Competing For Advantage Part IV – Monitoring and Creating Entrepreneurial Opportunities Chapter 11 – Corporate Governance

Key Terms Corporate Governance – set of mechanisms used to manage the relationships (and conflicting interests) among stakeholders, and to determine and control the strategic direction and performance of organizations (aligning strategic decisions with company values)

Governance Mechanisms

Critical Issues for Growing Family-Controlled Firms Owner-managers may not have access to all skills needed to manage the growing firm and maximize its returns for the family They may need outsiders to help improve management of the firm Owner-managers may need to seek outside capital and thus give up some of the ownership control

Agency Relationships Key Terms Agency Relationship – relationships between business owners (principals) and decision-making specialists (agents) hired to manage principals' operations and maximize returns on investment Managerial Opportunism – seeking self- interest with guile (i.e., cunning or deceit)

An Agency Relationship

Problems with Separate Ownership and Control Principal and agent have divergent goals Shareholders lack control of large publicly traded corporations Agents may pursue goals that conflict with those of principals

Product Diversification as an Agency Problem Key Terms Free Cash Flows – resources remaining after the firm has invested in all projects that have positive net present values within its current businesses

Product Diversification as an Agency Problem Increased product diversification allows top executives to increase their compensation Increased size is positively related to executive compensation Increased complexity and leadership demands more pay

Product Diversification as an Agency Problem Product diversification reduces risk for top executives Managerial employment risk includes the risk of managers losing their jobs, compensation, or reputations Diversification reduces managers vulnerability to reduced demand with a single or limited number of product lines or businesses

Product Diversification as an Agency Problem Use of Free Cash Flows Managerial inclination to overdiversify Shareholders may prefer that free cash flows be returned so they can control how the cash is invested Questions the validity of unrelated diversification

Agency Costs Key Terms Agency Costs – sum of incentive costs, monitoring costs, enforcement costs, and individual financial losses incurred by principals, because governance mechanisms cannot guarantee total compliance by the agent

Ownership Concentration Key Terms Ownership Concentration – governance mechanism defined by both the number of large-block shareholders and the total percentage of shares they own Large Block Shareholders – shareholders owning a concentration of at least 5 percent of a corporation’s issued shares Institutional Owners – financial institutions such as stock mutual funds and pension funds that control large-block shareholder positions

Ownership Concentration – Trends Increased equity ownership by institutional owners provides the size to influence strategy and the incentive to discipline ineffective managers Increased shareholder activism supported by SEC rulings in support of shareholder involvement and control of managerial decisions

Ownership Concentration – Trends Threats or initiations of a proxy battle to unseat the current board of directors Organization of press conferences Threats of a takeover bid Creation of shareholder “proposals” to be addressed at the next board meeting

Board of Directors Key Terms Board of Directors – group of shareholder-elected individuals whose primary responsibility is to act in the owners’ interests by formally monitoring and controlling the corporation’s top- level executives

Board of Directors Direct the affairs of the organization Punish and reward managers Protect shareholders’ rights and interests Protect owners from managerial opportunism

Board of Directors –Types

Insiders Knowledgeable Beholden to the CEO

Outsider Directors Improve upon weak managerial monitoring in comparison to inside directors Without knowledge and access to information about managers and strategy, they tend to emphasize financial controls, to the detriment of risk-related decisions by managers

Board Effectiveness – Trends Increased diversity of the backgrounds of board members Establishment and consistent use of formal processes to evaluate the board’s performance Creation of a “lead director” role that has strong agenda-setting and oversight powers Modified compensation of directors Requirements that directors own significant stakes in the company in order to keep them focused on shareholder interests

Board Effectiveness – Trends Become engaged in the firm, without trying to micromanage it Challenge the reasoning behind decisions, but be supportive of decisions that are made Provide an independent perspective on important decisions Separation of Chair and CEO - Duality

Executive Compensation Used to control the actions and behaviors of managers Align the interests of managers with owners

Executive Compensation – Complications Performance-based compensation imperfect in their ability to monitor and control managers Subject to managerial manipulation to maximize managerial interests

Executive Compensation Plans – A Question of Stock Issues Effectiveness Generally designed to maximize manager wealth rather than guarantee a high stock price that aligns the interests of managers and shareholders

Market for Corporate Control Key Terms Market for Corporate Control – external governance mechanism consisting of a set of potential owners who are seeking to acquire undervalued firms and earn above-average returns on their investments, a process which becomes active when a firm’s internal controls fail

Market for Corporate Control Addresses weak internal corporate governance Corrects suboptimal performance relative to competitors Disciplines ineffective or opportunistic managers