The basic precepts of good governance are fundamental to all organisations – having a board charter, well defined roles and responsibilities for board members, appropriate financial knowledge, accountability and transparency to members, shareholders and stakeholders.

A survey of the regulation of corporate governance in SMEs highlights a number of policy conclusions (see Clarke T & Klettner A, ‘Governance Issues of SMEs’, in Journal of Business Systems, Governance and Ethics (2010)):

  • The need for corporate governance guidelines to include flexibility, particularly for companies early in their life cycle;
  • The need to reinforce the robustness of the ‘if not why not’ approach and educate the market that disclosure, not uniformity, is important;
  • The fact that corporate governance demands upon companies develop as they increase in scale and complexity with more diffuse shareholders;
  • The fact that companies may carry with them problems of inadequate corporate governance and dysfunctional boards if these are not resolved early in the company life cycle;
  • The existence of a critical period in corporate governance when private companies become listed entities with wider accountability and a corresponding need for a more independent board;
  • The importance of legal and regulatory guidance and director education for companies preparing to list.

What is the nature of private companies?

A private company is a company that is registered as, or converts to, a proprietary company under the Corporations Act 2001. Directors of proprietary companies have legal duties and responsibilities under the Corporations Act 2001. Under that Act, a proprietary company must:

  • be limited by shares or be an unlimited company with a share capital;
  • have no more than 50 non-employee shareholders;
  • not do anything that would require disclosure to investors under Chapter 6D of the Act; and
  • have at least one director who must ordinarily reside in Australia.

Directors of a private company should be aware of se 111J of the Corporations Act 2001. That section, entitled 'Small business guide', summarises the main rules in the Corporations Act 2001 that apply to proprietary companies limited by shares.

The main difference between private companies and larger public companies is the lack of distinction between owners and managers. In private companies, they tend to be the same people because of the small size and lack of complexity of operations. They often have a quite informal approach to governance.

Reporting and disclosure requirements for private companies are lower than those for listed companies but there is still a considerable regulatory burden surrounding the daily operations of a small business.

Companies operating in certain industries (e.g. the part of the financial services sector regulated by the Australian Prudential Regulation Authority) are required by law to have boards.

The needs of a company will change as it moves into new stages of development. A start-up company’s needs are quite different to a mature company’s needs. As a company grows, a stricter governance framework will be required.

What governance issues do private company boards face?

Simple governance issues for SMEs can include managing intellectual property and legal risks, e.g. registration of trademarks, contracts with employees and family members, contracts with suppliers and customers.

Other issues include:

  1. Owner-related issues:

    1. Owner’s lack of time. Owners often run the business and have few staff. They struggle to find the time to view the business and market from a governance standpoint. They may lose opportunities due to a lack of time for strategic planning;
    2. Reluctance of owner/founder to let go. As the company grows and considers including independent directors, the owner may feel challenged when altering his or her role in the organisation. It can be hard to let go of the daily operations to become more strategic and entrepreneurial;
    3. Succession planning. Many small businesses suffer from key person risk – the success of the business is dependent on one person. If anything happened to that person, the organisation would change significantly. All businesses need a plan for dealing with an unexpected loss of the owner, e.g. becoming ill or dying and for the owner retiring. Refer to the Q&A on Succession Planning;
  2. Limited resources:

    Private companies may have only a small staff, often lacking in specialist skills and knowledge, and sometimes a limited cash flow. While some may want to improve governance by adding independent directors, they may feel that they cannot afford this;

  3. Growth and expansion:

    As a company grows, its needs to change. There may be a greater need for strategic skills and knowledge than management team can provide. Small companies may be used to meeting compliance requirements (completing forms for ASIC, etc) but will need to become more strategic to deal with greater requirements for disclosure, reporting and exposure to external scrutiny.

  4. Risk management;

    Relationships within many private companies are based on trust with family, friends, suppliers and customers. Fraud can occur and the company needs protection with contracts with all relevant parties. There should also be business continuity plans in case of crises, such as the succession planning issue referred to above.

When should a private company consider creating a board of directors?

Many private companies will start, and continue for some time, with the one director required by law. Company Director has suggested that the need for the addition of other directors and the formation of a board is triggered by certain events, rather than being determined by size of the company.

These events can include when the company:

  • Is making a transition from being family-owned to more professional management;
  • Wants to more readily raise capital. It may consider listing on the ASX to achieve this;
  • Is experiencing rapid change;
  • Is planning significant expansion and needs outsiders to guide it strategically;
  • Is dealing with generational succession issues.

What are the benefits of adding outsiders to the board?

Adding outsiders to a small company where key players have close and well established relationships will be challenging. However, the opportunities this can create can take a company forward to its next stage of development.

Independent directors appointed from outside the company can:

  • Bring a fresh perspective and focus;
  • Identify strategic issues;
  • Create more credibility in the market and make the company more attractive to investors;
  • Show a commitment by the company to corporate governance and regulatory compliance;
  • Act as a sounding board for the CEO and management.

Of course, having independent directors on a board does not guarantee success but it does make it a lot easier to focus on corporate governance issues. What should be considered when adding board members? A company considering the appointment of new board members recognises that it lacks the skills, knowledge and experience needed to push it forward. The key step then is to identify company needs in the short and medium terms. Consider especially what will be happening in that time, e.g. expansion into a new market (industry or geography), broadening the product or service range, etc. Potential candidates should be matched against these criteria. Friends and family, unless they possess this specific knowledge, will probably not be the best choice.

Expect that anyone offered the opportunity of sitting on your company’s board will do their own due diligence to evaluate the opportunity. To assist this process, it would be wise to supply procedural information such as what information they can expect to receive in advance of board meetings, the arrangements for remuneration and Directors’ & Officers (D&O) Insurance, frequency of meetings, appointment terms, board evaluation procedures as well as information on financial performance, industry trends, etc. Evaluating an organisation prior to joining will guide a company on the type of information to make available in order to attract a candidate to your board.

Do independent directors have to be paid?

When contemplating the addition of independent directors, many private companies are concerned about whether they can afford to pay an appropriate amount to their directors. According to the Corporations Act 2001,directors are to be paid the remuneration that the company determines by resolution (sec 202A). Because cash flow is very important to SMEs, it may be worthwhile considering payment in the form of shares. Corporate governance experts do not endorse this practice but it may be the only option for smaller companies.

Feedback

We encourage members to provide feedback by emailing library@aicd.com.au

Updated January 2013


Disclaimer

© This material is subject to copyright. This information may not be reproduced, stored or disseminated in whole or part without prior written permission. It has been prepared as a general overview for information purposes only and do not constitute legal, accounting or other professional advice. While all reasonable care has been taken in its preparation, the Australian Institute of Company Directors makes no representation or warranty of any kind, express or implied, as to accuracy, completeness, reliability or accuracy of the information. It should not be used or relied upon as a substitute for proper professional advice or as a basis for formulating business decisions. Information is subject to change without notice. The Australian Institute of Company Directors will not be liable for any damages of any kind to any person who acts or relies upon the information provided.  Links to third party websites are provided for convenience only and do not represent endorsement, sponsorship or approval of products or service offered.

Legal advice

The Australian Institute of Company Directors regrets that it is unable to provide legal advice to members. Accredited legal specialists can be found through your state Law Society.