Board governance for the lower middle market
We made our first acquisition over a year ago, in the fall of 2021. Since then, we have had to play many roles, from interim head of sales, to CFO, to interim CEO. Each role has elements that are familiar to former consultants like us, and elements that are new. By far the most interesting and challenging role we’ve had to play is that of board directors. Unlike managers, who quickly get busy with day-to-day tactical activities, board directors must spend most of their time looking toward the future. But unlike consultants who tend to be project-based workers digging deep into a few specific priorities, the board must look across all areas of a business and help to set priorities on a very long time horizon. The job requires a lot of time and an intimate knowledge of a company’s operations. For a large, complex, or fast growing business, this becomes a full-time job.
When we realized this fact, it explained two previously mysterious experiences: why a large share of public companies combine the roles of CEO and Chairman, and why family businesses often stagnate even when they have external management. Strategic planning is not a once per year exercise, and it cannot be done without a strong feel for what makes a company go…and what blocks it. Great chairmen spend a majority of their time looking forward, and they delegate as many smaller decisions as they can. In small companies, this is exponentially harder. There simply are not enough people with the skills and experience to make many daily decisions, and these inevitably get pushed up the chain. At this point, a board has two possible modes. On the one hand, a family-directed board can often seek to control even small decisions, taking valuable time to discuss things that could have been done weeks earlier if others were allowed to take the lead. Conversely, many other family businesses – and even more PE-owned and public companies – have boards that delegate everything to the management team and become too far removed from the company’s operations to guide effectively.
We ran into the first problem at a family business where the owner would review every invoice, regardless of size, to make sure everything lived up to his standard. This leader had always been good at vision-casting and creating the product roadmap, but as he spent more time on small decisions, his bandwidth was consumed, he spent far less time with customers, and his growth plans were less successful than they had been when the company was smaller. Eventually, he hired people to manage the company for him, but stayed too involved in the details to lead the company forward and it began to stagnate.
The opposite problem seems to have happened recently at Starbucks, where no one realized that the employee experience had deteriorated until it was too late. Howard Schultz had been a pioneer in creating a great place for employees to work, but when he handed the CEO reins to someone else he lost the pulse of what was really happening – even as he remained the chairman. Unions stepped in to fill the gap, which has created new headaches and damaged Starbucks’s market value. Now Schultz is back in the drivers’ seat, working with a new CEO (Laxman Narasimhan) to re-focus the company and set it on the right path for the future. Perhaps they caught their mistake in time, but many companies do not. We see the same problem in smaller companies often – they have a strong team, but without someone steering them into the future, they find stability difficult and growth nearly impossible. The board accepts monthly reports from management without digging deep enough into important but under-managed details that can eventually make or break the company’s trajectory.
The unique challenge for smaller companies
These lessons clearly apply to both major public companies and to PE-backed or family-owned lower middle market companies. But smaller private companies have several features that make them different from their corporate "big brothers." Particularly unique to this segment of the market is a question that every board must ask at least annually: “are we being ambitious enough, and do we need a different capital structure to enable bigger moves?” Public markets allow investors to diversify as they see fit, but private companies of the scale we invest in have an inherent concentration risk. For family owners the business can be close to 100% of their net worth. Such a concentration tends to force risk averse behavior that results in slow growth or stagnation. Even some PE firms may be reluctant to make a bet on the long-term in a company that they need to exit in a few years. To counter this tendency, private company owners should constantly be evaluating their ownership structure, cost of capital, and ability to stay oriented toward long-term value creation in the company. When the board is properly focused on the future, they will recognize if they cease to be the best owner or if they need to bring in a partner to help them take chips off the table and rebalance risk. Public companies have to make similar decisions about M&A, but this question of capital concentration is unique to privates.
How can board members focus their time and effort?
With all these considerations in mind, we see four key areas for lower middle market boards to focus their time and their energy. Each should be a part of every board meeting, but it can be practical to rotate through topics so that each quarterly meeting focuses more directly on one or more of these:
Protection and oversight. This includes basic risk management – things like cybersecurity and tax or legal reviews. This session is also where the board should review the weekly and monthly KPIs that they are receiving from management, and discuss with the team where the information is helpful and where it might be confusing.
Strategic guidance. The core of a board’s responsibility is to keep the company strategically on track. Every board session should include some discussion of the economic landscape, industry trends, and competitive and customer intelligence. At least once per year this should be a much more in-depth discussion, likely accompanied by an update on the annual and 5-year plan against which the team is executing.
Culture and performance, especially in the top team. The board is responsible to make sure that the management team has what they need to deliver, and then to hold them accountable for that delivery. The CEO (and often other top managers) should receive some degree of performance review and coaching directly from the board of directors. With executives other than the CEO, this often becomes an informal review and coaching process, supplementary to their formal performance reviews directly with the CEO.
Reach and relevance in the industry. In small companies with limited marketing resources, brand building can become very difficult. It can fall on the board to help make connections between the company and its peers – whether potential customers, competitors, suppliers, or future M&A partners. Continually refreshing the relevant industry rolodex will keep a board familiar with the industry topics that will ultimately drive strategic decision-making, and can also feed hiring decisions if the management team needs to be augmented in the future.
By structuring our board directorship along these lines – albeit imperfectly – we have been able to keep a pulse on the activities of our portfolio while also empowering management to manage. At its best, a board acts as a rudder, and these four focus areas we have laid out maximize the likelihood that the rudder will effectively steer the company without either missing changes in the wind or interfering with the team’s efforts to trim the sails.