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Corporate Governance

Prioritize Governance from the Start: How Small Cap Companies Can Build a Strong Governance Framework

Prioritize Governance from the Start: How Small Cap Companies Can Build a Strong Governance Framework

Good corporate governance is a strategic differentiator, particularly for small cap companies. However, unlike large cap companies that may have an abundance of resources to support more evolved governance structures, practices, and standards, small cap companies may lack those resources, and they may face additional challenges to their ability just to survive in the short-term. Lost amid the intense focus on achieving short-term results and growth, governance tends to be less of a priority, one viewed mainly through a lens of compliance.

The legal fiduciary responsibilities of a director of a small cap public company and a director of a large or mega cap company are the same. A company’s corporate governance framework should support board members’ ability to effectively carry out those duties. But corporate governance is not one-size-fits-all, and to be truly effective, a board may need to evolve as the company matures and its needs change. Governance should be considered more than a matter of compliance. If directors and officers  of small cap companies fail to properly prioritize governance, they are putting themselves and their companies at risk. With an estimated 72% of publicly listed companies sitting under $5 billion market cap, small cap companies should consider implementing robust governance structures to mitigate risk and support long-term strategic growth. (Source: https://www.russellreynolds.com/en/Insights/thought-leadership/Documents/TCB-Corporate-Board-Practices-2019.pdf) 

Small Cap Company Risks and Challenges

  • Pressure to grow and evolve
  • Access to capital and sufficiency of liquidity
  • Quickly determined success or irrecoverable failure
  • Ability to recruit highly qualified directors and build a well-balance board
  • Additional regulatory, reporting, and administrative responsibilities for directors associated with public company status
  • More inherent focus on short-term growth and profitability instead of long-term strategy
  • Likelihood of challenges from activist investors or skepticism from institutional investors

Over the past three decades, numerous corporate governance failures have contributed to the demise of companies both large and small. However, high potential small cap companies are more susceptible to deficiencies of governance, including the inability to focus management on long-term growth, to oversee risk management and mitigation, and to exercise appropriate and effective oversight of the CEO. Small cap companies that commit to building good governance from the start, instead of bolting it on piecemeal, may avoid major missteps and more effectively achieve significant growth in the short- and long-term, building on the drive and innovation of the company’s founders. To begin developing a resilient and effective governance framework, small cap boards should start by asking and answering the following questions.

Do we have the right board structure? Board structure can either support or limit a board’s ability to function optimally, and understanding the right structure for the company is a step towards effective governance. Is the company served best by its CEO assuming the role of board chair? If so, for how long? Would having an independent lead director help to ensure the board’s ability to exercise independent oversight? What size should the board be and what is the right number of independent - versus non-independent – directors? Among S&P 500 boards, 86% have written policies establishing a lead director role, indicating the importance of having independent board leadership. (Source: https://www.russellreynolds.com/en/Insights/thought-leadership/Documents/TCB-Corporate-Board-Practices-2019.pdf)

In some cases, a founder/CEO serving as chair at a small cap company may elevate the need for a lead independent director. If the CEO selected close associates to serve on the board or if directors were appointed by a major investor, the board’s independence could be called into question. Consider also the weight the founder’s opinion may carry with peer directors.

Committee structure also helps to drive efficient functioning of the board. Audit, compensation, and nominating and governance committees are legally required. What additional committees would add value and further support the board’s functioning?  Are directors assigned to committees based on their expertise and their ability to contribute meaningfully to the work of the committee? Are committee assignments made in a way that balances the work among the group?

Do we have the right composition and dynamics for now and the future? As small cap companies evolve, so too must their boards. The risks, challenges and opportunities a company must consider as it matures are likely to be significantly different than those it faced earlier in its life. Its board should have a process that allows it to evaluate its effectiveness and when appropriate, bring on new directors who have skills, experience and expertise that are aligned with the company’s evolving needs.

Board composition – and diversity, in particular - has been a top governance topic not only among boards themselves, but also among investors, state legislatures, employees, and the public. The board chair of a small cap corporation recently remarked, “diversity is in the DNA of our board, and it’s why we have more robust discussions and better board dynamics.” On the other hand, some boards may still view diversity as simply checking a box in the composition matrix. The perception that having one or two women on the board means the board has achieved diversity does not reflect an enlightened understanding of the value true diversity brings to a board. A diverse board is one where there is diversity of thought, experience, and background.

A regular cadence of board assessment and ongoing succession planning support continuous board effectiveness. Board members should be willing and able to ask the right questions, actively listen to and challenge each other, and weigh information carefully and thoughtfully. Board refreshment helps boards avoid the tendency of the group-think that can evolve when directors have worked together for too long.  

Do we have the right CEO, and have we set clear expectations for the CEO’s performance and development? Selecting the CEO is one of the most important decisions any board makes. While the founder of a start-up often serves as its CEO, evaluation and oversight of the CEO’s performance remain the board’s responsibility. The board should set clear performance expectations, have a process for evaluating performance to determine whether the CEO is delivering on those expectations, and regularly provide candid feedback. To support a new CEO’s development, board members - especially the board’s chair or lead independent director - can be key mentors to the CEO.

At some point, while a company’s founder may have had the vision and ability to establish the company and was able to serve as its first CEO, the board may determine that a change of executive leadership is needed. Effective CEO succession planning generally requires constant and diligent assessment of the leadership skills necessary for each phase of growth, as well as skillfulness to adeptly implement a smooth transition.

Because boards of small cap companies often work very closely with the CEO and management they should be particularly mindful to maintain the separation between the board’s role of oversight and management’s role.

Do we have a clear understanding of the board’s role in strategy? As views on governance have evolved to the point where boards are now recognized as a strategic asset, perspectives on the board’s role in strategy have evolved as well. A board that simply approves the strategy put forth by management without critique or assessment of alternatives may be forgoing its ability to provide valuable and critical expertise and insights – insights that can improve and solidify the company’s three- to five- year strategic plan, which is critical to growth. Boards should be committed to ensuring the company achieves its goals for growth by working with management to review, assesses, and approve updated long-term strategic plans that promote shareholder value.

In overseeing the company’s performance, small cap company boards – particularly in early stages – may focus heavily on reviewing financials. While oversight of financial performance should be a priority for every board, oversight of strategic implementation should take a broader perspective. In addition to the annual review of the strategic plan, an effective board should build strategy into every meeting, reviewing financial performance, corporate risks, operational performance, capital structure, organic and inorganic growth opportunities, corporate culture, investor relations, and other topics that indicate total corporate health. A meaningful strategic review should include thoughtful dialogue between the board and management and a process for identifying specific areas for follow-up and action so that the board is effectively addressing each relevant issue that is important to investors and customers throughout the company’s life cycle.

Governance should support the company’s evolution and growth.

Every high performing board should be committed to establishing a governance framework that supports governance excellence in the short- and long-term. Small caps that start with good governance have a clear advantage as they grow. Build good corporate governance now, instead of trying to bolt it on later.


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Kaley Childs Karaffa

Nasdaq

Kaley is the Director of Board Engagement at Nasdaq.

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