Adam J. Epstein | May 2016 | SPECIAL REPORT: OPERATING AN EFFECTIVE BOARD
In the US financial markets, investor, media and regulatory focus is predominantly trained upon the largest public companies. But, the large-cap bias in the US, and other global markets, camouflages a capital markets truism: the overwhelming majority of publicly traded companies are comparatively small. For example, in the US nearly seven out of every 10 exchange listed companies have market capitalization less than $1bn. Moreover, approximately 47 percent of companies listed on the Nasdaq and NYSE exchanges have market capitalization below $300m.
While it’s easy to comprehend why the principal focus in the US capital markets is on large-cap companies (they are the largest companies, they are household names, and large-cap stocks are ubiquitous in retirement accounts), this short-sightedness comes at a steep price.
Until recently, the US corporate governance dialogue has been fixated on issues faced by directors of large-cap companies. This is a mistake for two reasons: (i) boards of directors of smaller public companies are regularly beset by unique governance challenges without relevant resources to help them; and (ii) small-cap companies are invaluable sources of innovation and job growth.
The predominantly large-cap focused US corporate governance community has tacitly concurred over time that governing a $75m company is the exact same task as governing a $75bn company, even if operating them is self-evidently quite different. Put differently, it’s long been assumed by those ensconced in the large-cap ecosystem that corporate governance is essentially one-size-fits-all. Make no mistake however: governing General Electric is actually nothing like overseeing, for example, a nascent medical device company.
What makes governing small-caps so different? Strong balance sheets and cash flow provide large-caps with, among other things, strategic alternatives, financial flexibility and material margins of operating error. But, the opposite is true for small-caps. That is, small-cap boards of directors frequently govern far riskier companies with frail balance sheets where even seemingly straightforward daily business decisions can have enterprise-ending consequences.
There are myriad reasons why a one-size-fits-all approach to corporate governance serves small-cap shareholders poorly – consider the following three.
It is common for large-cap boards to have more than a dozen directors, in addition to extensive, skilled governance staff. Small-cap companies, however, often can only afford a handful of non-executive directors and rarely have additional governance support. To put the resource disparity into even sharper relief, consider that there are large-cap companies that spend more on a single director than many small-cap companies spend on their entire governance infrastructures. Large-cap boards also often benefit materially from hiring expert third-party advisers to assist with, among other things, strategy optimization, compliance, training, and risk management, while small-cap boards often can’t afford any advisers and instead must simply rely on existing officers and directors. So, small-cap boards must not only oversee a daunting continuum of existential threats daily, but they must also do so with a fraction of the resources.
Management and board experience
Large-cap companies are often managed and governed by those with extensive public company experience. Conversely, it’s not uncommon for small-cap officers and directors to occupy their roles for the first time (otherwise successful careers notwithstanding). It’s un-rebuttable that a board of directors comprised of industry icons overseeing a transcendent CEO like Steve Jobs might as well be on a different planet compared to a board with predominantly novice directors governing a nascent company run by a first-time CEO.
Capital markets and corporate finance
Large-cap companies typically access capital markets selectively from positions of strength due to financial health. Alternatively, small-cap companies must regularly access capital markets to supplement cash flow that is insufficient to fund growth initiatives. Doing so at inopportune times and often without material capital markets experience in boardrooms, small-cap companies routinely undertake highly dilutive financings. Even worse, insufficient trading volume or encumbered capitalization can foreclose small-cap access to the capital markets altogether, resulting in insolvency.
So why do these observations matter? They matter a lot because risk is relative. A corporate action that might not require any board oversight at one company could well require extensive review at another. A cruise ship needn’t pay any attention to 10-foot seas, while those same conditions could swamp a fishing trawler. And, therein lies the problem.
Historically, a systemic large-cap bias has meant that generations of large-cap corporate governance experts have defined what constitute salient corporate governance issues. Said differently, governance axioms and best practices have always been handed down from large-caps to small-caps. That’s fine for large public companies, but that one-size-fits-all approach has proved destructive to generations of small-cap shareholders.
Small-cap directors need to be proactively involved in all kinds of issues that would never receive material oversight from large-cap directors, because existential threats lurk everywhere in small-cap companies. For example, the one-size-fits-all corporate governance playbook doesn’t exactly envision the technology company where a first-time CEO is in the midst of raising must-have growth capital when a short-biased, anonymous blog post on an investing website is published that causes the company’s stock to fall by 70 percent in one day. The one-size-fits-all playbook also doesn’t really speak to the nascent biotech company facing ‘bet the farm’ patent litigation without any officers or directors who have ever presided over litigation. For these small-cap boards of directors (and their shareholders), there are no resources to help them, inasmuch as the large-cap infused one-size-fits-all governance rubric doesn’t even recognize these examples as ‘governance issues’. And without relevant small-cap boardroom resources, shareholders suffer.
The overwhelming majority of public companies in the US are small, and the overwhelming majority of directors actually govern small public companies. Moreover, small-cap companies are irreplaceable sources of jobs and innovation. The large-cap ecosystem shouldn’t be relied upon to dictate what constitutes ‘governance issues’ for disparate sized companies. The lion’s share of public companies – small-caps – face resolutely unique governance issues. Ignoring the same and staying wed to a one-size-fits-all governance ethos hurts shareholders, and results in fewer jobs and less innovation.
If you’re a deckhand on a fishing trawler, would you really want the captain of a cruise ship determining what constitutes dangerous maritime conditions?