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15 July 2010 Corporate governance for small-to-medium enterprises (SMEs)

By Alistair Jaque, Partner


In brief – Corporate governance for SMEs

Many SMEs consider that corporate governance is only relevant to large companies. However, good governance presents major advantages for all companies, especially when raising capital or selling the business.


All companies benefit from good corporate governance

The majority of companies in Australia are small-to-medium enterprises which often view corporate governance with scepticism. Good governance in this context is not primarily concerned with compliance with formal rules and regulations. Rather it is about establishing a framework of company processes and attitudes that add value to the business, help build its reputation and ensure its long-term continuity and success.

Good corporate governance is particularly important to the shareholders of unlisted companies. In most cases, such shareholders have limited ability to sell their ownership stakes and are therefore committed to staying with the company for the medium to long term. This increases their reliance on good governance.

Twelve essential principles of corporate governance for SMEs
  1. Shareholders should establish an appropriate governance framework for the company. The process and the governance requirements will develop with the growth of the company.
  2. Family companies should establish family governance mechanisms which promote coordination amongst family members and organise the relationship between the family and the business.
  3. It is important to establish an effective board which is collectively responsible for the long-term success of the company. A starting point for an SME may be the creation of an advisory board for management.
  4. There should be a clear division of responsibilities at the head of the company between the running of the board and the running of the company’s business. No one individual should have unfettered powers of decision.
  5. All boards should contain directors with a sufficient mix of competencies and experience. The size and composition of the board must reflect the scale and complexity of the company’s activities.
  6. The board is responsible for risk oversight and should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets.
  7. Dialogue should be encouraged between the board and the shareholders on the company’s strategic objectives. The board should always remember that all shareholders have to be treated equally.
  8. A stakeholder engagement process should be established, ensuring that the board always presents a balanced assessment of the company’s position and prospects to its stakeholders.
  9. The board should be supplied in a timely manner with appropriate information and should meet sufficiently regularly to comply with its duties.
  10. All directors should receive induction training on joining the board and should regularly update and refresh their skills and knowledge.
  11. The board should undertake regular appraisals of its own performance and that of each individual director. 
  12. Levels of remuneration should be appropriate to attract, retain and motivate executives and non-executives of the quality required to run the company successfully.
Seven key concepts of good governance

Any company can develop good corporate governance practices. The key is to understand the foundations of good governance and how these will apply to your company.

Delegation of authority

In any company, the origin of authority is ownership. However, the company may soon reach a point in its development where the main shareholder is no longer able to fulfil the roles of shareholder, executive director and manager simultaneously.

The owner and/or the board should develop a systematic approach to delegate authority and should formalise this in writing. A schedule of matters reserved for the board and for executive management should be established.

Delegated authorities should be reviewed periodically to ensure that they remain appropriate given the structure, size, scope and complexity of the company.

Checks and balances

A basic principle of good governance is that no one individual should have unfettered power over decision-making. Aside from the practical difficulties involved in a single person making all the decisions, a lack of appropriate checks and balances exposes the enterprise to human weakness. Even the most capable of individuals can sometimes make mistakes or lose their ability to analyse issues in an objective manner. To minimise these risks, it is important to establish governance procedures that subject all decision-making to some kind of third party scrutiny.

Specific examples of checks and balances within the corporate structure include separating the role of executive management from that of the chairman of the board, the requirement of a “four eyes” principle when signing contracts or making important commitments on behalf of the company and the involvement of independent directors on the board.

Professional decision-making

The focus of collective decision-making in most companies is the board of directors. However, simply placing competent people of goodwill around a boardroom table will not necessarily result in an effectively functioning board. Building an effective board takes time and patience on the part of board members and benefits from a professional approach to boardroom procedure.

The chair has a particular responsibility in moulding a group of capable individuals into an effective board team. The chair has to find a way to reach a consensus between diverging views on the company and its future. An atmosphere of open discussion should be encouraged. Perspectives and viewpoints should be properly documented in the minutes, allowing dissenting voices to be recorded. There should also be a clear formulation of decisions, so that the decision-making process is followed by decisive action.

Accountability

It is important that each employee, manager and board member understands expectations about the nature and scope of his or her responsibilities. As the company expands in size and complexity, explicit business conduct rules including ethical principles will need to be formalised.

Once responsibilities have been defined, the efficient functioning of the system depends on proper oversight.

Transparency

Directors, managers and employees are likely to give greater thought to their conduct if they perceive that they are being observed.

A key stage in opening up the company to external scrutiny is taken by the appointment of independent non-executive directors. This signals a company’s willingness to become more open and accountable in respect of its decision-making and performance assessment. The replacing of the owner-manager or founding entrepreneur by external management can also be perceived as an important step in this direction.

At some stage, the SME must make choices about the extent of its disclosure to external stakeholders. This is important if the company is seeking external capital or contemplating a future listing.

Conflicts of interest

Especially in small companies, it is important to recognise that the company is not an extension of the personal property of the majority owner.

The principle may be difficult for owner-managers or large shareholders of SMEs to accept or understand. They may view the company’s interests as synonymous with their own. This may lead to a self-interested bias in their decision-making. At worst, it could lead to them seeking ways of expropriating the assets of the company at the expense of minority shareholders or stakeholders.

A robust governance framework needs to define credible mechanisms by which potential conflict of interest issues can be managed or resolved. Directors should always declare potential conflicts of interest to the rest of the board and abstain from influencing such decisions.

Aligning incentives

The directors and employees are primarily incentivised by the SME’s remuneration policy. SMEs benefit from the fact that they are not subject to the same degree of public scrutiny and mandatory transparency regarding remuneration as publicly listed companies. However, SMEs have the same need to ensure that the remuneration policy is incentivising behaviour from directors, managers and employees in a way that is consistent with the long-term interests of the company.

Furthermore, a credible and transparent remuneration policy can help win the commitment and loyalty of company stakeholders to the company’s objectives.

Conclusion – Good governance is for everyone

Remember, good corporate governance is not just for large publicly listed entities. All companies, regardless of their size or extent of their operations can achieve tangible benefits from implementing strong governance systems.

For further information or to discuss your specific governance needs please contact:

Alistair Jaque, Partner  |  Phone: +61 2 9233 5544  |  Email: afj@swaab.com.au

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This article is not legal advice and the views and comments are of a general nature only. This article is not to be relied upon in substitution for detailed legal advice.

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