Attribution

This post is re-published with kind permission of Professor Mervyn King. It was first published in Professor King’s boardroom journal, Corporate Report

Foundations of Corporate Governance

The UK Governance Code and the King Code are each considered minimum standards for entry to the stock markets of their respective countries, the UK and South Africa. They have similar, yet fascinatingly different origins. The UK Code was established in response to massive corporate failures in the UK, which left shareholders’ funds ravaged, with no recourse or accountability. The UK business community itself initiated the Cadbury Committee’s work under the direction of the late Sir Adrian Cadbury. In South Africa, the King Code too was established in response to untenable circumstances, but this time as result of the liberation of a nation from disenfranchisement, oppression, and separatism. The King Committee was established by the late President Nelson Mandela in response to the business community in a now famous phone call to his “favourite Judge” Professor Mervyn King.

The “fathers of corporate governance,” Cadbury and King, both broadly defined corporate governance in terms of systems and processes by which companies are directed and controlled, and indeed these are the recognised fundamentals of governance and are prerequisites for internal control, quality assurance, and managing risk, resources and productivity. Their work has seen massive improvements in the accountability, stability, and reliability of formal business practices in their countries and beyond where the principles of their respective Codes are either adopted or incorporated into other nations’ governance codes.

There is a subtle yet significant difference between the founding principles of the two codes. Cadbury’s approach requires listed companies to either comply with the provisions of the Code, or if they do not comply, explain publicly why they do not. King, on the other hand suggests boards apply or explain. The difference “complying” and “applying,” in my opinion, is the difference between declaring conformance to set standards on one hand, and the freedom and ability to lead a company whilst applying recognised standards or practices on the other.

Millennials, Crowd-funding and Venture Capital

We also know that in parallel to listed companies and established businesses, start-ups, early-stage, and crowd-funded companies are a rapidly developing sector and are attracting increasingly larger quantities of investment, in some cases to the detriment of more traditional models of funding. The crowd-funding model shifts the burden of financial risk from traditional banking institutions to legions of smaller investors who, by definition, have a stake in the success of the funded entity. This element is no different from the vested interest of a bank in the successful recuperation of its loans and interest. But what standards apply in reality to crowd-funded start-ups, if any?

Do venture capitalists and crowd-funding vehicles have codes of governance that enshrine the minimum standards their funded start-ups must comply with and apply in their corporate practices? Is it appropriate even to do so? If not, how are they “governed” and is governance the victim in the start-up battle for innovative supremacy and corporate progress?

Imposing hefty codes of governance on start-ups and innovative new companies, and requiring them to apply those principles or explain what they did, would probably prove prohibitively expensive for most of them. Certainly, for many, the concept of being heavily regulated at start-up-stage might even feel like a restriction that could limit their ability to innovate or to respond rapidly to changes and challenges in the market.

On the other hand, 21st century markets and their “consumers” are able to lay their hands on so much more information and analysis about the value of things than any 20th century investor did, and at the mere stroke of a touch-screen at that.

Hence, “Millennials” have far more developed opinions about a wide range of matters than the previous generation ever had the opportunity to develop, other perhaps than through a university education. Indeed, it would previously have taken post-graduate qualifications to arrive at any useful analysis of the sorts of volumes of intelligence available today. The millennial generation can and does now make choices based both on value and on values, not just on price. They are aware of the effects of industry and corporations on people and the environment; and, they know about the mega-trends rising rapidly around them.

So when a start-up goes to market with their products, having relied on crowd-funded capital to get there, do they take into account the whole spectrum of potential value creation across all of the possible domains of value they have affected and that affect them in return? Probably not; and yet, these are the standards the new generation of informed consumers are beginning to judge them by.

The informed Millennial knows right from wrong because she has at least 50 more years of experience, albeit virtual, in making that value judgement than the 1980s teenager (because the internet offers her a neat précis and besides, she’s been thinking about it whilst saving up for it). Her decision will be researched, informed, and probably based on popular sentiment, tempered by her own deliberations. Increasingly, she will be taking into account whether she feels comfortable giving money to a company that does not clearly demonstrate the values she holds dear. She will consider quality and how long the item will last, after-sales support, and service.

Some of these values are easier for a start-up to demonstrate. The quality of a product is one thing a company can just get right, as are after-sales support and service, and even fashion can be neatly pandered to with clever add-ons, accessories, or personalisation. However, becoming and remaining a company she trusts, that holds the same or compatible values as she does, and always does the right thing is a standard that is much harder to achieve. This trust, this reputation, cannot be bought. It cannot be created by a marketing or public relations campaign. Nor will a clever Corporate Social Responsibility (CSR) programme do the trick. Corporate philanthropy might even make her wonder what terrible atrocities they are trying to make up for. All of those elements of what used to be business-as-usual have withered on the vine because they were not integrated into core business. They were never central to the business plan.

Furthermore, despite comprehensive, nationally accepted governance frameworks and codes, it remains possible for a company to run a highly successful business model focussed on generating large volumes of profit for shareholders, whilst showing in its annual returns that it has complied with its national code of governance, only for that company to fail in the blink of an eye.

The “Risk of Risks”

Massive risks lurk in wait for businesses trading in the 21st century. These range from factors such as cash flow, temporary interruptions to production lines from accidents, power failures, or staff shortages, through to full-blown natural disasters, climate change, and rising sea levels. In between is the myriad of pitfalls and hazards we are all familiar with, disruptive technologies, regulatory breaches and fines, accounting errors, untoward incidents, the rising tide of stakeholder activism, corruption, or running out of crucial raw materials (a brewer’s water, or a mobile device-manufacturer’s so-called ‘rare earth minerals’) for example.

Even riskier though, is damage to corporate reputation and loss of stakeholder confidence. Damage to reputation is widely held as “the risk of risks,” and it is why companies must guard against it, and act swiftly to repair reputational damage if they cannot avoid it in the first place.

This headline recently caught my eye:

“Farmers herd cows through [supermarket] in protest at plummeting milk prices.”

Cows herded through Asda

Cows herded through Asda. Photo
Ben Stewart @RealBenStewart

I read the account with fascination, and, admittedly, a slightly guilty chuckle (it’s not funny, really). Cows had apparently been herded through a supermarket in Stafford (England) during a protest over the wholesale price being paid to dairy farmers for milk. Farmers said they did so because the wholesale price paid for milk was lower than the cost of production, lower even than the cheapest supermarket bottled water. By the next morning, two supermarket chains had raised the wholesale milk price paid to dairy farmers. Was this a case of reputation saved through a swift corporate response? Yes, possibly, but one wonders why it took such an extraordinary piece of performance art to engage the supermarket with their immediate stakeholders’ plight.

By contrast, VW may find that the act of returning its “green car of the year” awards does little to restore its ravaged reputation after arguably breaching the trust of every possible stakeholder world-wide by using a ‘defeat device’ to beat emissions tests in its cars.

In a different industry, the government regulator of the National Health Service (NHS) in the UK has introduced a “Fit and Proper Persons Test” (FPPT) test for directors or their equivalents (such as senior managers). The test prevents people from becoming or continuing as directors of a hospital or hospitals if they are not, or no longer continue to be “fit and proper persons.”

This barrier was set up in response to the dreadful untoward events and clinical incidents that unfolded at a hospital where patients were neglected to the extent that a public inquiry, costing circa £15 million was required to find the underlying cause of it. In responding to the public inquiry, the Department of Health said “the public have the right to expect that people in leading positions in [healthcare] organisations are fit and proper persons; and that where it is demonstrated that a person is not fit and proper, they should not be able to occupy such a position.” There is also a new criminal offence for wilful neglect, showing the government intention to legislate so that those responsible for the worst failures in care are held to account.

The key corporate governance questions to ask about these three very different cases of things going wrong are:

  1. What did the leadership of the company know?
  2. When did they first come to know it?
  3. How did they respond?
  4. When did they respond?
  5. If they knew nothing (highly improbable), why not and what was their focus prior to that point?

These are run-of-the-mill questions that any public inquiry or diligent investor should and would ask, but the wider implication is far more fundamental. Why did these companies adopt the strategies that caused these outcomes in the first place? Why force milk prices down to below cost price when that action endangers the entire supply chain? Why cheat vehicle emissions tests when the result has the potential to ruin the environment? Why focus almost exclusively on finance in a hospital to the extent that patients are left literally to suffer in their beds? Most importantly, what shared values were the strategic decisions underpinning these outcomes based upon?

We may never fully understand the reasoning behind these decisions, but rightly or wrongly, market-pressure will be quoted as a factor in all three cases. There is something else that these three cases have in common. All three business models are 20th century models. Fossil fuel engines, large, overburdened, cumbersome hospitals, and supremely powerful supermarkets all have their roots deeply embedded in 20th century business thinking. We also know that we cannot solve today’s problems using yesterday’s thinking. After all, it was often flawed, isolated, silo-thinking that generated the problems in the first place. Let us not forget that each of these three example industries had robust codes of conduct and corporate governance with which they claimed to be compliant.

New Frontiers

As we look towards business and sustainability in the 21st century, we know that just as it was in the 20th century, strategic leadership without a foundation of sound systems of internal control, quality assurance, and stakeholder engagement will fail. Likewise, achieving demonstrable “compliance” with the applicable codes of governance will not yield sustainability without competent, engaged, responsive, and accountable leadership.

The challenge faced by 21st century boards of directors is to achieve the balance between systematic compliance-based control and values-based leadership. Furthermore, it has become vital to understand how these factors combine to create value, whether tangible balance-sheet assets and revenue, or intangibles and social value, or a combination of both.

Essentially, start-ups are pioneers; they lead the charge into new sectors and uncharted territory, often disrupting previous business models with innovation, determination, and drive. Few, if any of them have boards of directors in their early stages. Some are no more than individuals or limited-scale collaborations.

So what is to stop them disregarding every previously hallowed standard of corporate conduct with a flagrant disregard for the environment and other stakeholders? Well, nothing. Nothing, except the market, and that means you; that is your role in the new century. You have the tools, the insights, the lessons and case studies and the incentives to hold people and entities to account for their personal and corporate conduct in business. How can you do this, other than by driving cows through your local supermarket?

What tools do we have?

We, the stakeholders, should be asking VC and crowd-funded start-ups and early-stage companies to set out their plans for avoiding the pitfalls we have become all too familiar with, and at the end of key milestones, to report on the progress of those plans. We do not need to invent new tools, and we certainly do not want any more ‘guanos’ or ‘gravy trains’. No, the tools already exist for both founders and funders. They may need a little tweaking, and that is a project I invite you to join me in at the end of this article.

The first tool is the International Integrated Reporting Councils’ Integrated Reporting <IR> Framework, with a little adjustment and paring down to suit smaller enterprises. It is ideal for founders and funders alike. In particular, the identification of value-creation across the whole spectrum of “capitals” (financial capital, manufacturing capital, human capital, social and relationship capital, intellectual capital and, natural capital) requires a careful consideration of the full context of any enterprise even before the outset.

In most cases, this exercise will expose numerous additional elements of value-creation that the entrepreneur had not yet factored into their value, and even their potential market cap. In a minority of cases, the examination may reveal that the enterprise is unsustainable in one or more of the capitals, and is therefore likely to be at best a short-term proposition, with potential for causing various deleterious effects.

Either of the outcomes should be a highly attractive prospect to the start-up founder and their funders. It provides both parties with a detailed and developed risk screen through which to view and manage uncertainty in business, and as such, it raises the chances of success outweighing the risk of failure due to unseen and unintended consequences.

An example of the second (complimentary) tool is the Social Earnings Ratio. The S/E Ratiotm is a recognised leader in the measurement and transfer of value. If the total value of an organisation is the sum total of its financial and social value, the one-number index of financial value is the Price Earnings Ratio (P/E)—the corollary is the Social Earnings Ratio (S/E).

Given that 86% of the S&P 500’s value cap is intangible, the S/E Ratio is arguably at least as important if not more important than the P/E Ratio in how we perceive the full and true value of a company or other entity. Founders and funders can use the S/E Ratio to measure and predict the value and changes in value of their company depending on the impact of various actions in real time.

In a world driven by sentiment (how we feel about things), demonstrating that you have carefully assessed the impact of your actions, before you take them, will go a long way to building and maintaining that all-important corporate reputation.

Together, the <IR> Framework and S/E Ratio provide a powerful set of metrics and analysis for both founders and funders to evaluate value as well as strategic risk.

Where to for Founders and Funders?

We know that no amount of strategic planning can overcome the natural inertia of a corporate culture once it is established and entrenched. Most major mergers fail for that very reason; humans do not naturally like change unless they absolutely have no option. Peter Drucker, known as the founder of modern management is attributed with the saying “culture eats strategy for breakfast.” The point here is that getting both strategy and culture right from the outset is just as important as finding the right product, service, or business model.

Having assessed numerous corporate failures, I have seen the Drucker concept proven in practice time after time. It is true in almost every case that the one element missing from the equation is action, or the absence of action, to be more precise. If the corporate culture is not lived and led by the leadership [principally the directors], no combination of systems and processes will assure the success of the corporation. On the contrary, governance systems and processes serve only to control the functions of a business, they are inanimate, and are innately limited in their ability to guide behaviour, other than functional behaviour. As discussed, governance without leadership, without action, intervention, direction, and the pervasive modelling of the right behaviours will simply fail.[bctt tweet=”#Governance without #leadership, action & direction will fail” username=”ToGovern”]

Happily, though, there are clear lessons from the past that boards of directors, or those charged with the leadership of corporations can apply from the outset to minimise the risk of disaster further down the line. I include the following “Eight Core Values” in my advice in various weights and forms, depending on the industry [I added 9 and 10 to the blog version, they are not in the print original].

To have any chance of corporate success in the 21st century, you must:

  1. Invest in people and develop strong cultural values from the outset – do so deliberately by recognising and embracing difference and engaging diversely. Address inadequacies or inequalities right across your stakeholder community. Empower people by placing the value of individual freedom to act over rigid constraint (within the bounds of your jurisdiction). Everyone should be able to “stop the line.”
  2. Promote ‘Millennials’ who have no responsibility for what went before, but who know what they want next.
  3. Merge with your stakeholder community and act in the interests of the company AND the community. You can do this easily by leveraging your purchasing power for the common good. Buy local and aggressively root out corruption, do not wait for the authorities to do it for you, they will not.
  4. Co-create clear strategic principles in collaboration with your stakeholders and let them solve some of your toughest problems using their collective mind. Crowdsource your conscience and the maintenance of your reputation.
  5. Be the change you want to see in the world. Challenge the status quo. Do not accept “that’s just how we do things here.” Abolish redundant systems and behaviours or they will bankrupt you both financially and emotionally.
  6. Learn from mistakes, then learn again, and repeat. Commit the lessons learnt to corporate memory AND embed them in the corporate culture.
  7. Be courageous, but not fearless.
  8. Keep a personal journal.
  9. [new!] Take time to think, and,
  10. [new!] Find a coach to help you reflect and develop.

By actively embracing and bringing these Eight Core Values to life in your business, you will create a cultural identity and impetus that will empower you better to take on the shifting challenges of doing business in the 21st century. Importantly, you will be able to demonstrate how you create long-term stakeholder value and sustainability.

The reputational power of achieving this should please shareholders and marketing directors equally. You will also know that if they are not pleased, they are probably part of the problem, not of the solution.

In the words of a learned colleague, “above all, boards need to have a steady nerve, be in it for the long term, and have a clear sense of their own values and the direction in which they are going.” If your start-up does not have a board, or you are just setting out, adopt the Eight Core Values as your own personal values, and test your decisions against them. Keep your thoughts on these values and your actions in your personal journal; you will revisit them again in the future, perhaps when your biographer asks you for material.