VBM Principles During Crisis: A Guide for Corporate Governance
7/1/2020
Right now, during a period of market fragility and change, is the time to re-evaluate your organization’s corporate governance. The efficacy of corporate governance can oftentimes determine the success or failure of an otherwise promising company. VBM - Value Based Management™ understands the centrality of corporate governance on a business’s operations and position in the overall market. This article looks at how VBM can improve three high impact areas of corporate governance.
Tightened Capital Allocation
Often overlooked as an area of corporate governance, capital allocation is itself the child of corporate governance colliding with the realities of corporate finance. “As a matter of corporate governance, capital allocation is important with regard to achieving the appropriate type and balance of capital funding to allow a company to pursue its mission and strategic objectives, and to provide sufficient returns and protections to providers of risk capital.”¹
As macro-economic forces continue to batter the overall market, the result has been an operating environment for business in which the availability of necessary capital has been significantly curtailed. While this undoubtedly has detrimental consequences for a corporation in need of additional capital, within this capital constraint lies opportunity. When capital is abundant, the bar for capital allocation is lowered. Conversely, the unavailability of capital demands, and subsequently results in, better capital allocation.
Practically, the most effective way to determine the allocation of limited capital is through Economic Value Added or EVA®. By determining which projects create the most EVA and return above the cost of capital, scarce capital is more efficiently allocated. Further, EVA analysis for capital allocation focuses on the future, where real value resides, as well as mitigates some of the risk of inevitable internal politicking surrounding capital allocation decisions.
Corporate leaders should look at this crisis and accompanying capital crunch through the lens of opportunity. Within this seemingly suboptimal environment lies an opportunity to improve upon capital allocation decision-making and create more accountability for the creation or destruction of value resulting from capital use.
The Invisible Non-Decisions
You’re the CEO of a tech company, and last year you decided to engage in a particularly successful acquisition of an up-and-coming competitor, along with a choice to invest more heavily in a promising new service line. Your board is happy with you and CNBC is inviting you on for morning analysis on all the market movers.
Now imagine you are a CEO of a bank in 2005. Your competition has been giving out credit and loans as if they were Halloween treats. You refuse to go along because you think that the unseen risk is much too high. Many of your managers are wondering why you have been so reticent in following suit, especially since this means that they are missing out on some of the bonuses they see their peers getting for the expanded issuance of such easy yet subprime credit. Your board is unhappy and guest commentators on CNBC are criticizing you for lagging while the competition sweeps you away. Finally, everybody has had enough of you and you are fired. A new CEO is appointed, and he greenlights a strategy to catch up with the bank’s peers in subprime credit and lending.
The financial crash comes and the Great Recession ensues. Your strategy has been vindicated, finally. But at the time when it really mattered, during the buildup, nobody cared to listen to you.
Because we are all naturally biased toward action, even if non-action is a superior choice in a given situation, we generally reward the first CEO in our example and extol his superior business acumen over that of the second CEO. In reality, avoiding catastrophic risk can be as important to long-term value creation, not to mention fundamental viability, as traditional expansion or income growth.
Good corporate governance means creating corporate structures and culture that favor sustainable, long-term value creation over transitory and unsustainable short-term gains. To effectuate this kind of culture, corporations should do two things:
First, ensure that C-suite leadership communicates with investors and the market transparently, frequently, and through language grounded in long-term strategy. Short-term tactical decisions should be communicated within the context of their role within the longer-term strategy.
Second, boards must support instances where executives do not act in order to mitigate true risk, as well as weigh certain tail-risks as much as they weigh the potential benefits of future opportunities. Finally, companies should adopt VBM incentive compensation plans, which promote long-term thinking and add skin in the game for management.
Unbridled Optimism Must Be Grounded by Realism
Decision-making in any context, but especially in business, is among the most difficult activities that one can undertake. We are never omniscient, and we always operate with a degree of blindness. In the business world, effective decisions can only be undertaken when the optimism of potential gains is tempered by the fear of potential losses.
How do we then effectively incorporate fear of loss into everyday decision-making within corporations? This is where VBM incentive compensation plans can play a critical role. As is widely acknowledged, one of the most important components of corporate governance is executive pay. When integrated vertically into all aspects of corporate governance, VBM incentive plans act upon the most powerful driver for human decision-making: incentives.
Through provision of greater incentives for projects that are truly economically profitable over a sustainable time frame, removal of caps on potential bonuses, and allowance for value destruction to make bonus bank balances negative in the event of poor capital allocation, VBM compensation plans encourage appropriate levels of risk aversion while still facilitating innovation. VBM plans emphasize the long-term over the short-term, and therefore projects that have high short-term payoffs but greater risk as time increases are less likely to be acted upon since the risk to one’s incentive pay would be too high should something go wrong. Risk is thus incorporated into decision-making because both the risks and rewards hit close to home, thereby amplifying the prudence applied by decision makers.
Conclusion
Improving corporate governance is imperative for businesses to succeed over the long-term. Well-governed corporations provide the fertile ground necessary for the seeds of value creation, innovation, and economic productivity to be sown. Through the application of VBM in capital allocation, recognition of non-actions to prevent risk, and re-configuration of incentive pay with VBM to align with risk and reward, corporations can set up strong foundations from which to tackle unforeseen challenges.
¹Capital allocation: A governance perspective, by George Dallas of International Corporate Governance Network. Accessed on Ethicalboardroom.com