By Alec Aaltonen
Corporate governance has traditionally been associated with large, predominately listed, companies. There is, however, a growing acknowledgment that corporate governance can play a crucial role to support the growth and sustainability of Small and Medium-sized Enterprises (SMEs). Indeed, a 2011 survey by Hawkamah and Dubai SME found that 75 per cent of SMEs in Dubai considered corporate governance to be either important or very important to their business. However, given that theories of corporate governance and best practices have evolved in the realm of large, listed companies, it is not readily apparent for SME owners what is the most meaningful governance framework for their companies. The statement “one size does not fit all” is particularly true for SMEs.
It is our view that corporate governance is a journey for SMEs, where the growth of the company must be matched with the growth of the governance practices. The most appropriate framework is one that reflects the vision and long-term strategy of the owner(s) and the company.
For example, a falafel stand, which is operated by an individual who is both the sole owner and sole employee, has very little need for a governance framework. Of course, even in this very basic setting, some governance-related regulations maybe imposed upon the business (company law, financial reporting standards, and other relevant legislation) depending on the jurisdiction. But from the internal perspective, there is very little need for corporate governance.
That is, until you bring another individual into the equation. In case this individual is an employee, then the governance framework will largely take the form of internal controls ensuring that falafels continue to be served according to your standards, that the employee will not be pocketing proceeds from the sales, and that any sign-off authorities are effective and aligned with business needs. And as the business grows, perhaps to a chain of restaurants, employing more and more people, the control environment needs to grow accordingly.
The situation becomes much more complex if you bring in an investor into the equation. How will she or he know that her or his investment is safe in your hands? Issues relating to information asymmetry, audit practices as well as management remuneration become prevalent. It is for these reasons that many investors insist on having board seats, which necessitates the establishment of a board. From the governance perspective, the role of the board needs to be very clear. There needs to be clarity on what types of decisions can be taken by managers, which by the board and which will need to have shareholder approval.
In this scenario, shareholder rights need be formalized. How should the profit be shared? What percentage of profit is to be distributed among the shareholders or will the dividends be retained and reinvested back into the company? The most important right for most investors is the right to participate in the profits of the company, but other rights are also important. These rights include, among others, the right to vote on the composition of board, approve expenditure beyond pre-defined limits, departing from the agreed business plan or capital changes, approve the annual report and financial statements, and the right to access information about the company and its activities. Through these rights, shareholders ensure that the managers or other shareholders of the company do not misappropriate their investment or treat the company’s assets as their private property.
Another important consideration to be taken into account is the issue of share transfer – what happens if a partner wishes to sell their share. Will there be any restrictions? Must the shares be offered to the remaining shareholders and if so, at what price?
The governance framework also needs to reflect the number and diversity of the investors. The higher the number of shareholders, the more complex the scenario becomes. The shareholders may have very different needs and investment horizons, and catering to those interests will have a significant impact on the company’s governance and reporting practices.
But let us assume that our falafel stand owner decides against outside financing, opting for organic growth instead. If this is a “life style” business for the owner, then there may be very little incentive to take governance further in the company (although many entrepreneurs may find the establishment of an “advisory board” useful to support the growth of the business). However, if the desire is to keep the business growing without the owner’s active involvement, then clearly a governance framework needs to be established to institutionalize the company. The key issue here is succession.
Succession planning can be divided into two main sub-categories: ownership succession and management succession. These concepts are essentially inter-linked and it is crucial that they build on and support each other. Succession planning should be aligned with the company’s business objectives and potential exit strategies of SME owners.
If the falafel business owner’s intention is to pass the business on to a subsequent generation of family members, the governance framework should be focused on family governance first (see article pages). If a trade sale to a strategic acquirer or a competitor is the preferred exit plan, then the SME needs to understand how to make the business more attractive to such parties, and this usually entails that the company has a strong middle management meaning that the company can function with the previous owner-manager. Private equity may also be an option. If the company wishes to opt for an initial public offering, it needs to prepare for the relevant listing requirements well in advance, which involves adhering to financial reporting and corporate governance standards determined by the listing authority.
In other words, the answer to the question “what is governance for an SME” is very short: it depends. It is not a science and there is no one single framework. Instead SME owners need to have a clear vision, identify the key stakeholders, current and future, involved and build an effective governance framework to support this vision.
There are, however, well-developed key principles and building blocks for SMEs to use when constructing their governance frameworks. For example, the Corporate Governance Code for SMEs (see below), developed by Hawkamah and issued by Dubai SME, offers business owners a basic check list of items they should consider in their governance journeys. The key issue is to understand the rationale behind each principle and apply them to needs of each individual SME.
NINE PILLARS – CORPORATE GOVERNANCE CODE FOR SMALL AND MEDIUM SIZED ENTERPRISES
Pillar 1: Adopt a formal corporate governance framework outlining the roles of the key bodies such as partners, shareholders, board of directors and management
Step 1: Partners’ and shareholders’ rights and obligations should be clearly set out
Step 2: Delegation of authority should be formalized in writing defining the role of the management and specifying matters reserved for shareholders and the board of directors
Pillar 2: Conduct a succession planning process
Step 1: Succession planning is a long-term process, and it should be aligned with the company’s business objectives, growth and potential exit strategies of SME owners.
Step 2: Companies should have a rigorous succession planning methodology in place providing for both planned and emergency scenarios.
Pillar 3: Establish a timely, open and transparent flow of information with shareholders
Step 1: All shareholders should be treated equitably and companies should establish clear lines of communication with their shareholders
Step 2: An effective engagement mechanism to gauge the views of shareholders should be established
Pillar 4: Endeavor to set up a formal Board of Directors to accompany the growth of the company
Step 1: Smaller companies may wish to set up an “advisory” board with no formal decision making powers but which offers its expertise and networks to guide and support the business
Step 2: A formal board of directors should be established with formal procedures
Step 3: Companies should consider appointing independent board members
Step 4: New directors should undergo a tailored induction program
Pillar 5: Develop a clear mandate for its Board of Directors to oversee the operational performance of the business as well as evaluating and improving business strategies
Step 1: The role of the board should be defined in clear terms. It should be ensured that it has the resources and receives the information it needs to fulfill that role.
Step 2: A professional board with independent non-executive directors, meeting on a regular basis, should be responsible for monitoring and evaluating management’s performance
Step 3: Boards should undergo regular performance evaluation process and regularly review the composition of the board
Step 4: Large companies should consider separating the roles of the chairman and the chief executive
Pillar 6: Maintain credible books of accounts, which are annually audited by an external auditor
Step 1: Companies should follow credible accounting practices from day one and utilize a reputable independent accounting firm to prepare a complete set of financial statements including a statement of financial position, comprehensive income, cash flows and changes in equity statement
Step 2: Companies should formally evaluate the effectiveness of the external audit and formulate policies on preserving the independence of the audit function
Pillar 7: Set up an internal control framework in place and conduct a regular review of risk
Step 1: Companies should establish a formal process for identifying significant business risks and the management should adopt formal control mechanisms
Step 2: More developed companies should set up a specialized board-level committee to monitor the overall control environment of the company.
Step 3: Companies should consider establishing an internal audit function
Pillar 8: Recognize the needs of stakeholders
Step 1: Policies should be formulated governing the company’s relationship with its stakeholders
Step 2: Targets relating to the management of stakeholder relations
Pillar 9: Formulate a framework setting out the family’s relationship with the business
Step 1: A family constitution should be formulated setting out the family’s vision and policies regulating the family’s relationship with the company
Step 2: A family governance institution with written procedures should be established to facilitate effective communication and coordination between family members and the company