There’s a dirty secret at the heart of corporate governance. Governance rules don’t create value. They only prevent it’s destruction.
A business with perfect governance that doesn’t make money is worthless. So, how should we keep our eyes on the ball?
What Makes a Business Valuable?
A business is worth the returns it makes for its investors over time. In financial terms, this is the discounted present value of future cash flows.
Discounted cash flows constitute the business’s intrinsic value. But we have to discount this intrinsic value by at least two kinds of risk. The first is political risk. This means political or regulatory changes or instability in a country that divert or block the cash flows from going to investors.
A second discount arises from corporate-governance risk. This means the chances that the business’s controlling owners, directors, or managers will steal, divert, or waste the cash flows that should go to the investors according to their respective classes (lenders, preferred shareholders, common shareholders).
Governance Rules Fall Silent on Value Creation
For a corporation, the Board of Directors’ and managers’ most important task is creating value. Directors do this by hiring and counseling the CEO, as well as guiding formulation of corporate strategy. The CEO runs the company’s day-to-day affairs.
Such actions and decisions almost exclusively involve business judgment. As a result, corporate-governance rules in this area have next to nothing to say.
Corporate-governance laws and regulations instead focus on steps and duties to prevent value destruction. This is an important task, but secondary to value creation. A company with faulty governance that makes money is still worth something. A company with flawless governance that makes no money is not worth anything.
Keeping Our Eyes on the Ball: Results, Not Process
Corporate scandals infuriate us. Faithless shepherds who pillage the flock they are charged with guarding deserve condemnation and punishment.
But, we must stay mindful that, at some point, ever more invasive and cumbersome rules on Directors and managers can hurt value creation.
We must also recognize that corporate governance has become an industry of its own. A vast array of legislators, regulators, experts, academics, advisors, and advocacy groups make their livings by constantly pushing “new and improved” corporate-governance frameworks and rules. There is a ratchet effect. Compliance involves ever more people, more time, and more resources.
Rather than telling Directors and managers in greater and greater detail what to do, we should find better ways to hold them accountable. To promote such accountability, for example, Berkshire Hathaway does not buy Directors and Officers liability insurance for its Board.
Boards and managers must allocate their time and energies. I argue here for reason and balance in light of priorities. We need Boards and managers to create value and then to prevent its destruction.