By Warren D. Miller, CPA-ABV, CMA, Beckmill Research, Lexington, Va

In Pawns or Potentates: The Reality of America’s Corporate Boards, author Jay Lorsch quotes two directors of large NYSE companies:

“Directors today don’t want colleagues like the old ones who rubber-stamped management’s decisions. You don’t want to share responsibilities—or liabilities—with people who don’t pull their own weight or do their Homework.”

“Directors are more forward nowadays. There’s no more of the good-old-boy club meeting atmosphere, because of the directors’ responsibility and liability. They don’t assume something is correct simply because the CEO said it. They want proof he’s right.¹”

It’s unfortunate that not until they had personal liability did most directors do what they should have been doing all along: looking out for the best long-term interests of the shareholders and, by extension, the company itself. Maybe this was one of those rare times when the tort bar got one right.

Of course, large publicly held companies can afford the “D&O” (directors’ and officers’) insurance premiums, but what about the closely-held business without the resources of a big company? Does it need an active board? How big should a company be before it seats some outsider directors? How does it choose such persons? What are some of the benefits and the drawbacks of having independent outsiders?

Overseeing Owners

In most large companies, the CEO seldom owns a controlling interest. That is a major difference between public companies and family businesses: In a smaller business, directors, who are traditionally viewed as representing the shareholders, may be overseeing him!

So what if the sole shareholder wants to do something dumb? What if she wants to put her drunken son-in-law on the payroll in an executive slot? Isn’t that her right?

It depends on one’s perspective. After surveying over 1,100 directors of the S&P 400, Lorsch classified board members into three groups.² The first, which he calls “traditionalists,” take the narrow view that their job is to do what’s best for the shareholders. No more, no less. The second group, so-called “rationalizers,” recognize that there might be more to it than that, but they figure that if they do right by shareholders, the rest will somehow take care of itself.

Lorsch labels the third contingent “broad constructionists.” This phrase describes directors who take a broader view of their responsibilities, who believe they should take the long view of the company and its business, its employees, its customers, its suppliers, and the communities where it does business, even if such a view conflicts with the desires of the CEO/chairman who appointed them. (In the family business, of course, such directors can be summarily dispatched, no matter the merits of their views.)

The presence of two overriding issues make outside directors desirable in the smaller business, in our view: growth and succession. Rapid growth has impoverished many times more companies than it has enriched. Directors who have weathered that elsewhere can make a big difference.

And succession can be a monumental hurdle, especially when the person in charge is an aging founder long past his or her prime. Sometimes it takes someone the owner plays golf with to look him in the eye and say, “You know, Bruce, it’s time we made some plans to turn this thing over to someone younger.”

Size vs. Growth, Management Skill, and Industry Volatility

The traditional view is that any company with fifty or more employees will benefit from having an outside board. We believe that there’s more to it than that.

In our view, the question of outside directors depends more on growth, internal management skill, and industry volatility than on a company’s size. A fast-growing $1 million business whose owner refuses to delegate anything probably will benefit more from outside directors than a slow-growing $10 million concern with dispersed management responsibilities. The obvious challenge is for the non-delegating owner to recognize she needs help, or to hear that message from someone close to her.

An industry’s rate of change is also an important variable. This is a crucial question, as we have seen in several situations in recent years, where the controlling shareholder was aging, out of touch, and in denial about both. As GE’s Jack Welch said, “When the rate of change outside a company exceeds the rate of change inside it, the end is near.”

The Liability Issue

Many smaller companies that could benefit from having outside directors may protest that they cannot afford the insurance that would-be directors demand to protect them from personal liability. However, empirical data suggest that the liability issue may be greatly exaggerated. A survey by a prominent risk-management company found that companies with under $50 million in assets and fewer than 500 shareholders had about a 1 percent probability of being sued under a D&O claim.

Still, 1 percent is a real number. What can a small company do to entice outside directors? For one thing, in its bylaws or through letter agreements with individual directors, it can indemnify them from personal liability and legal expenses. It can also provide D&O insurance—if it can afford the $15,000-25,000 annual premium. The good news about this expense is that it should decline significantly after the first couple of years—if there is no litigation targeting directors as defendants. One of our clients reported a 50 percent decrease after two years.

A good solution is to form a “council of advisers” or “advisory panel.” Be careful to avoid the word “board” (as in “advisory board”). Using this term creates ambiguity which could result in attempts to impose liability later.

To realize the full legal protection this mechanism offers, there should be no overlap between board membership and council/ panel membership, except for the CEO/owner. The regular board of directors should continue to meet and discharge its legal obligations. All documents emanating from and relating to the council/panel should routinely stipulate that “its nature and function are purely advisory” and that “the company’s legally constituted board of directors remains the proper entity for considering and implementing policy.”

As always, there is no substitute for consistent and thorough documentation. Minutes of council/panel meetings should be kept, right along with those of the legally-constituted board of directors. In addition to noting which recommendations of the council/panel go before the board, documentation should clearly identify those which do not go there. This will further substantiate the council/panel’s separation from the board.

In the concluding installment on this topic, we will discuss how to identify the knowledge and experience needed in this cadre of outside advisors. We will also talk about recruiting, preparing a written profile of the company, compensation issues, meeting frequency, the benefits and drawbacks of such advisors, and other matters concerning corporate governance in the closely-held business.

¹ Pawns or Potentates: The Reality of America’s Corporate Boards by Jay W. Lorsch with Elizabeth Maciver (Boston: Harvard Business School Press, 1989), p. 5.

²Lorsch op. cit., pp. 39-49.