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 regarding significant company decisions.
Through the establishment of an effective corporate governance structure, a company ensures that 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, to ensure the company operates effectively and continues to provide value to outside investors and lenders.
Companies will find this article 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, often by necessity, the corporate governance structure will change. For a startup entity, which may be a sole proprietorship or partnership, perhaps family-owned, the founders usually serve in the critical role of guiding 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 likely be required by the state in which the company incorporates. Over time, the composition of the board may change, perhaps beginning with “closely trusted advisors” that have been there from the onset, and eventually transition 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 includes 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 outcomes. 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 corporate oversight.
Structure & Size
The structure and size of the board of directors is governed by a company’s bylaws. The bylaws define the number or range of board members, the term limits, the required qualifications and selection process, and how frequently the board will meet to conduct business. The required number of board members is generally based on the size and complexity of the company.
According to Governance Today, “… the decision makers should reflect on the optimal number, with 8 more appropriate for a larger more commercial operation and 10 more suitable for a smaller operation.”
In addition, while the number of board members may be effective today, as a company grows and evolves over time, it should evaluate whether its board size continues to provide effective oversight.
Internal versus External (Independent) Representation
As a company’s board of directors represents all stakeholders, it is important that it consists 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.
Again, 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 the decisions made consider 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 over time. At a minimum, the company should always ensure its board complies with the laws of its state of incorporation.
Variation in Backgrounds & Skill Sets
When establishing a board, a company should select individuals with the appropriate level of experience, industry knowledge, and financial literacy that offers valuable insights to assist in making relevant decisions that help the company achieve its goals and overcome challenges. This is especially important in times of economic uncertainty.
It is also critical that the board of directors reflects a sufficient level of diversity. This includes diversity in age, gender, and race/ethnicity, as well as level of experience and skill set. Establishing a well-diversified board of directors is crucial to ensure that all company stakeholders are represented, and that differing perspectives address corporate issues and challenges. Board diversity allows for the synthesis of differing opinions and innovative ideas that help the company achieve its strategic 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 & 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 of available financial information, results of operations and past actions, and discuss and approve policies (including compensation arrangements). As a best practice, the board should maintain the minutes of the meetings to document key items discussed and decisions reached, allowing for adequate transparency to company stakeholders.
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.
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 governing a board of directors, its members, and 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, want to be traded on a recognized exchange. There are timelines established for a newly public company to comply with certain requirements, and some underwriters will not provide transactional assistance to a company that is not already compliant with those requirements, or at least will be by the date it becomes public. Advance planning related to the timing of board changes and development will be critical in the following areas:
- Seating board members independent of the company under the varying definitions of “independent”
- Creating or enhancing an audit committee of the board, including appropriate composition and responsibilities
- Creating other required committees of the board and establishing their responsibilities
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