Corporate governance is the focus of this week's material. What are your key learnings from Chapter 11? What are your key learnings from the Berenbeim reading? Explain the corporate governance for your organization, or an organization your are familiar with. What mechanisms or relationships are particularly effective?
Slide 1 Competing for Advantage 1 Chapter 11 Corporate Governance PART IV MONITORING AND CREATING ENTREPRENEURIAL OPPORTUNITIES 1 The Strategic Management Process 2 Figure 1.6: The Strategic Management Process – A logical approach for responding to 21st century competitive challenges. Provides an outline of the content of the textbook by each chapter. Monitoring and Creating Entrepreneurial Opportunities Corporate governance – addresses increasing concerns and efforts to ensure that strategic decisions and actions align with values and stakeholder interests Strategic entrepreneurship – examines the need for firms to continuously seek entrepreneurial opportunities Strategic flexibility and real options analysis – a useful tool for evaluating new ventures and maintaining strategic flexibility, which examines the real choices to pursue investments while containing perceived risks Corporate Governance Key Terms Corporate governance Set of mechanisms used to manage the relationships among stakeholders and to determine and control the strategic direction and performance of organizations 3 Corporate Governance – an increasingly important part of the strategic management process Discussion points: At its core, corporate governance is concerned with ensuring that strategic decisions are made effectively. Governance is a means corporations use to establish effective relationships between parties (such as the firm’s owners and its top-level managers) whose interests may be in conflict. Corporate governance reflects and enforces the company’s values. A primary objective of corporate governance is to ensure that the interests of top-level managers are aligned with the interests of the shareholders. Traditionally, shareholders are treated as the firm’s key stakeholders because they are the company’s legal owners. In a range of countries, but especially in the U.S. and the U.K., the fundamental goal of business organizations is to maximize shareholder value. The firm’s owners expect top-level managers and others influencing the corporation’s actions (for example, the board of directors) to make decisions that will result in the maximization of the company’s value and, hence, of the owners’ wealth. In many corporations, shareholders hold top-level managers accountable for their decisions and the results they generate. Corporate governance involves oversight in areas in which owners, managers, and members of boards of directors may have conflicts of interest. The primary goal is to ensure that the firm performs well and creates value for the shareholders. Corporate governance has received a great deal of attention in recent years. Corporate governance mechanisms occasionally fail to adequately monitor and control top-level managers’ decisions. Examples: Enron and the recent financial crisis Evidence suggests that a well-functioning corporate governance and control system can create a competitive advantage for a firm. This attention has resulted in changes in governance mechanisms in corporations throughout the world, especially with respect to efforts intended to improve the performance of boards of directors. These changes have generated some confusion about the proper role of the board – some boards are only seeking to comply with regulations, whereas others are making fundamental changes in the way they govern. It has been suggested that the board of directors is rapidly evolving into a major strategic force in U.S. business firms. Effective governance of corporations is also of interest to nations, which stand to gain a competitive advantage over rival countries. This chapter describes actions designed to implement strategies that focus on monitoring and controlling mechanisms, which can help to ensure that top-level managerial actions contribute to the firm’s ability to create value and earn above-average returns. Corporate governance reflects company standards, which in turn collectively reflect societal standards. In what areas do owners, managers, and members of boards of directors have potential conflicts of interest? In the election of directors In the general supervision of CEO pay In the more focused supervision of director pay In the design of the corporation’s overall structure In the establishment of the firm’s overall strategic direction Why is effective corporate governance of interest to nations? Every country wants the firms that operate within its borders to flourish and grow in such ways as to provide employment, wealth, and satisfaction, not only to improve standards of living materially but also to enhance social cohesion. These aspirations cannot be met unless those firms are competitive internationally in a sustained way, and it is this medium- and long-term perspective that makes good corporate governance so vital. Governance Mechanisms 4 Table 11.1: Governance Mechanisms – The majority of this chapter is used to explain various mechanisms owners use to govern managers and to ensure that they comply with their responsibility to maximize shareholder value. The modern corporation uses three internal governance mechanisms and a single external one in a well-functioning corporate governance and control system. Discussion points: The external market for corporate control is the set of potential owners seeking to acquire undervalued firms and earn above-average returns on their investments by replacing ineffective top-level management teams. Importantly, the mechanisms discussed in this chapter can positively influence the governance of the corporation, which has placed significant responsibility and authority in the hands of top-level managers. The most effective managers understand their accountability for the firm’s performance and respond positively to corporate governance mechanisms. The firm’s owners should not expect any single mechanism to remain effective over time. The use of several mechanisms allows owners to govern the corporation in ways that maximize value creation and increase the financial value of their firm. With multiple governance mechanisms operating simultaneously, however, it is also possible for some of the mechanisms to conflict. Separation of Ownership and Managerial Control OwnershipManagement Founder-Owners Family-Owned Firms ShareholdersProfessional Managers Modern Public Corporations 5 Separation of Ownership and Managerial Control – The relationship between owners and managers provides the foundation on which the corporation is built. Discussion points: Evolution from Founder-Owners Historically, founder-owners and their descendants managed U.S. firms. In these cases, corporate ownership and control resided in the same people. As firms grew larger, the managerial revolution led to a separation of ownership and control in most large corporations. These changes created the modern public corporation, which is based on the efficient separation of ownership and managerial control. Modern Corporations As firms grew in size, control of the firm shifted from entrepreneurs to professional managers while ownership became dispersed among thousands of unorganized stockholders who were removed from the day-to-day management of the firm. Supporting the separation of ownership and managerial control is a basic legal premise suggesting that the primary objective of a firm’s activities is to increase the corporation’s profit and thereby the financial gains of the owners (the shareholders). Shareholders’ ownership of stock entitles them to income (residual returns) from the firm’s operations after paying expenses. Shareholders’ rights, however, require that they also take a risk that the firm’s expenses may exceed its revenues. To manage and reduce overall investment risk, shareholders usually maintain a diversified portfolio, investing in several companies. By holding a diversified investment portfolio, poor performance or failure of any one firm has less overall effect. Thus, in addition to seeking maximum returns, shareholders specialize in managing their investment risk. As decision-making specialists, managers are agents of the firm’s owners and are expected to use their decision-making skills to operate the owners’ firm in ways that will maximize the return on the owners’ investment. Without owner (shareholder) specialization in bearing risk and management specialization in making decisions, a firm probably would be limited by the abilities of its owners to manage and make effective strategic decisions. The separation and specialization of ownership (risk bearing) and managerial control (decision making) should produce the highest returns for the firm’s owners. Family-Owned Firms In small firms, managers often are high-percentage owners, so there is less separation between ownership and managerial control. In fact, ownership and managerial control are not separated in a large number of family-owned firms. In the U.S., at least one-third of S&P’s top 500 firms have substantial family ownership, holding on average about 18% of the outstanding equity. In many countries outside the U.S., such as in Latin America, Asia, and some European countries, family-owned firms represent the dominant business organization form. Family-owned firms perform better when a member of the family is the CEO than when the CEO is an outsider. There are at least two critical issues for family-controlled firms as they grow. Owner-managers may not have access to all of the skills needed to effectively manage the growing firm and maximize its returns for the family. Thus, 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. In these cases, protection of the minority owners’ rights becomes important. To avoid these potential problems, as they grow and become more complex, the owner-managers may contract with managerial specialists. The separation between owners and managers creates an agency relationship. Agency Relationships Key Terms Agency relationship Relationship which exists when one or more people (principals) hire another person or people (agents) as decision-making specialists to perform a service Managerial opportunism Seeking self-interest with guile (i.e., cunning or deceit) 6 Agency Relationships – exist when one party delegates decision-making responsibility to a second party for compensation Discussion points: Material in this chapter focuses on the agency relationship between the firm’s owners (the principals) and top-level managers (the principals’ agents) because this relationship is related directly to how the firm’s strategies are implemented. The separation of ownership and control can result in divergent interests between the two parties and creates the potential for managerial opportunism. It is not possible for principals to know beforehand which agents will or will not act opportunistically. Reputations of top executives are an imperfect predictor. Opportunistic behavior is usually evident only after it has occurred. Thus, principals establish governance and control mechanisms to prevent agents from acting opportunistically, even though only a few are likely to do so. Interestingly, research suggests that when CEOs feel constrained by governance mechanisms, they are more likely to seek external advice that in turn helps them to make better strategic decisions. What are some examples of agency relationships? Shareholders and top executives Consultants and clients The insured and the insurer Managers and their employees within an organization Top executives and the firm’s owners An Agency Relationship 7 Figure 11.1: An Agency Relationship – In modern corporations, managers must understand links between agency relationships and firm effectiveness. The Agency Problem The agency problem occurs when the desires or goals of the principal and agent conflict and it is difficult or expensive for the principal to verify whether the agent has behaved inappropriately. The Agency Problem – Research evidence documents a variety of agency problems in the modern corporation. 8 Problems with Separate Ownership and Control Principal and the agent having different interests and goals Shareholders lacking direct control in large publicly traded corporations Agent making decisions which result in actions that conflict