How to Form an Effective Board of Directors

By May 13, 2019Other

The board of directors (board) is the most powerful group in an organization. This group deals with a company’s greatest risks, makes the most consequential actions, and impacts every aspect of a company. However, the board of directors often has limited exposure to a company’s day-to-day activities, which causes their role to seem a little obscure. This article clarifies the role of the board of directors, the challenges the board faces and the keys to creating an effective board.

What Is a Board of Directors?

The board of directors is a group of individuals elected by the shareholders to represent them in corporate governance and strategic matters. In an organization’s early stages, most businesses are owned and managed by a single individual or small group of individuals. However, as those firms grow, the ownership is likely to be shared by a larger group of investors who are less connected to the daily operations of the company. These shareholders do not actively participate in the management of the firm and are known as absentee owners. Therefore, they elect a board to oversee and advise the management of the company and protect the interests of absentee shareholders. In fact, it is required by law that all public companies have a board of directors comprised mostly of independent directors.

Primary Roles of the Board of Directors

The board has three important functions:

  1. Advisory. The board advises management regarding the strategic and operational direction of the company. Typically, the management team proposes a corporate strategy to achieve the objectives set by the board. The board then reviews, modifies, and ultimately approves the final strategy that the company will pursue.
  2. Oversight. The board also monitors management‘s performance. This oversight function includes considering the key management performance measurements, overseeing risk management and making sure the company complies with all regulatory requirements, such as reviewing financial statements.
  3. Support. The board also helps promote the success of the executive team. This can involve providing mentorship to CEOs, helping with the development of the executive team, and supporting the CEO in the preparation of management succession plans.

The table below provided by McKinsey’s 2016 board survey summarizes the most important issues boards focus their attention and time on:

Dealing with these issues often requires significant thought and debate among the board members, sometimes requiring that they seek help from outside advisors such as bankers, lawyers, and accountants. Much of a board’s work is conducted by board committees, which will be explained in more detail below.

Structure of a Board of Directors

A board of directors is almost always comprised of the following:

  1. Chair of the board. The chairman is nominated by the nominations/governance committee of the board and elected by members of the board. The chair maintains communication with management, sets the board agenda (together with the CEO), and often represents the organization before large institutional investors (together with management).
  2. Non-independent directors. Most boards have one or more directors that are directly involved in the day-to-day operation of the company. This group almost always includes the Chief Executive Officer (CEO) and sometimes the chief financial officer, past CEOs or other company insiders.
  3. Independent directors. Independent directors are not and cannot be executive officers, employees, or major owners of the company. The main purpose of having independent directors is to help overcome the principal-agent1 problem and provide unbiased perspectives regarding issues presented to the board by management. Stock exchanges such as the New York Stock Exchange and Nasdaq require that the majority of the board of a public company be comprised of independent directors2. For private companies, having independent board members is still a beneficial best practice. Independent directors can also provide advisory services and help increase transparency within the organization. As a result, many private companies such as the Larry H Miller Group of Companies have a large number of independent directors on their boards.

Once your company goes public, the SEC requires your board to set up permanent, standing committees, including the audit committee, nomination/governance committee, and the compensation committee. Public companies can have other board committees if they choose but only these three are mandated. To qualify under the SEC’s rules, all three of these committees must be comprised of only independent directors. These committees allow the board to “divide and conquer,” concentrating board expertise on specific issues. The audit committee oversees financial reporting, financial disclosures, risk management, legal issues, and relationships with internal and external auditors. The nomination/governance committee has the duty of maintaining the corporate bylaws and policies. This committee also finds and recommends to new candidates for the board of directors and determines who serves on and chairs the various committees. The compensation committee is responsible for determining the compensation structure, including both cash and equity compensation, for executives and the directors of the company.

Forming the Board of Directors

For a new startup, the board of directors is often composed of the founders and business advisors. When the company starts to receive funding from venture investors, the venture capital firms will normally require seats on the board to monitor the business. After a company goes public, new directors will be recommended by the nomination/governance committee and approved by the full board, in a manner consistent with the company’s bylaws. At this point, the board of directors often consists of individuals who have previous experience running successful public companies3. At least every three years and almost always on an annual basis, the board members are approved by the company’s stockholders.

Key Challenges of Building a Board of Directors

Board Composition

Boards of directors often deal with various issues involving different subject matters such as finance, legal, I/T, business strategy and human resources management. As a result, a strong board should include directors with diverse skills, experience, personalities, and backgrounds. According to PwC, board diversity has been a “hot-button issue,” with an increasing emphasis on the diversity of age, gender, and race4. Young directors (Age 50 or younger) comprise only six percent of S&P 500 company board seats and less than 50 percent of S&P 500 companies have a young director. While older directors have decades of work and board experiences, younger directors can bring fresh perspectives to the table, especially in terms of technology, social media and finance5. In today’s rapidly changing business environment, having a young board member can provide the board with the flexibility to handle unexpected changes in the business.

To have the right board members, first, business owners should determine the desired attributes for the future board. Recall that diversity in all dimensions is important, including background, experience, skill, age, gender, race, and industry experience. Many founders start their board member search by leveraging their existing network. Others use a head-hunting firm such as Korn Ferry or Heidrick Struggles to assist them in finding good board members. Frequently entrepreneurs prefer prominent and established individuals on their boards because it allows them to take advantage of their connections and create trust for investors. However, having experienced and/or prominent individuals on a board does not guarantee the success of the board or the company. Let’s look at the example of Theranos. Its board was comprised of impressive individuals such as former Secretary of State Henry Kissinger and former CEO of Wells Fargo Dick Kovacevich. Nevertheless, these well-known board members were not well equipped to understand the intricacies of the biotech industry, which was a factor contributing to the downfall of the billion-dollar company. Instead of relying solely on candidates’ prominence, companies should focus on the skills, industry knowledge, and competence of potential board members. After compiling all relevant qualifications for potential board candidates, companies should create a board matrix6 like the one below to assess the board composition.

Board Dynamic

Unlike company executives, board members have limited exposure to the daily activities of the business. Companies overcome this information asymmetry through board meetings and regular communication where CEOs present key information to the board, including performance reviews, tentative strategic plans, financial results, possible acquisition targets, and other strategic company information. However, a formalized-only approach impedes the information flow for two reasons. First, the content is controlled by the CEO and other members of management. Second, lengthy presentations may focus more on providing information than in soliciting board member input and critical analysis. As a result, too much formality or management-driven agendas can prevent the board from receiving the necessary information to make the right decisions on key matters such as strategy and performance monitoring.

To tackle this problem, companies like Netflix have deployed the following practices:

  1. Deep access to management discussion. Directors should be invited to executives’ meetings as observers to gain more company insight. At Netflix, attending executive meetings helps the board better understand the issues the company is facing and the analytical process the executive team goes through to resolve those problems. This also creates a constant interaction between the board and executives, which enhances the board’s ability to advise and monitor management performance.
  2. Condensed board memo. Instead of lengthy board memos, executives should communicate with the board through short, condensed memos. At the same time, board memos should focus more on critical analysis rather than just providing information. At Netflix, the board memo is a 30-page digital document that is shared between the executive team and the board. It highlights the company performance, industry trends, and other strategic matters. It also includes links to the analysis and access to supporting data and information. Furthermore, this online memo allows the directors to make comments and ask questions, to which the executives can respond quickly. It increases the information transparency within the organization and helps directors be well-prepared. As a result, board meetings can focus more on discussion rather than the presentations, resulting in more efficiency and effectiveness.
  3. Creating trust. Trust within the organization is key to achieving transparency. Both the board and the executives should maintain an open-door policy. The board and the CEO should feel welcome to ask and address tough questions. Furthermore, the board and the executives should spend time together outside of formal meetings (The SEC requires a minimum of 4 board meetings annually but most effective boards spend 41 days per year on their roles7). These informal meetings are opportunities for the board and the executive team to develop stronger relationships. This creates trust within the organization which results in increasing information transparency between the board and the executive team.

Board Compensation

Board members are almost always compensated for serving on a board. For a new startup, determining a board’s compensation can be challenging. Various factors should be considered when determining the nature and amount of board compensation, including the role each director plays and the size of your company. During the start-up phase of a company, board compensation is usually primarily equity based with the highest compensated individuals being the chairperson of the board and committee chair. When the company enters the growth stage, directors are often compensated with both cash and equity compensation. It is also important to note that as the company receives new funding, the board’s share of equity may be diluted. To avoid dilution, the board may be granted additional equity in the form of restricted stocks or stock options, which often vest over two- to four-year periods. Once the company prepares to go public, directors and officers (D&O) insurance should also be obtained. A company’s industry is another factor that impacts the board’s compensation package. According to Lodestone ‘s 2017-2018 Private Company Board Compensation Survey, boards serving in technology and real estate receive the highest amount of compensation8 (Directors at Alphabet Inc. made more than $600,000 in 20189). To attract talented board members, companies should consider industry factors (such as competitors and industry averages) and work with compensation consultants to create a competitive compensation plan.

Summary Table

The table below summarizes the top challenges faced by boards and potential approaches to address those challenges:

Conclusion

The board of directors is one of the most important groups in a company and plays a critical role in the success of the business. By understanding important issues related to the board of directors such as the board composition, team dynamic, and compensation, you will be in a much better position to select the right board members and help the group run effectively.
 


 

 

Resources Consulted

 


 

Footnotes

  1. The principle-agent problem is a conflict of interest between a company’s management and the company’s stockholders. Shareholders often focus on long-term gain while management tends to focus on short-term gain.
  2. NYSE Company Guide- Section 802 a
  3. Forbes, “How to get on a board of directors” by Nancy Collamer, Sep 2017
  4. PWC, Board composition: Key trends and developments, Jul 2018.
  5. https://www.pwc.com/us/en/services/governance-insights-center/consider-the-value-of-younger-directors-on-your-board.html
  6. PWC, Board composition: Key trends and developments, Jul 2018.
  7. McKinsey, The CEO guide to boards, Sep 2016
  8. Forbes, “How Much Should I Pay My Directors In 2018?” by Bernie Tenenbaum, May 2018
  9. https://www.wsj.com/articles/pay-for-big-company-directors-tops-300-000-1530194401
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Author Tom Tran

Tom was born in a small farm in the outskirt of Hanoi, Vietnam. Tom’s life model is “Today I will do what others won't, so tomorrow I can accomplish what others can't.” Besides accounting, Tom loves singing and writing songs on his guitar.

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