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The Importance of Directors

Written by: Dennis Gerschick

Article Overview: This article focuses on the importance of directors in closely-held companies. It discusses the factors that should be considered in selecting a director. The article explains how effective directors can help the management team.

The Importance of Directors

Many companies are in trouble for a variety of reasons, including inadequate risk management. It is now clear many companies were assuming a level of risk that the management team did not fully appreciate. Where were the directors? Perhaps it is too much to expect directors to understand the level of risk exposure a company has if the top management team, who work there full-time, do not understand it. Do directors have any responsibility? As a practical matter, directors’ personal liability is often eliminated by corporate codes and the business judgment rule. However, even if directors are not held personally liable, there are still adverse consequences for many parties including the company and its shareholders.

In previous articles, I have emphasized the importance of having competent management in three areas: (1) operations, (2) marketing, and (3) administration which include financial, tax, and legal. We know that a Board of Directors should select the Chief Executive Officer (“CEO”) and review management’s business strategy and their execution of it. A Board of Directors should also strive to help the company by considering not only the upside potential of its operations and new opportunities but also the downside risks.

The corporate governance issues are similar for both publicly-traded corporations and private or closely-held companies. However, there are significant differences for several reasons. First, many private or closely-held companies do not have experienced management in all three areas noted above. Consequently, directors need to take a more “hands-on” approach and get more involved in issues that an experienced management team would normally handle on their own. Second, many private companies do not have an internal auditor or a sophisticated internal control system. As a result, the risk of fraud or other problems may be higher. Third, many private companies do not have audited financial statements or, if they are audited, the auditors may not be of the highest quality. Finally, many private companies are controlled by one or just a few owners, and the controlling shareholder is often the CEO. Private companies are also often reliant or heavily dependent on one or a few key people; one key person is often, but not always, the majority or sole owner. Directors should represent all of the corporation’s shareholders. What may be good for the majority shareholder may not be good for the minority shareholders. However, the majority shareholder usually has the voting power to remove any director, so there is an obvious incentive to “go along to get along.” Good directors resist this pressure. I am writing this article with closely-held companies in mind, not large publicly-traded corporations, although many of the concepts apply to both.

The importance of having well-qualified, engaged directors should be clear to all, regardless of the economic environment, but especially in a depressed environment. Issues and problems arise frequently in operating any business. One person should not be expected to be in total command, especially if the CEO is not old enough to have acquired significant experience. Many dot-coms failed because the CEO was age 30 or less and did not have the experience to manage a successful business. Even the best CEO can be kept in the dark by subordinates below. I believe many business owners and executives need help. No one knows it all.

An effective Board of Directors can provide a tremendous benefit by being a sounding board for the CEO and the senior management team. Directors should provide their candid opinions in a concise, informative, and civil manner. Some may play devil’s advocate to ensure all aspects of an issue are considered. Directors can also be a “coach” or mentor to the CEO – there to advise and encourage but not be a “rubber stamp.” My mantra is “Great things can happen when people put their egos aside and their heads together.” Sound easy? I have found it is very hard for a number of reasons. CEOs do not always bring relevant issues to the Board for their consideration and input. Many CEOs avoid doing so because they are concerned that the Board will think they are less capable, the Board might lose confidence in them, or the CEO does not want any input because they believe they have it all under control. Many CEOs believe that if their company is not performing as expected then that means they are incompetent or have failed in some way. This is not a pleasant thought so many CEOs do not like to address difficult issues or tackle trouble head-on. Getting people to put egos aside is a challenge.

Much has been written about risk management. A Board of Directors should help management assess the company’s level of risk and manage the various risk factors to minimize the odds of something going seriously wrong at the company. To put it simply, it comes down to addressing important questions, including: (1) What can go wrong? (2) If something does go wrong, what are the potential consequences? (3) What can the company do to eliminate, reduce, or transfer the potential adverse consequences? Usually using a cost vs. benefit analysis, consider the cost of implementing appropriate policies and procedures and enforcing them. Many private business owners would be well advised to get some outside directors on their Board of Directors. Outside directors are not dependent on the company and do not need to “play company politics” so they can be more objective and forthright. Outside directors can put the difficult issues on the agenda and ensure they are addressed.

In selecting outside directors, many factors should be considered including the type of expertise the company already has thru its own personnel and existing outside advisors. I believe too much emphasis is given to having directors with experience in the company’s industry. Outside directors with experience in other industries can challenge conventional thinking and the standard way of doing things. Directors can use experience gained in one industry for the benefit of a company in another industry. Getting people to try new things is a challenge because you are taking them out of their comfort zone. Maintaining the status quo is comforting to many. Albert Einstein defined insanity as doing the same thing and expecting a different result. Unfortunately, many companies continue to do the same old thing even though they are not getting good results because that is what they know and are comfortable with. Doing things differently creates some uncertainty because you are exploring a new territory.

An important factor to consider in evaluating a potential director is the amount of time he or she is willing to devote to the company. Private companies cannot afford figureheads or just having a “name” on the Board. They need people who are competent and committed to helping the company succeed. Will the directors attend all Board meetings? Will they come prepared? Will they participate in the meetings? Are they available to consult in between meetings? I believe Board meetings should include spirited but civil conversation. It is hard to be a good director; some are better at it than others.

I like adages because they are pithy statements that usually contain a lot of wisdom. However, one adage, that I believe has done more damage to businesses than any other is, “If it ain’t broke, don’t fix it.” At G.E., they have revised it to, “If it ain’t broke, break it. Because if you don’t break it, your competitors will. Beat ‘em to the punch.” What does this imply? Businesses should not be complacent; instead, they should constantly strive to improve every segment of the business. An effective Board will inquire about the changes that are being made within the company and offer suggestions about what works and what does not.

The financial performance of many companies, both publicly traded and private, has deteriorated. The CEO, who is often the controlling owner, should acknowledge the fact. Instead of making excuses, they should explore ways to shake things up. Often the CEO did not keep up with changing trends and/or was slow to react. An active Board can help educate the CEO and ensure that significant trends affecting the company are considered in a timely manner in developing and executing the company’s strategy. Two, three or five heads are usually better than one.

Key Points

1. Many private companies do not have qualified management in operations, marketing, and administration. Outside directors and advisors can help fill the gap.

2. Outside directors can help management by acting as a sounding board and help ensure that all relevant trends and aspects of an issue are considered. The outside directors’ knowledge and experience can supplement the CEO’s.

3. It is better to have one committed outside director than 3 or 5 “names” who are there for “window dressing” and do not really participate.

4. In putting together a Board of Directors, consider the expertise the company already has and the areas it needs help in. The Board should include people with a variety of backgrounds who can have spirited but civil conversations. Everyone should contribute.

Related Articles
  Director’s Liability Notices from the Australian Taxation Office
  Governance in the SME Sector (including NFPs) – A Waste of Time?
  Your Internal Board of Directors ... Part II: Red Flags, Green Lights and Wisdom
  Talking to Directors
  Your Internal Board of Directors ... Part III: What Part of You is Running Your Business?

Article Tags: board of directors, business judgment rule, business strategy, chief executive officer, competent management, consequences, corporate governance issues, corporations, downside, execution, financial statements, internal auditor, internal control system, new opportunities, personal liability, private companies, risk exposure, risk management, shareholders, top management team



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