Competing For Advantage
Part IV – Monitoring and Creating
Entrepreneurial Opportunities
Chapter 11 – Corporate Governance
The
Strategic
Management
Process
International Strategy
 Key Terms

Corporate Governance – set of
mechanisms used to manage the
relationships (and conflicting interests)
among stakeholders, and to determine
and control the strategic direction and
performance of organizations (aligning
strategic decisions with company
values)
Governance Mechanisms
Critical Issues for Growing
Family-Controlled Firms
 Owner-managers may not have access to
all skills needed to manage the growing firm
and maximize its returns for the family
 They may need outsiders to help improve
management of the firm
 Owner-managers may need to seek outside
capital and thus give up some of the
ownership control
Agency Relationships
 Key Terms

Agency Relationship – relationships
between business owners (principals)
and decision-making specialists (agents)
hired to manage principals' operations
and maximize returns on investment

Managerial Opportunism – seeking selfinterest with guile (i.e., cunning or deceit)
An Agency Relationship
Problems with Separate
Ownership and Control
 Principal and agent having different
interests and goals
 Shareholders lacking direct control of
large publicly traded corporations
 Agent makes decisions that result in
the pursuit of goals that conflict with
those of principal
Product Diversification as an Agency Problem
 Key Terms

Free Cash Flows – resources
remaining after the firm has invested
in all projects that have positive net
present values within its current
businesses
Product Diversification as an Agency Problem
 Increased product diversification allows top
executives to increase their compensation

It usually increases the size of a firm, and size
is positively related to executive compensation

It increases the complexity of managing a firm
and its network of businesses, so its
leadership positions may demand more pay
Product Diversification as an Agency Problem
 Product diversification (and the resulting
diversification of the firm’s portfolio of
businesses) reduces risk for top executives

Managerial employment risk includes the risk of
managers losing their jobs, compensation, or
reputations

Diversification reduces these risks because a
firm and its managers are less vulnerable to the
reduction in demand associated with a single or
limited number of product lines or businesses
Product Diversification as an Agency Problem
 Use of Free Cash Flows

Managerial inclination to overdiversify
can be acted upon when free cash
flows are available

Shareholders may prefer that free
cash flows be distributed to them as
dividends, so they can control how the
cash is invested
Agency Costs
 Key Terms

Agency Costs – sum of incentive costs,
monitoring costs, enforcement costs,
and individual financial losses incurred
by principals, because governance
mechanisms cannot guarantee total
compliance by the agent
Ownership Concentration
 Key Terms

Ownership Concentration – governance
mechanism defined by both the number of
large-block shareholders and the total
percentage of shares they own

Large Block Shareholders – shareholders
owning a concentration of at least 5 percent of
a corporation’s issued shares

Institutional Owners – financial institutions such
as stock mutual funds and pension funds that
control large-block shareholder positions
Ownership Concentration – Trends
 Increased equity ownership by institutional
owners provides the size to influence
strategy and the incentive to discipline
ineffective managers
 Increased shareholder activism supported
by SEC rulings in support of shareholder
involvement and control of managerial
decisions
Ownership Concentration – Trends
 Threats or initiations of a proxy battle to
unseat the current board of directors
 Organization of press conferences
 Threats of a takeover bid
 Creation of shareholder “proposals” to be
addressed at the next board meeting
Board of Directors
 Key Terms

Board of Directors – group of
shareholder-elected individuals whose
primary responsibility is to act in the
owners’ interests by formally monitoring
and controlling the corporation’s toplevel executives
Board of Directors
 Direct the affairs of the organization
 Punish and reward managers
 Protect shareholders’ rights and interests
 Protect owners from managerial
opportunism
Board of Directors –Types
Outsider Directors
 They improve upon the weak managerial
monitoring and control that corresponds
to inside directors
 Without access to daily operations and a
high level of information about managers
and strategy, they tend to emphasize
financial controls, to the detriment of riskrelated decisions by managers
Board Effectiveness – Trends
 Increased diversity of the backgrounds of
board members
 Establishment and consistent use of formal
processes to evaluate the board’s
performance
 Creation of a “lead director” role that has
strong agenda-setting and oversight powers
 Modified compensation of directors
 Requirements that directors own significant
stakes in the company in order to keep them
focused on shareholder interests
Board Effectiveness – Trends
 Become engaged in the firm, without trying
to micromanage it
 Challenge the reasoning behind decisions,
but be supportive of decisions that are made
 Provide an independent perspective on
important decisions
Executive Compensation
 Key Terms

Executive Compensation – governance
mechanism that seeks to align the interests
of top managers and owners through
salaries, bonuses, and long-term incentive
compensation, such as stock awards and
stock options
Executive Compensation
 Executive compensation is thought to
be excessive and out of line with
performance
 Alignment of pay and performance is a
complicated board responsibility
 The effectiveness of pay plans as a
governance mechanism is suspect
Executive Compensation – Complications
 The quality of complex and nonroutine
strategic decisions that top-level managers
make is difficult to evaluate
 Decisions affect financial outcomes over an
extended period, making it difficult to assess
the effect of current decisions on corporation
performance
 External factors affect a firm’s performance
besides top-level managerial decisions and
behavior
Executive Compensation – Complications
 Performance-based compensation used to
motivate decisions that best serve
shareholder interest are imperfect in their
ability to monitor and control managers
 Even incentive compensation plans that are
intended to increase the value of a firm in
line with shareholder expectations are
subject to managerial manipulation to
maximize managerial interests
Executive Compensation Plans – A
Question of Stock Issues Effectiveness
 Many plans seem to be designed to
maximize manager wealth rather than
guarantee a high stock price that aligns the
interests of managers and shareholders
 Repricing – strike price value of options is
commonly lowered from its original position
 Backdating – options grant is commonly
dated earlier than it was actually drawn up
to ensure an attractive exercise price
Market for Corporate Control
 Key Terms

Market for Corporate Control – external
governance mechanism consisting of a
set of potential owners who are seeking
to acquire undervalued firms and earn
above-average returns on their
investments, a process which becomes
active when a firm’s internal controls fail
Market for Corporate Control
 Addresses weak internal corporate
governance
 Corrects suboptimal performance relative
to competitors
 Disciplines ineffective or opportunistic
managers
Corporate Governance – Germany
 Concentration of ownership is strong
 Banks exercise significant power as a source
of financing for firms
 Two-tiered board structures, required for
larger employers, place responsibility for
monitoring and controlling managerial
decisions and actions with separate groups
 Power sharing includes representation from
the community as well as unions
Corporate Governance – Japan
 Cultural concepts of obligation, family, and
consensus affect attitudes toward governance
 Close relationships between stakeholders and a
company are manifested in cross-shareholding,
and can negatively impact efficiencies
 Banks play an important role in financing and
monitoring large public firms
 Despite the counter-cultural nature of corporate
takeovers, changes in corporate governance
have introduced this practice
Global Corporate Governance Trends
 Relatively uniform governance structures
are evolving
 These structures are moving closer to the
U.S. model of corporate governance
 Although implementation is slower, this
merging with U.S. practices is occurring
even in transitional economies
Corporate Governance and Ethical Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups
Capital Market
Stakeholders
• In the U.S., shareholders (in the
capital market stakeholder group) are
the most important stakeholder group
served by the board of directors
• Governance mechanisms focus on
control of managerial decisions to
protect shareholders’ interests
Corporate Governance and Ethical
Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups
Product Market
Stakeholders
• Product market stakeholders
(customers, suppliers and host
communities) and organizational
stakeholders (managerial and nonmanagerial employees) are also
important stakeholder groups
Corporate Governance and Ethical
Behavior
It is important to serve the interests
of the firm’s multiple stakeholder
groups.
Capital Market
Stakeholders
Product Market
Stakeholders
Organizational
Stakeholders
• Although the idea is subject to debate,
some believe that ethically responsible
companies design and use governance
mechanisms that serve all
stakeholders’ interests.
• Importance of maintaining ethical
behavior through governance
mechanisms is seen in the example of
Enron and Arthur Andersen.
Ethical Questions
Do managers have an ethical responsibility to push
aside their own values with regard to how certain
stakeholders are treated (i.e., special interest
groups) in order to maximize shareholder returns?
Ethical Questions
What are the ethical implications associated
with owners assuming that managers will act in
their own self-interest?
Ethical Questions
What ethical issues surround executive
compensation? How can we determine
whether top executives are paid too much?
Ethical Questions
Is it ethical for firms involved in the market
for corporate control to target companies
performing at levels exceeding the industry
average? Why or why not?
Ethical Questions
What ethical issues, if any, do top
executives face when asking their firms to
provide them with golden parachutes?
Ethical Questions
How can governance mechanisms be
designed to ensure against managerial
opportunism, ineffectiveness, and unethical
behaviors?