The governance imperative

In new-age companies with no promoters, institutional investors have a crucial role in shaping the board

Historically, for public market investors, it has been a straightforward exercise when assessing the governance and board dynamics of listed companies. The majority of these companies had a single large shareholder (the promoter), who held the largest block of shares, typically between 35 and 55 per cent of the equity.

The promoter would either directly be involved in management or appoint professionals, and they would have a major say at the board. Even with an independent board, as required by the regulator, most director nominations would be supported by the promoter group, and they would be elected unopposed. The mantra was clear: With their permanent and large shareholding, promoters exercised huge influence over the board and management of the company. You looked more to the promoter group than to the board for assurances on governance. There was no expectation of the board protecting you. In effect, you were making a judgement call on the promoter group to exercise proper governance and capital allocation, knowing that they were the largest shareholder and could not be easily voted out. You bought or sold shares in the company based on your level of comfort with the promoter group.

Promoters in India range from being world-class to value-destroying. Successful investing required one to figure out the quality of the promoter and where they stood on this spectrum of value creation. There were also a handful of companies in India that were truly board-managed. They had no dominant promoter group. However, India has not had a good experience with promoter-less, board-managed companies. With one or two exceptions, we have seen board capture and the emergence of the cult of superstar chief executive officer (CEO) in all these cases.

The board capture has led to compensation abuse, empire-building, weak succession planning, and poor capital allocation. The board has typically not been able to stand up to the CEO, with the CEO acting as the promoter with unchecked power, despite not having the shareholding. Institutional investors have not ensured true board independence. Even in the US, until activist shareholders became powerful and started attacking poorly-run companies and voting against the board, many boards were ineffective. Companies with broadly dispersed institutional shareholding were also prone to board capture by the professional management team.

The regulator, recognising this construct, has therefore empowered minority investors. Related-party transactions and many other critical issues now require the majority of the non-promoter shareholders to vote in favour. This is a far more powerful tool for investor protection than the board, given the current construct in India.

Today, however, we are seeing a new construct of the venture capital (VC)- and private equity (PE)-backed company. This universe is likely to deliver the majority of the future blue-chips, with hundreds possibly listing over the coming decade. These companies typically have the founder group having less than 10 per cent shareholding, with everything else being owned by the VC/PE funds. Before these companies list, they recast the board, including two-three investor directors, the founders, and three-four independent directors. These outside directors are often selected by private investors or the founders. However, in many cases, through amending the articles, some private investors retain disproportionate board rights even after listing and exiting the bulk of their shareholding.

The board in these new businesses is absolutely critical to protecting public shareholders. Public investors need the board to serve as a check and balance to both private investors and founders, whose time horizon and motivations may differ. The board has far more influence and power in a company with no single large permanent shareholder, and investors can be far more influential in shaping board composition. In older companies, the promoter group drives the board and the direction of the company, and see themselves as permanent shareholders. The founders and private investors are attempting to play the same role in new-age listings despite lacking permanent shareholding.

In these next-gen companies, we have a situation wherein institutional shareholders, each on their own, may own more than the founders. In many cases, founders act more like professional management, given their stake and time horizon. The VC/PE funds are going to exit completely. Therefore, these new listings have the construct of a company with no promoter.

Our track record with such companies is not good, as their boards were too weak and subservient to management. In a situation with no dominant single shareholder and fragmented institutional ownership, how the board is appointed, compensated, and driven becomes  critical. Who takes the lead on the board? How do they balance different stakeholder interests? We should not allow board capture by founders, as many do not have the maturity, time horizon, and stake to balance the interests of different stakeholders.

Given their lack of public market experience, institutional investors cannot always rely on the founders to drive the board to maximise value creation. There has to be enough properly-aligned and experienced people in the room. Founders in many cases act as if they have dual-class shares with supernormal voting rights, a concept that has thankfully not taken root in India. Institutional investors have to get much more involved and ensure there is a board in place that is truly independent and balanced.

Many companies are already experiencing a natural tension regarding Esops, employee stock options, and compensation for founders. Every founder group seems to demand significant shares prior to the listing to establish their shareholding at a respectable level, and some continue pushing for further equity grants post-listing. Deciding how much equity should be given, with what milestones, and at what price is a critical board-level decision. How do we handle succession? When should the original founders step down? What if they have lost the drive? What happens when these businesses turn cash generative? Another issue will be capital allocation. Most founders, being growth-oriented, don’t seem to have a mindset to return capital to investors. In these companies public market investors need to focus far more on the board’s selection process. Why should private investors who are by definition going to fully exit, decide the board? Should the founders with only a 10 per cent shareholding control the board? If these companies are going to be majority-owned by institutional equity investors, these investors must be involved in choosing genuinely independent directors who will protect the interest of all shareholders. Institutions cannot repeat their mistake of passively allowing board capture.

The market regulator has given public shareholders the tools to elect independent directors. Institutions must consult one another and rally behind directors they can trust to be independent. A misaligned board can cause serious loss of shareholder value. Genuinely independent directors exist today and more will assert their independence as investors demand neutrality. The company must be allowed to properly compensate these directors and give them equity in addition to fair compensation. True, there are fears around conflicts of interest, but most public market investors would much prefer directors who care about the share price and have skin in the game. The equity grants can vest over time and there can be a clawback mechanism to guard against short-term thinking or governance failure.

The quality and independence of the board are critical in these new listings. Many fail the test of independence, experience, and understanding whose interests they are tasked with protecting. Institutional investors have the opportunity to intervene and shape the board. It is critical that they exercise their fiduciary responsibility to their investors. One can no longer outsource governance to a promoter group with substantial ownership. They do not exist in these new-age companies.

The writer is with Amansa Capital