What is the right governance structure for my SME?

BDO Partner Eddie Chung provides an introduction to governance for your SME.

Under modern governance principles, there is a difference between the governance of an organisation and the operations of the business of the organisation.

Governance generally refers to a number of governing functions in relation to an organisation, which are well articulated in ‘Tricker’s framework’ of corporate governance. Formulating and monitoring the strategic direction of the oragnisation is one of the important aspects of governance. Examples of discussions and consideration in relation to governance include questions such as — should we add a new business to the existing ones? Should we maximise the value of the business in the next three years with the view of selling it? Now that the industry in which we operate has been disrupted by technological newcomers on the market, what do we need to do in response to remain relevant and financially sustainable?

On the other hand, operations deal with the day-to-day running of the business to achieve the strategic direction of the organisation, which may involve discussions and consideration such as — should we change our existing supplier to one that provides a better bulk discount? Should we restructure the business to clarify the chain of command and authority in the organisation to enhance the accountability of everyone’s role? Should we introduce a new system to increase the efficiency of our existing business systems?

While some issues may be reasonably clear cut in terms of whether they are related to the governance or operations of the business, it is sometimes difficult to separate the two because they bear a strong correlation with each other. While governance sets the direction and operations implement that direction in simplistic terms, operations may encounter issues and developments at the ‘coal face’ that may demand the organisation to change its strategic direction; similarly, governance may require detailed operational data to assist with framing the organisation’s strategy.

In many ways, it is this tension between governance and operations, if handled in a constructive way, that provides a healthy balance to safeguard the viability of the organisation.

With the above in mind, what is the right governance structure for your business?

Governance models

There are many alternatives for governance structures, depending on who you are asking. For simplicity and ease of understanding, I tend to boil them down to the following three general models:

1. No separate governance structure;
2. An advisory board; and
3. A proper board.

The more complex is the business and the more owners are in the organisation, the closer the governance structure may lean towards a full board.

No separate governance structure

When a business is relatively simple and small, especially during its early stages, the governance and operational issues are likely to be fundamentally intertwined, so it may not be practical to have a separate governance structure to specifically address the governance issues of the business.

However, if there are multiple owners (and decision-makers) in the business, an informal ‘chair’ should perhaps be nominated by the group to keep any meetings on track simply because trying to reach any consensus between a larger of group people is often challenging.

The owners may also consult external subject-matter experts (eg, external accountant, lawyer, etc) for ad hoc advice to support their decision-making process.

As the complexity of the business increases, there may come a point when it may be worthwhile for the group to separate their meetings between governance meetings and operational meetings. This may help focus the group on strategic issues without getting too bogged down by the operational details but it is likely that some operational issues will still be discussed in governance meetings.

Advisory board

As the business continues to gain sophistication, it is likely that more energy and discipline will be required to focus the discussions in the governance meetings on governance issues without drifting too much into operational and ownership matters. At this point, having a chair with corporate governance experience and expertise may be helpful. Such a resource is usually not readily available in-house, which is why it may be time to consider setting up an advisory board.

An advisory board is different from a proper board in that it is not constituted by a group of directors appointed under the Corporations Act (or other statutes) as statutory officeholders. In other words, an advisory board is like a formal board except that the members are not necessarily directors. Rather, the members of an advisory board generally include some or all of the owners of the business and external experts who are there because of their specific skill-set.

While the advisory board is likely to focus discussions on strategic matters, it is more often than not that some operational issues will still be raised and discussed because the information provides context for the external members of the advisory board who are not involved in the day-to-day running of the business.

Decision-making in an advisory board is still somewhat skewed towards the internal decision-makers because they are usually owners of the business. While the external members may be called upon to express their views on various issues, they are ultimately resources who contribute their skills to assist the decision-makers without any formal decision-making power unless it is specifically delegated to them by the owners. If such decision-making power is bestowed upon the external members, they need to be comfortable that they are not seen as de facto directors under the law. Otherwise, they will be treated as if they are real directors.

Many small-to-medium enterprises and family businesses with limited owners often favour the advisory board model because it provides a structured forum for governance discussions without being subject to the onerous rules and regulations imposed by the law on proper boards. To that end, it is not uncommon for the external accountant of the business to be appointed as an advisory board member to bolster the financial governance capability of the group.

Proper board

When a business has reached a level of complexity such that energy and time need to be regularly devoted to strategic matters or the number of owners of the business makes it no longer practical for all the owners to sit around the boardroom table to make decisions, a formal board may be the appropriate governance structure for the business.

While a proper board is often preferred by medium-to-large enterprises and large family businesses, as well as not-for-profit organisations, it does present difficulties if the board members happen to also be managers and owners of the business because it may be difficult for these board members to discuss and make decisions in the boardroom in the best interest of the company, especially if those decisions may unfavourably affect them as manager or owners of the business. For instance, the board may decide that it is not in the best interest of the company to pay a dividend to the owners because it needs to retain funds for future expansion, which will obviously affect the financial position of the owners.

Despite this potential difficulty, the reality is that the directors of a proper board are subject to statutory duties and the contravention of those duties may cause the offending director to become personally liable to debts and penalties. Therefore, regardless of how difficult it is for the directors to wear the hats of board members, managers, and owners in different occasions, they need to be clear on which hat they are wearing in the boardroom and make decisions for the company accordingly. If they find themselves not being able to observe the demarcation, they should perhaps not accept the board position in the first place and delegate the governance function of the company to others.

There is much written on the protocols and technicalities associated with setting up and running a board but the gist of the above is that there may be a point when it is appropriate to move from an advisory board to a proper board, which is often signalled by milestones such as the admission of more owners or investors into the business, unprecedented growth in the size and scale of the business, acquisition of another significant business, etc. One of the main ingredients for success in transitioning to a proper board is to ensure that the appointment of the directors is based on a proper skill-gap analysis, which may mean that the members of the advisory board may not necessarily become directors of the proper board.

Last words

Owners of small businesses are often tempted to continue the status quo in terms of how their business is governed and operated. After all, they have been successful to date, so it is easy to be complacent and assume that growth will continue to come in the business’ current form. However, the existing governance structure, or lack thereof, may be the limiting factor that inhibits the business from growing to its next phase. In the end, if you don’t give your business the right tools to grow (in the form of an appropriate governance structure), you can hardly expect to unlock and maximise its potential.

Important disclaimer: No person should rely on the contents of this article without first obtaining advice from a qualified professional person. This article is provided on the terms and understanding that the author and BDO (QLD) Pty Ltd are not responsible for the results of any actions taken on the basis of information in this article, nor for any error in or omission from this article. The article is provided for general information only and the author and BDO (QLD) Pty Ltd are not engaged to render professional advice or services through this article. The information in this article is general in nature and does not take into account your personal circumstances, financial needs, or objectives. Before acting on any information, you should seek independent financial advice. The author and BDO (QLD) Pty Ltd expressly disclaim all and any liability and responsibility to any person in respect of anything, and of the consequences of anything, done or omitted to be done by any such person in reliance, whether wholly or partially, upon the whole or any part of the contents of this article.