up entity, which may be a sole proprietorship or partnership, perhaps family-owned, the founders usually serve in the critical role of guiding the early development. Furthermore, many entities evolve through incorporation for various reasons (e.g., forming an S-corporation or a C-corporation for tax or liability considerations).
A board of directors will almost certainly be required by the state in which the company incorporates. Over time, the composition of that board may change, perhaps beginning with “closely trusted advisors” that have been there from the onset, and eventually transitioning into a more professional or “corporate” board. Whatever its constitution, a board of directors will be a critical component of a strong corporate governance structure.
Key Components to Establishing an Effective Board of Directors
A company’s board of directors should include individuals selected to represent the company’s stakeholders and make decisions on their behalf. In that role, the board of directors is responsible for several activities, including adopting company policies, hiring, and compensating company executives, providing financial reporting and company oversight, and assisting with formulating or confirming management’s strategic goals (and eventually achieving those goals). While it may not be an explicit requirement for certain privately held companies, having an established board of directors can provide an effective means of sufficient corporate oversight.
Structure and Size
The structure and size of the board of directors is governed by a company’s bylaws. The bylaws should define the number or range of board members, their required qualifications, how they are selected, term limits, and how frequently and by what processes the board is expected to meet and conduct business. The number of board members needed will generally be based on size and complexity of the company.
Per a 2020 U.S. Board Index Report (focusing on public companies given the availability of data), the average number of board members for S&P 500 companies was 10.7, with 12% of companies having less than eight directors. In addition, while the number of board members a company has may be effective today, as a company grows and evolves over time, it should evaluate whether its board size continues to be appropriate to effectively provide oversight.
Internal versus External (Independent) Representation
As a company’s board of directors should represent all stakeholders, it is important that it consist of members that are both internal and external to the company. A board member that is internal to the company (e.g., president, CEO, CFO) is highly knowledgeable of the company’s operations and represents the interests of executives, management, and employees, while a board member that is external to the company can provide an objective perspective and represent those outside of the company such as shareholders and lenders. Additionally, some states and regulators require boards to have independent representation.
In establishing a board of directors, a company should consider having at least one independent board member (i.e., external to the company) to ensure that decisions are made considering the views of all stakeholders. For smaller or family-owned companies with plans to grow and expand, a transition to a board composition of internal and external members will evolve. At a minimum, the company should always ensure its board complies with the laws of its state of incorporation.
Variation in Backgrounds and Skill Sets
When establishing a board, a company should select individuals that have the appropriate level of experience, industry knowledge, and financial literacy such that they can offer valuable insights to assist in making relevant decisions to help the company achieve its goals and develop solutions to challenges. This has been especially important in the current economic environment, as uncertainty remains, and companies continue to face operational and financial hurdles.
It is also critical that the board of directors reflect a sufficient level of diversity. This includes diversity in age, gender, and race/ethnicity, as well as level of experience and the skill sets noted above. Establishing a well-diversified board of directors is important to again ensure that all company stakeholders are represented, and, more importantly, to ensure differing perspectives address corporate issues and challenges. Board diversity allows for differing opinions and innovative ideas to be collectively synthesized for helping the company strategize and achieve its goals. Studies have shown that diversity is a key factor in companies making better decisions and meeting performance goals, outcomes that can lead to a competitive advantage.
Meeting Frequency and Goals
A company’s board of directors should meet regularly and at a frequency established in the company bylaws. During these meetings, the board should evaluate information impacting the company, such as current or updated strategic goals, review available financial information and results of operations and past actions, and discuss and approve policies (including compensation arrangements). As a best practice, the board should maintain minutes of these meetings to document the key items discussed and decisions reached. This allows for adequate transparency to the company’s stakeholders that the board was selected to represent.
Establishing a Board for a Public Company
Establishing strong corporate governance structures through an effective board of directors better positions a company for success in the future, especially if the company has long-term strategic goals of “going public.” But as a “public company” there are also rules and regulations that may impact how a company establishes its current corporate governance practices based on those plans.
The road to becoming a public company is wider with the traditional initial public offering, or IPO, now being supplemented by the growing number of “SPAC transactions.” A Special Purpose Acquisition Company (SPAC) is a non-operating company that is already public, well capitalized and liquid that is looking to acquire a private operating company. After acquiring the private company in a transaction referred to as “de-SPACing,” the operating company most frequently steps into the shoes of the SPAC as the public company. The board of the now-public company may consist of board members from the previous SPAC itself, as well as board members from the acquired private operating company.
Regardless of the path to becoming public, an effective board is critical. However, once public, there are other regulatory requirements to be considered. The Securities and Exchange Commission (SEC) has certain rules around a board of directors, its members, and its committees. As a result of past legislation, principally the Sarbanes Oxley Act of 2002, the SEC issued rules requiring the exchanges (e.g., the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotations (NASDAQ)) to promulgate their own rules for their listed companies around corporate governance. The requirements of the NYSE and NASDAQ are important as most companies, once public, also want to be traded on a recognized exchange.
While there are timelines established for a newly public company to comply with some of the requirements, there are some underwriters that will not assist in a transaction for a company that is not already compliant with those requirements, or at least will be on the date the company becomes public. So advance planning and timing of board changes and development will be critical in the following areas:
- Seating board members that are independent of the company under the varying definitions of “independent;”
- Creating or enhancing an audit committee of the board, including appropriate composition and responsibilities; and
- Creating other required committees of the board and establishing their responsibilities.
At every stage in the life of a company, a strong corporate governance infrastructure should be front and center. While the goals and objectives of corporate governance are enduring, the infrastructure may change over time as a company grows and moves into its next stage of development. At some point in that life cycle, that corporate governance structure should, and likely must, include a board of directors. Establishing that structure now, with a look toward the future, can make the company more desirable to potential investors and make the transition from private to public more seamless.
For more on corporate governance, contact us at firstname.lastname@example.org or reach out to a DHG Advisor.