Corporate Governance for Small Cap Issuers

corporate governance

Often more associated with larger firms, corporate governance is just as important for small and microcap companies. By adhering to high governance standards, small caps are better placed to achieve their goals and attract new investment.

The legal fiduciary responsibilities of a director of a small cap public company and a director of a large or mega cap company are the same. A company’s corporate governance framework should support board members’ ability to effectively carry out those duties.

The Principles of Corporate Governance

Corporate governance is carried out in accordance with the company’s Corporate Governance Code and is based on the following principles:

Accountability. The Code provides for accountability of the Company’s Board of Directors to all shareholders in accordance with applicable law and provides guidance to the Board of Directors in making decisions and monitoring the activities of the executive bodies.

Fairness. The Company undertakes to protect shareholders’ rights and ensure equal treatment of shareholders. The Board of Directors shall give all shareholders the opportunity to obtain effective redress for violations of their rights.

Transparency. The Company shall provide timely, accurate disclosure of information about all material facts relating to its activities, including its financial situation, social and environmental indicators, performance, ownership structure and governance of the Company, as well as free access to such information for all stakeholders.

Responsibility. The Company recognizes the rights of all interested parties permitted by applicable law and seeks to cooperate with such persons or companies for their own development and financial stability.

Corporate governance is not one-size-fits-all, and to be truly effective, a board may need to evolve as the company matures and its needs change. Governance should be considered more than a matter of compliance. If directors and officers of small cap companies fail to properly prioritize governance, they are putting themselves and their companies at risk. With an estimated 72% of publicly listed companies sitting under $5 billion market cap, small-cap companies should consider implementing robust governance structures to mitigate risk and support long-term strategic growth.

Small Cap Company Risks & Challenges

Unlike larger public companies, most pre initial public offering (IPO) and small cap companies are more concerned on a daily basis with surviving, not thriving. If you are a director of one of the thousands of smaller public companies or soon-to-be public companies that lack robust cash flow and healthy balance sheets, you must navigate a challenging path sometimes even maintain solvency. Other challenges may include:

  • Pressure to grow and evolve
  • Access to capital and sufficiency of liquidity
  • Quickly determined success or irrecoverable failure
  • Ability to recruit highly qualified directors and build a well-balance board
  • Additional regulatory, reporting, and administrative responsibilities for directors associated with public company status
  • More inherent focus on short-term growth and profitability instead of long-term strategy
  • Likelihood of challenges from activist investors or skepticism from institutional investors

Corporate Governance for Small Cap Companies

Given the challenges mentioned above, good corporate governance is a strategic differentiator, particularly for small cap companies. This is not merely an ideal for an emerging growth company to strive for as it develops and matures, but one of the most important aspects of its long-term viability. Best practices entail navigating and making decisions about corporate finance, capital markets, and the selection and reliance on service providers. They also include negotiating with investors, communicating with shareholders, responding to critics and short-sellers, and navigating the gauntlet of investment bankers, investor relations firms, legal advisors and news media that hover around high-growth companies.

Additionally, the role of the board of directors becomes more prominent and may evolve as the company grows. The importance of good governance increases linearly with the size of the business and the number of shareholders. Priorities or needs can also be industry dependent. For example, in an industry that’s consolidating at a rapid pace, you’re going to want someone on the board who has M&A advisory expertise. If you’re making an acquisition a year, you want someone on the board with a very strong financial background to work closely with the CFO. If the need for additional financing arises, the board may require someone who has some expertise on how to access different levels of capital.

How Small Cap Companies Can Build a Strong Governance Framework

Small cap companies that commit to building good governance from the start, instead of bolting it on piecemeal, may avoid major missteps and more effectively achieve significant growth in the short- and long-term. To begin developing a resilient and effective governance framework, small cap boards should start by asking and answering the following questions.

Do we have the right board structure? Board structure can either support or limit a board’s ability to function optimally and understanding the right structure for the company is a step towards effective governance.

Do we have the right composition and dynamics for now and the future? As small cap companies evolve, so too must their boards. The risks, challenges and opportunities a company must consider as it matures are likely to be significantly different than those it faced earlier in its life.

Do we have the right CEO? Have we set clear expectations for the CEO’s performance and development? Selecting the CEO is one of the most important decisions any board makes. While the founder of a start-up often serves as its CEO, evaluation and oversight of the CEO’s performance remain the board’s responsibility.

Do we have a clear understanding of the board’s role in strategy? As views on governance have evolved to the point where boards are now recognized as a strategic asset, perspectives on the board’s role in strategy have evolved as well.

It’s imperative that governance is set up to support the company’s evolution and growth.

Ideally, the market should reward good governance as well. There’s a lot of widely accepted evidence that good corporate governance pays off. If you’re still skeptical, consider these points.

  • Back in 2001, Harvard and the University of Pennsylvania did a study on 1,500 U.S.-based companies. They came up with a strategy in which you bought companies with strong shareholder rights protections and sold short companies with weak protections. Such a strategy yielded additional returns of 8.5 percentage points per year over the market’s average return.
  • More recently, to determine the reasons for the improved performance of more democratic companies, Institutional Shareholder Services and Georgia State University produced a joint study aimed at dissecting the findings of said Harvard publication. That study found that the best-governed companies achieved higher average returns on equity by 23.8%.
  • The CFA Institute, which traces its existence back to Benjamin Graham’s words when he proposed a rating system for financial analysts, believes that the evidence adamantly supports the direct link between good corporate governance practices and higher valuations for businesses.

In conclusion successful corporate governance can be achieved by adopting a set of principles that depends upon honesty, generosity, justice and the manner in which companies conduct their affairs. Good governance obviously doesn’t guarantee success, and success doesn’t guarantee good governance. CEOs, especially of small cap companies, need to realize that better corporate governance is not just benefiting them, but ALL stakeholders as well.