Bridging the Chasm: What Small-Cap Investors Want Board Members to Know

59 minute read

Bridging the Chasm: What Small-Cap Investors Want Board Members to Know

By Adam J. Epstein, Guest Edited by Andrew E. Shapiro

One of the reasons why the overwhelming majority of shareholder activism campaigns are in small-cap companies is because there is a pretty substantive disconnect between what investors expect of board members, and what actually happens on a day-to-day basis in many boardrooms. This article aims to succinctly address some of the key issues that give rise to the friction.

In order to make the material as practical as possible, we’ve elected a Q&A format.

The Role

The primary role of a board member is to mentor the CEO, and help develop business opportunities, right?

The primary role of a public company board of directors is to oversee – on behalf of all shareholders – the business affairs of the corporation, and hire, task, and hold the CEO accountable.

If board members can, additionally, provide mentorship and help develop business opportunities, that’s terrific.

Who should appoint board members?
Let’s start with the wrong answer first: CEOs.

CEOs don’t appoint or elect board members, nor should they nominate them.  Board members should be nominated based upon the recommendation of an independent Nominating/Governance committee[1] of the board.  Thereafter, shareholders ratify directors who are nominated by the board.

CEOs, as members of the board, certainly have input into new board members, but non-executive – so-called “independent” board members – are primarily vested with the job of nominating the slate of board members for shareholder election.

Unfortunately, in many small-cap companies, CEOs usurp proper board function, and unduly influence the nomination of board members.  This results in CEOs subverting the primary function of a board – objective oversight on behalf of all shareholders – and stacking the board with their friends and family, etc.

Boards comprised of the CEO’s friends/family are easily the biggest complaint of seasoned investors, because investors know that better governed companies make more money.

Aren’t “independent” board members de facto “objective” in their board roles?
Not necessarily.

A CEO could stack the board with non-executives who are all close friends.  Those “friends of the CEO” would technically be deemed “independent” per Nasdaq and NYSE listing rules, but it’s highly unlikely they are going to objectively oversee the CEO – their friend.  In fact, the reason why CEOs tend to put their friends on their boards is to ensure that there won’t be objective oversight.  Rather, the board will “rubber stamp” the CEO’s initiatives/performance, instead of rigorously questioning it.

“Independence” is a very low hurdle.  “Objectivity” isn’t.  Investors desire boards that objectively oversee management’s execution of strategy on behalf of all shareholders.  In the absence of objective oversight, corporate governance is just a time- and expense-wasting façade.

What’s the thinking behind having term limits for board members; we have some board members who have been on our board for 15 years and do a great job?
There is no consensus among investors in the United States regarding term limits for board members.

But here’s the concern: the longer board members serve together, and oversee the same CEO, the less likely it is for them to remain fiercely objective and proactive on behalf of all shareholders. Put differently, it’s just human nature; time breeds comfort, and comfort is the nemesis of intellectual rigor and curiosity.

Are there long-tenured board members who buck convention, and are tremendous assets for shareholders in the boardroom?  The answer is yes, and every experienced investor knows that.  That said, there is a reason why the UK Corporate Governance Code actually revokes your independence stature after 9 years of cumulative board service.

Accordingly, the onus is on the company to explain clearly to investors why re-electing its long-tenured board members, in particular, is in shareholders’ best interests.

I read a lot about the pressure on large-cap companies to separate the CEO and chair roles; what’s a best practice in the small-cap world?
The short answer is that while there isn’t a consensus, investors will never fault you for separating the roles.

From a purist standpoint, the roles should always be separate, since a chair leads the board, and the board’s role is to oversee the CEO.  Put differently, it’s impossible to oversee yourself.  That said, most investors are inclined to tolerate the combined roles in companies that are otherwise high performing.

From a practical standpoint, boards should consider adopting separation of the roles when: (1) companies aren’t performing well compared to their peers; (2) the CEO is inexperienced in operating a public company; and/or (3) CEO succession opportunity arises. It’s also worth noting that in companies where the roles are separated, overall executive/board compensation is often lower.

Every investor will tell you that the surest way to optimize governance is to install a highly experienced, independent chair to a board.  They not only help the CEO better understand their public company role, but they also can similarly help less-experienced board members.  That said, investors have learned that it’s best when the independent chair is an individual skilled in governance and the operation of boards, versus an industry executive who poses a constant operational leadership threat to the CEO.

Who Should, and Shouldn’t Be On Your Board

How do investors determine whether boards have the “right” directors?
Every company has a handful of key: (1) strategic imperatives; (2) impediments to achieving those imperatives; and (3) customers/vertical segments.  Every independent board member needs to be an expert in at least one of these three buckets, and the board collectively needs to have at least one expert in each bucket.

For example, a life science company that isn’t yet revenue producing is reliant upon capital raising; i.e., financing is a key impediment.  Accordingly, any pre-revenue life science company that lacks a board member with material, recent, relevant capital markets/corporate finance experience has substandard board composition.

The easiest way for boards to think about board composition is that board members can’t possibly independently and objectively assess key strategies and risks if they lack experts in those areas.  While the law allows boards to rely on management input, it is advisable for board members to not solely rely on management input.

And since the three buckets of required board expertise are constantly changing – particularly in small-cap companies – board composition needs to continuously be re-examined.  A technology company might have a perfectly comprised board, and six months later – subsequent to a major strategic pivot – it might be conspicuously lacking key expertise.

Are there certain kinds of board members that investors are skeptically inclined towards?

Does that mean that you shouldn’t ever have these people on your board?  No.  But, if the nom/gov committee believes that a prospective director who fits one of these descriptions is otherwise going to be a valuable addition to the board, the company’s proxy materials should thoroughly set forth why shareholders should suspend their skepticism.  Think of it as a sliding scale: the more naturally skeptical shareholders are of a board member, the better job the company needs to do to make the case for their candidacy.

It seems like boards tend to be composed of sitting and retired CEOs and CFOs. Are investors principally desirous of those backgrounds on boards?

There is no data whatsoever to suggest that CEOs or CFOs make more effective board members than other executives.  While there are certainly current and former CEOs/CFOs who make terrific board members, there is also plenty of anecdotal data to suggest that they often struggle with the transition from leadership to oversight, and also often don’t always “play nicely” with others.

Investors are increasingly critical of boards heavily stacked with C-level executives for contributing to higher executive compensation, and for being less engaged due to their extensive other commitments.

Boards should choose board members by the expertise they require and their ability to be engaged providing such expertise, not by their titles/business cards.  Limiting board searches to CEOs and CFOs will eliminate countless, highly qualified potential board members who are able to bring more energy to the job.

Board Compensation and Stock Ownership

Our board’s compensation is similar to our peer companies, so why are investors so upset about our director compensation?
First, investors are wise to companies that use “aspirational” peer compensation benchmarks, as opposed to “realistic.”  Compensation committees need to be mindful that many third-party compensation consultants try to do their best to justify the highest possible remuneration for boards; consultants that routinely do the opposite, don’t get a lot of repeat business.  Accordingly, board members need to view the peer groups suggested by compensation consultants with the same skepticism that investors will deploy.  That is: “Is company X or company Y really a comparable company to us… today?”

Second, while reasonable people will certainly differ about whether it should be this way or not, scrutiny of corporate governance is typically inversely proportional to corporate performance.  Said differently, if investors are taking unusually close looks at your company’s governance, your company is probably underperforming its peers, indices, or both.  Accordingly, board members need to similarly be mindful about the board’s compensation relative to better performing peers.  If your company is being outperformed, for example, by all its publicly traded peer group, then investors will typically take the position that your board should be the least well compensated.

Our board members don’t own shares, per se, but they have material “skin in the game” through their option grants. Do investors distinguish between options and shares when they analyze whether our company’s interests are appropriately aligned with theirs?
Investors definitely distinguish between the two.

Stock options never constitute “skin in the game” from a buy-side perspective.  You’re either a shareholder, or you’re not.

Investors will further distinguish between board members who were granted restricted stock, versus those who took cash out of their pockets and purchased stock.  Remember, the only way investors can acquire your company’s equity is using cash.

Investors have encouraged our company to implement stock ownership guidelines for officers and directors. What is that, and why is that attractive to investors?
The lion’s share of large-cap companies in the US now require named executive officers (NEOs) and board members to attain a certain level of stock ownership within a defined time period, and then to maintain that ownership during the course of their tenures.

The rationale for stock ownership guidelines (SOGs) is that when NEOs and directors have actual “skin in the game,” their interests will be more aligned with shareholders, and they will have more incentive to focus on long-term value creation.

It’s not just large-cap companies that are adopting SOGs though.  According to the National Association of Corporate Directors, 46 percent of public companies with revenue between $50 million and $500 million now have some form of SOGs for board members (up more than 25 percent from 2012).

A small-cap company’s SOGs might, for example, require: (1) the CEO to own three times their annual base salary in stock; (2) other NEOs to own one times their annual base salaries in stock; and (3) non-executive board members to own three times their annual cash retainers in stock.  SOGs often provide five years for NEOs and board members to comply, and most have hardship exemptions that are reviewed by the board, or applicable board committee, on a case-by-case basis.

The Job

Whose job is it to develop a company’s strategy: management’s or the board’s?

Management’s job is to present their recommendations regarding corporate strategy to the board for the board’s approval.  As part of that process, a well-comprised board will utilize their collective expertise to help further refine the strategy that is ultimately agreed upon by the full board.

But, it’s not the job of the board to originate/formulate the company’s strategy.  When boards are forced to author corporate strategy from scratch or require a major revision of what management has proposed, there is only one conclusion for that board to reach: “we have the wrong CEO.”

Our management team is not only stretched thin, but they also lack appreciable experience scaling a public company. Since I have lots of experience, I feel like it’s important for me to be a “hands on” board member, and help train/direct employees, and drop by various employee meetings when I’m able. I’m guessing shareholders would really value that “hands on” approach, yes?
The short answer is: no.

Management are vested with the responsibility for operating public companies.  Boards are in the business of oversight.  Board members should always keep their noses in the business, but their fingers out (a handy acronym to remember this is NIFO).

It is never OK for board members to provide any guidance or direction to any employee other than the CEO or CFO.  Moreover, board members should never show up at any corporate office or facility unannounced; they should only do so with the prior approval of the CEO.

When a board member’s site visit is approved by the CEO, their interactions with employees should be limited to fact finding (i.e., asking relevant questions, and listening to the answers).

When boards feel like they need to be operating the company, it is a sure-fire indication that the board, or a particular director, does not have confidence in the CEO.

Some of our largest investors have asked to meet with our compensation committee chair to better understand some of the rationales for how we’re paying our CEO. The CEO feels like it’s a good idea, but our lawyers have repeatedly advised us that it’s not the job of board members to meet directly with investors. How do investors view this situation?
Your counsel is correct that there is no formal such requirement.  Moreover, there are many companies, board members, and attorneys, who continue to maintain that it’s not the province of board members to meet directly with investors.

Meeting and engagement between a director or committee of directors and shareholders are now commonplace in the Fortune 1000 ecosystem and becoming more common in the small-cap world.

Here’s why: Board members are elected by shareholders to oversee companies on behalf of all shareholders. From the perspective of investors, there is no question that board members should meet with investors under appropriate circumstances (i.e., with company counsel present), to answer compensation and governance-related questions so long as answering those questions doesn’t violate Regulation FD.

It’s also worth noting that in addition to a duty of loyalty (i.e., no self-dealing, conflicts of interests, etc.), board members have a fiduciary obligation to be informed.  One excellent way to stay informed is to periodically hear directly from investors about their concerns.

[Here is an in-depth article about how board members should approach meeting directly with investors.]

Is it appropriate for independent board members to meet/confer with other independent board members without the CEO present?
Absolutely.  In fact, it’s impossible to effectively oversee the CEO without meeting regularly in their absence, and independent board members of listed companies (i.e., Nasdaq and NYSE) are actually obligated to meet in “executive session” outside the presence of management regularly.

If your CEO expresses their disapproval of the same, they either don’t understand the role of a public company board, or perhaps there are other larger issues afoot.

Our chairperson recently chastised some board members for supplementing the information supplied by management to support their strategic recommendations with our own independent research on the topic. Is it considered improper for board members to conduct their own research or diligence?


Independent board members need to think independently.  It is the job of independent board members to “trust but verify” when it comes to management recommendations.  In practice, that means engaging in rigorous boardroom debate, and becoming as educated as possible about all issues that affect boardroom decisions.  When board members get 100% of their information from management, they are not thinking/acting independently.

If board members arrive at a place, however, where they simply don’t trust what they’re being told by management, then the company has the wrong CEO.

We have a new board member, who is a career, large-cap executive; our board is his first small-cap experience. Some of the board members are concerned that our CEO, who is new to running a public company, doesn’t really know how to interface with the Street. But our new large-cap board member has been clear with us that “CEO communication” isn’t really a governance issue, it’s a management issue. Is he right?
He’s likely right in the large-cap context, but he’s not right in the context of most small-caps.

Tim Cook and Jamie Dimon likely need no board oversight whatsoever with respect to their interactions with the sell- or buy-sides.  That is, Apple and JP Morgan are immense, stable, wildly profitable, global companies, that are run by extremely experienced public company executive teams.

But Tom Cork or Janine Diamond, who are both shepherding public companies for the first time and are presiding over companies that are always one or two capital markets missteps away from disappearing, absolutely require board oversight and assistance with respect to their interactions with the Street, among countless other items.

When small-cap boards simply assume that CEOs are expert storytellers and have the requisite poise and savvy to interact with experienced investors, bad things often transpire.

Corporate governance isn’t one size fits all; governing a small public company is nothing like overseeing a large-cap company. This is why, in composing the optimal board for a smaller company, at least one financial/public markets experienced board member is a must.

[1] There are three, typical, standing, board committees: (1) audit committee; (2) compensation committee; and (3) nominating/governance (or “nom/gov”).  The audit committee’s primary responsibility is to oversee a company’s financial reporting, internal financial controls, and risk management infrastructure.  The compensation committee’s primary responsibility is to oversee the compensation of executives and board members.  The nom/gov committee’s primary responsibility is to oversee board composition and succession planning.