Value-Creation & The Board
The Guidance on the Strategic Report, a part of company’s annual report (along with a new UK Corporate Governance Code 2018 and Guidance on Corporate Effectiveness) was published in July last year. It contains a glossary of the terms used in the document. They include:
Purpose: “why the entity exists”
Business Model: “how the entity generates or preserves value over the long-term”
Objectives: “a specific aim that the entity wishes to achieve”
Strategy: “a plan or approach which is intended to help the entity achieve an objective”
It is great to note that mission, vision and values do not appear on the list. But I think we can simplify matters even more.
Let me suggest that all businesses and organisations have only one purpose, to create value in some form. The way they decide to do that, the “business model”, determines objectives, which are achieved by implementing a strategy. Over time, all may evolve or change. But the purpose is less likely to change than the other elements.
So, the biggest strategic questions are, “what value do we create, who for and how”? Ask yourself if the business or organisation of which you are a director, executive, manager or employee has clear answers to these questions. It is worth taking a moment to reflect on this.
Now consider, how confident you are in the business model, the objectives and the strategy? And ask yourself, what are the chances the business or organisation will achieve its purpose, assuming you are clear what that is?
Most people, including strategists, struggle to define what strategy is. But nobody I have spoken to so far struggles with the idea that the purpose of any business or organisation of any type, and in any sector of the economy, is to create value of some kind. For this reason, I believe a conversation about value is a pragmatic way to approach a conversation about strategy. It is also the reason I coined the term Valueism, enterprise focused on value creation.
There is ample evidence that a large majority of businesses and organisations of all types and sizes are directed and led by people who are unclear about what value they create, who they create it for and, or, how they create it. Let me offer some evidence to back up what sounds like an outrageous and false slur but is sadly true.
“Boards aren’t working”, wrote Dominic Barton, until very recently Global Managing Director of McKinsey & Company, and Mark Wiseman, President and CEO of the Canada Pension Plan Investment Board, in a Harvard Business Review article in 2015. “Aren’t working” meant, “most boards aren’t delivering on their core mission: providing strong oversight and strategic support for management’s efforts to create long-term value”.
They cited research findings. “A mere 34% of the 772 directors surveyed by McKinsey in 2013 agreed that the boards on which they served fully comprehended their companies’ strategies. Only 22% said their boards were completely aware of how their firms created value, and just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries”. And “In March 2014, McKinsey and the Canada Pension Plan Investment Board (CPPIB) asked 604 C-suite executives and directors around the world which source of pressure was most responsible for their organizations’ overemphasis on short-term financial results and under emphasis on long-term value creation. The most frequent response, cited by 47% of those surveyed, was the company’s board. An even higher percentage (74%) of the 47 respondents who identified themselves as sitting directors on public company boards pointed the finger at themselves”. They suggested it is time for everyone to “firmly grasp what a director’s “fiduciary duty” is”, an indication that in their view boards are not fulfilling their fiduciary duty.
In meetings with the CEO of a large institutional investor, an investment industry regulator and a former investment fund manager, I shared these “shocking results”, as Barton and Wiseman call them. And I asked a few questions: first, did they think the findings reflected their own experience. All said they thought they were quite accurate. Then I asked if they implied boards, and the individual directors on them, were in breach of their fiduciary duty. All agreed this must be the conclusion. It begs the question, are institutional investors also in breach of their fiduciary duties, but I cannot go into that matter in this article.
What I can say is that the new code and guidance make clear what is expected of boards. The guidance on the strategic report says, “The content elements for the strategic report set out in the guidance are derived from the Companies Act 2006, and include a description of the entity’s strategy, objectives and business model. In addition, the strategic report must include an explanation of the main trends and factors affecting the entity; a description of its principal risks and uncertainties; and an analysis of the development and performance of the business, including key performance indicators”.
And, in the context of the findings from Barton and Wiseman, I can ask, how can an entity that is unclear about what value it creates, for whom, or how, produce a strategic report? Or, have a strategy that is worth the paper it is written on? A key principle of the report is “materiality”. The information in the report needs to be regarded as material to investors. How can an entity that is unable to answer these value questions understand what is material?
As for understanding the business model, section 7A.16 of the Guidance on the Strategic Report makes a very clear point, “A critical part of understanding an entity’s business model is understanding its sources of value, being the key resources and relationships that support the generation and preservation of value. In identifying its key sources of value, an entity should consider both its tangible and intangible assets and also identify those resources and relationships that have not been reﬂected in the ﬁnancial statements because they do not meet the accounting deﬁnitions of assets or the criteria for recognition as assets. This information may provide insight into how the board manages, sustains and develops these unrecognised assets”. The same guidance also notes, “There should be alignment between the KPIs presented in the strategic report and the key sources of value and risks identiﬁed in the business model”.
By now I hope you are already clear that compliance with the new code and guidance will represent a huge challenge to most businesses, and I do not mean only listed corporations. Whilst the new corporate governance code only applies to listed corporations, the guidance on the strategic report applies to all entities currently required to prepare a strategic report under the 2006 Companies Act.
A strategic report for a ﬁnancial year of a company must include a statement (a ‘‘section 172(1) statement’’) which describes how the directors have had regard to the matters set out in section 172(1) (a) to (f) when performing their duty under section 172.72. The matters set out in section 172(1) (a) to (f) are:
(a) the likely consequences of any decision in the long term;
(b) the interests of the company’s employees;
(c) the need to foster the company’s business relationships with suppliers, customers and others;
(d) the impact of the company’s operations on the community and the environment;
(e) the desirability of the company maintaining a reputation for high standards of business conduct;
(f) the need to act fairly between members of the company.
Let me suggest that this requires companies to adopt a much broader definition of “value” when considering how they create value, and that who they create value for must include all the stakeholders just referred to in (a) to (f) above. To achieve this, I further suggest that directors will need to ensure they have a clear understanding of what “value” means by looking at the question from the perspective of each stakeholder group.
To make my point even more clearly, the guidance says, “The information contained in a section 172(1) statement will depend on the individual circumstances of each company, but companies will probably want to include information on some or all of the following:
(a) The issues, factors and stakeholders the directors consider relevant in complying with section 172(1) (a) to (f) and how they have formed that opinion;
(b) The main methods the directors have used to engage with stakeholders and understand the issues to which they must have regard;
(c) Information on the effect of that regard on the company’s decisions and strategies during the ﬁnancial year.
The guidance adds, “The description of the company’s business model in the strategic report should provide an insight into the key resources and relationships that support the generation and preservation of value in the company. Stakeholder relationships are often a key source of value that help to ensure that an entity’s success is sustainable over the longer term. It is important that boards identify its key stakeholders and the importance of those stakeholders to the long-term success of the company”. And addressing the issue of short-termism the guidance says the Companies Act, “requires directors to have regard to the likely consequences of decisions in the long-term. The section 172(1) statement could provide information on how the long-term success of the company has been considered in making strategic decisions. This could include considering the interests of other stakeholders, the long-term impact of the company’s activities on the community and environment or other broader matters that may affect company performance over the longer term”.
The guidance proposes directors establish stakeholder engagement policies and procedures, so they have “appropriate information to make informed judgements” and that it “explain the outcomes of its engagement with key stakeholders and the impact on the board’s decision making”. And it adds, “The interests of one group of stakeholders may not always be aligned with the interests of other stakeholders or with the interests of shareholders. Where there are conﬂicts, or where in the interests of one group have been prioritised over another, the section 172(1) statement could explain how the directors have considered the different interests and the factors taken into account in making that decision”.
Here it is worth noting that the code and guidance make clear that directors have a fiduciary duty to serve the long-term interests of the firm and to consider the interests of all stakeholders, not only shareholders. And the guidance deals with the matter how to deal with the conflict of interest between short-term and long-term investors saying, “On a year-to-year basis, directors will decide how to apply the company’s capital allocation and dividend policies given events and circumstances that have arisen during the period. In both the setting of the policy and the application of that policy in any given period, directors are encouraged to consider the interests of the company’s shareholders as a whole, while having regard to, for example, the long-term viability of the company, the need for research and development or capital investment and the interests of other stakeholders, such as the pension fund or current employees”.
I have long argued that it may be easier to just regard all stakeholders as investors of one kind or another, since to varying degrees all have a vested interest in an entity. They all seek a return on investment in one form of value or another, and this explains why Valueism calls for value to be defined in broad terms. Value needs to be seen, understood, analysed and accounted for from the perspective of each group of stakeholders. Such an approach is the only way to achieve fairness and balance over time, which is essential if the entity is to be sustainable in the long-term.
This article is an edited version of the one I published in July 2018. Since writing it I have had many discussions about it with board members, annual report preparers, investors and investor relations executives. They all agree that the new requirements present corporations and larger listed businesses with a great challenge. And that Valueism will help them consider the issues when addressing it.