Corporate governance and founder-led small caps: 'Balancing investor expectations with entrepreneurial growth'

Founder-led companies have a strong track record of delivering superior returns for investors as compared to professional manager-led counterparts, with a 2016 analysis by Bain and Company highlighting that an index of S&P 500 companies that have founder involvement performed almost three times better than other companies over 15 years (Zook, C 2016, Founder-Led Companies Outperform the Rest — Here’s Why, Harvard Business Review). Domestically, there are some notable founder-led examples at the smaller end of market that have a track record of strong performance, including Technology One, Pro Medicus, Nick Scali, Netwealth Group, and ARB Corporation. This outperformance needs to be balanced with several risks that have the potential to adversely affect shareholder value.

Back testing by the Maple-Brown Abbott Australian small caps team has shown that corporate governance is the most significant driver of ESG outperformance at the smaller end of the market. As such, the potential for enhanced returns from founder-led companies must be balanced with corporate governance principles that shouldn’t be applied prescriptively and instead, with the unique features being considered.

This article outlines the key governance principles investors should consider when investing in founder-led businesses. Additionally, it addresses both the positive and negative indicators of corporate governance at founder-led businesses as well as the key areas where investors should consider greater flexibility in governance practices to preserve the advantages that exist at companies led by its founders.

Outperformance of founder led companies

The outperformance of founder-led companies can be attributed to several factors, notably the founders’ significant holding in the business which serves the benefit of providing strong alignment between company management and shareholders. A key example of this alignment in our portfolio is seen with our holding in Nick Scali, a furniture retailer led by Anthony Scali, the son of the founder, who owns almost 8% of the company’s issued capital. Given the significant stake in the company, the founders financial success is inherently tied to the performance of the company and creates a strong incentive to drive strategies that deliver long-term value for shareholders.

The significant shareholding is typically coupled with long tenure of founders which is another key performance driver. Founders are long-term minded with long tenures relative to the average tenure of an S&P/ASX 100 CEO of just over six years (UBS analysis) which allows a strategic vision that prioritises long-term value creation over short-term incentives. Furthermore, founders have deep company and industry experience which they can pair with their historical business experience and understanding of the company purpose which is invaluable when setting the strategic direction of the company, as is the case with Nick Scali. Anthony Scali has been with the company for 41 years and is credited for building the business to scale with his hands on approach to the business’s day-to-day operations. This focus on detail and the overall end to end customer experience is typically shared by founders who have successfully scaled the business is yet another advantage of investing in founder-led companies.

Whilst this deep company and industry experience is valuable, it must be balanced with the significant risks posed by the reliance on a key individual’s vision as the main value creation driver. Such risks include reputation risk, risk of conflicts of interest and the risk of the founder’s other interests impacting the business negatively. Hence high standards of corporate governance are particularly critical for founder-led businesses. Recent examples of corporate governance failures highlight the financial impacts when strong corporate governance principles are not implemented and/or upheld. In the case of Mineral Resources (not held), the founder/CEO was alleged to have engaged in several activities that are indicative of poor corporate governance, including related party transactions between the company, the founder and his family members as well as the founder using company resources for his own personal benefit.

Corporate governance: positive and negative signs

There are several signs that investors can look to as indicators of good corporate governance and a number of red flags that can suggest signs of poor corporate governance. The composition of the board is vital at founder led companies as the board is responsible for oversight of the CEO. Some of the characteristics that showcase good corporate governance are a board that is made up of majority independent directors with all board committees comprising of independent directors. A diversity in the directors’ background, experience and skillset is also a valuable attribute and could foster discussions where different perspectives are considered and debated (Reynolds, A & Lewis, D 2017, Teams Solve Problems Faster When They’re More Cognitively Diverse, Harvard Business Review). A board that has also highlighted a focus on succession planning is a positive attribute for companies that rely on its founders strategic vision and gives shareholders comfort on the company's future direction.

Another way in which shareholders and founders can be aligned is through the disciplined use of incentive programs. In our portfolio GQG Partners exemplifies this practice. The company’s co-founders Rajiv Jain (CIO) and Tim Carver (CEO) are not eligible to participate in the annual variable award program and only receive a fixed salary which is unusual for listed companies in Australia where the expectation is a short term (1 year) incentive plan combined with a long term (3 years and above) incentive plan.

Whilst this arrangement may seem at odds with accepted standards of corporate governance, given the co-founders substantial holding in the business their financial benefit is tied to value creation for shareholders and thus flexibility is applied in how we assess the company’s remuneration practices. This practice is unlike professionally managed companies where incentive programs make up a large portion of managements remuneration and large cash bonuses are widespread which may lead to the prioritisation of short-term growth over sustainable long-term growth.

On the other side a number of poor corporate governance practices that have come to light in recent company failings include large related party transactions, a CEO who has multiple personal distractions such as business interests outside of the company, a board that does not exercise its power to hold the CEO accountable and companies that grow into larger businesses but do not enhance their corporate governance practices and/or principles to reflect its increased size and increased shareholder expectations.  

A nuanced approach to corporate governance

whilst these corporate governance principles are important to monitor it is also critical that investors of founder led businesses at the smaller end of the Australian equity market apply a nuanced approach to the assessment of company corporate governance. There must be a balance between effective oversight of the founder CEOs actions and the freedom for the founder to grow the business.

For example, we believe that it is best practice for director tenure to not exceed 12 years to maintain director independence, however there are cases at founder-led companies where exceptions should be considered. At Pro Medicus, a radiology technology business, one of the company’s founders has been on the board for 41 years. Whilst conventional corporate governance principles would view this as a negative, we believe that the founder is best placed to shepherd the business forward and his interests are aligned with those of shareholders given his large shareholding of 24% of the company’s issued shares. Further, the founders holistic view of the company will support the board in making decisions. However, this is not without trade-offs, namely the potential reduction in new ways of thinking and ideas. This can be balanced by examining the independence, diversity and skills of the remaining board members. In the case of Pro Medicus, the board is majority independent and has close to 30% female representation. Furthermore, all committee chairs are independent allowing for independent thought.

Director independence and diversity of the board is an area in which we regularly engage with companies. Another important consideration is that founder-led companies may have directors who are long standing and have been with the company since inception with a depth of knowledge, thus any board renewal may take some time as the company has to find the appropriate replacement with the required skills. Thus, our engagements with these companies focus on long term succession planning and finding suitable high quality candidates with the aim of over time improving board independence and diversity.

Another category of company CEOs in small caps are the ones who act like founders. These executives with long tenure in the business and substantial shareholdings often have similar characteristics to founders and thus also require high standards of corporate governance. An example from our portfolio is Light & Wonder, a company that designs, manufactures and distributes gaming products and services. Whilst the company's board doesn’t meet our criteria for diversity, we voted in favour of the re-election of a number of directors who we viewed as being critical for the business, whilst voting against other directors to encourage diversity. Applying a nuanced approach to our voting activities we believe balances the need for the positive effects of diversity as a key feature of good corporate governance with the appropriate talent and skills the company needs to grow.

Conclusion

To truly benefit from the range of positive outcomes of investing in founder-led companies including the founder’s alignment with shareholders and deep expertise, shareholders must remain vigilant in overseeing corporate governance. Maintaining flexibility whilst encouraging high standards of corporate governance is crucial. Applying a holistic view to board structure and compensation allows founder-led businesses to thrive whilst also balancing the associated risk and oversight. As is the case with all our investments engagement with companies we hold over time has been key to both understanding the unique dynamics of founder led companies but also encouraging better corporate governance practices.