Introduction
In business school, I had the pleasure of taking Corporate Governance instructed by probably my favorite professor at Johns Hopkins. Sound corporate governance is absolutely essential for the value of the firm and for protecting investors. The concept can be defined as the system of rules, practices and processes by which a firm is directed and controlled. More specifically, it refers to balancing the interests of a company’s many stakeholders which includes shareholders, management, customers, suppliers, financiers, government and the community. Corporate governance refers to the framework for attaining a company’s objectives and integrates with multiple levels of management pertaining to action plans, internal controls, performance measurement, and corporate disclosure.
In business school, we were taught that the term broadly refers to two different methods of control:
- Direct management control by corporate over other organizational units
- Indirect ownership control by shareholders and other stakeholders via intermediary boards over corporate.
The board’s include a formal board of directors and an optional informal advisory board. Primarily, it is important to focus on three entities: corporate, shareholders (and other stakeholders), and the board of directors (advisory board optional). These entities should interrelate to create long-term enterprise value. After all, the main purpose of a corporation is to provide value to shareholders. Period.
Now, why is all of this important when it comes to building wealth? Well, one of the essential components in building wealth is investing. I am willing to bet that a lot of individuals out there do not truly understand what exactly they are purchasing when they buy securities and the parameters of that holding. When a share of stock is purchased, at that point in time, you become a shareholder. The corporation of which the share of stock was purchased is now responsible for returning value to you as an owner. Therefore, it is important to understand the basic relationship triangle of the corporation, board of directors, and the shareholders.
The Corporation
A corporation is a legal entity that is separate and distinct from its owners. Corporations are used throughout the entire world to operate in various forms of business. Now, ”corporate”, as an organizational unit, is responsible for holding the company executive team who formulate the business plan strategy, including the business success criteria for performance measurement; and for overseeing the company business plan’s execution, reporting, and updating, and any transformations needed to maximize the company’s overall value and the return-on-investment to its shareholders and other external stakeholders.
Corporate exists as the overarching organizational unit within the enterprise under which executive management (agents) including the officers and executives (CEO, CFO, COO) operate. Executive management are known as “agents” because they work for the “owners”…aka the shareholders. These agents manage the day-to-day operations and other employees in order to execute the business strategy of the corporation.
Board of Directors
A board of directors is a group of individuals elected to represent shareholders. It is the responsibility of the board to establish policies for corporate management and oversight and make decisions on major company issues. Essentially, they are in place to advise the corporation and serve in the best interests of the shareholders. The board of directors is a formal entity with legal status, and typically consists of a chairman of the board, vice chairman, and other members elected by the shareholders. Board members are often called “directors” because they “direct” the CEO. By law, a US corporation must possess a formal board of directors, and an informal advisory board is optional.
The board of directors focuses on helping and monitoring the CEO with strategic guidance, often through committees such as nominations, compensation, risk management, audit, and mergers and acquisitions. In addition, the board is constructed of a diverse mix of members, usually with many years of experience and specializations in different areas. There are different types of board structures and board involvement (pertaining to the level of interaction with CEO); each are very important regarding the effectiveness of the board.
Shareholders
A shareholder, commonly referred to as a stockholder, is any person, company, or institution that owns at least one share of a company’s stock. Due to the fact that shareholders are the owners or “principals” of the company, they receive the proceeds pertaining to a corporation’s success as a result of the execution of the organization; predominantly in the form of increased stock value. Of course, shareholders can also lose money as a result of decreased stock value.
Essentially, shareholders exert ownership control indirectly over corporate via the representation of the board of directors (and optional advisory board). Shareholders are often called “investors” because they provide capital with the expectation of a reasonable return on investment. Corporate governance directly protects the interests and rights of the shareholders. Keep in mind, things can get tricky here because shareholders typically include some if not all CXOs (CEO, CFO, COO and etc). So, it makes sense that “agents” (CXOs) are compensated heavily with equity because the direct result of their performance is represented within the stock (equity) value.
Now that you have a broad overview of the corporation, board of directors, and shareholders, let’s look at how they relate to each other.
The Relationship Triangle
Please see below for the relationship triangle in both directions. The direction arrow is represented and defined numerically below each representation.
Corporate (enterprise) –> (1) Board of Directors (advisory board if established) –> (2) Shareholders (other stakeholders) –> (3) Corporate (enterprise)
(1): Corporate Performance Accountability – Corporate reports to the board of directors.
(2): Board of Directors Performance Accountability – The board of directors reports to the shareholders.
(3): Investments (capital) – The shareholders provide capital to the corporation via stock purchase (the shareholders are only accountable to themselves).
Corporate (enterprise) –> (1) Shareholders (other stakeholders) –> (2) Board of Directors (advisory board if established) –> (3) Corporate (enterprise)
(1): Return on Investments & Disclosures – Corporate provides return on investments in the form of increased stock valuation and also provides information and disclosure to the shareholders.
(2): Monitors Remotely & Elects/Dismisses Board Members – The shareholders monitor the board of directors remotely and has the authority to elect and dismiss board members.
(3): Directs (Strategic CEO Guidance) & Appoints/Fires CEO – The board of directors provides strong direction to the CEO and has the authority to hire and fire the CEO (the board must act in the best interests of the shareholders).
Conclusion
This relationship triangle is perhaps the single greatest take away I acquired from the class of Corporate Governance. As illustrated above, the corporation, board of directors, and shareholders are all interrelated. Each of which is bound to another. This relationship understanding is extremely important for investors looking to make security purchases from different corporations.
Now that the relationship triangle is understood, hopefully as investors, you have a better understanding of the reporting structure pertaining to your capital that you invest. It is absolutely critical that the corporation you invest into possesses sound corporate governance structure. Corporate governance possesses a tremendous amount of variables in relation to corporate structure and return on investment for shareholders…so it is very important to do your homework.
Overall, becoming an investor is crucial when it comes to building wealth. However, I strongly urge you to be fully prepared before venturing into purchasing securities of corporations (please see my post here pertaining to whether or not you are ready).
In addition, it is important to be able to track the performance of investment holdings once they are purchased. This is made much easier through the use of personal finance software programs such as Personal Capital. Please click here to acquire Personal Capital for free!
As investors, you now understand the relationship triangle pertaining to your capital when invested to purchase securities of corporations. Do not just buy stock and think you are set. Truly understand the parameters of the investment.
Redefine.
-James