CandidCapital

Can there be too much trust and mutual understanding between management and shareholders - and what are the potential implications of this?

In the preamble to the UK Combined Code on corporate governance, there is a rather lofty sentence: "Whilst recognising that directors are appointed by shareholders who are the owners of companies, it is important that those concerned with the evaluation of governance should do so with common sense in order to promote partnership and trust, based on mutual understanding."

The Benefits and Drawbacks of Effective Communications

This resonated with me when a fellow early-stage investor commented on the almost perfect match he observed in his portfolio between investees that had excellent investor relations and those that performed well financially. This makes sense - effective, timely accountability to shareholders requires good management information systems and communications processes. These are also virtues that enable a board to be well-informed about the performance of a business and enhance its ability to give relevant, timely advice where variance to plan or other unexpected events occur.

Sometimes, despite the best efforts of management, including an effective investor relations programme, shareholders lose their confidence in the progress of the business. Most obviously in public markets - where the amount of information available to shareholders is limited, as is the time and effort that an institutional shareholder can give to one small cap stock - there's considerable potential for confidence in the business and/or the management to evaporate when numbers are missed, even where the fundamental performance of the business is sound.

Investor Delusion & Cognitive Dissonance

Yet the opposite phenomenon also occurs - where the relationship between management and shareholders is so strong that faith can be maintained notwithstanding repeated underperformance. How is this - when human beings in random aggregation (such as investors) should behave in a reasonably consistent way? The answer may lie in that psychological phenomenon beloved of ad men - cognitive dissonance.

Investors don’t like tension between what management are telling them and the evidence they see in actual sales and profit performance. Get this wrong more than once in a public company and the stock price is likely to be hammered. Clearly there are two possible ways out of this dilemma: either make the sales and profit that you promise or, alternatively, promise something that the market can’t measure. It’s the latter approach that has characterised biotechnology investment since the 1980s. Most famously, British Biotech sustained a market capitalisation of nearly $2.5Bn in the mid 1990s when little real progress was being achieved in their therapeutics targeted at cancer and pancreatitis. The company’s fired head of clinical research, turned whistleblower, asserted that "the Board were running a business plan consistent only with extreme and unfounded optimism".

In one of our portfolio businesses, I can see some of the same characteristics: repeated failure to meet development milestones and an amazing suspension of disbelief by most shareholders. Why is this? First, the chief executive is an effective, and very low-key (which is often all the more convincing), communicator who instils confidence at general meetings and other presentations to investors and, secondly, the board is, essentially, compliant with the chief executive’s view of the business and its progress. When we've challenged the skill set of the board, suggesting that it needs strengthening in commercialisation and manufacturing expertise, we’ve been politely rebuffed – and there’s nothing we can do about it.

Good Communications are not Enough

This brings me back to the points made by Pangloss in his blog Trust but Verfity last November and my blog Lucifer’s Angels earlier in the year. You really cannot afford to give management free rein to divide and rule among shareholders in a private company – where investors don’t have the ultimate sanction of being able to sell stock when they lose confidence in management. The great risk for business angels, and seed funds which behave like angels (which was especially prevalent in the heady days of the late 1990s, as Pangloss points out) is that management can become essentially unaccountable, either to shareholders directly or to the board, if the board is itself appointed by the founder/founders alone.

That said, angels are getting savvier and increasingly operate as a coherent body through syndicates or funds which are capable of demanding and getting increased accountability such as the right to make board appointments. The UK government has also encouraged the growth of funds, most obviously Enterprise Capital Funds that specifically co-invest alongside angel investors, bringing the advantages of special share rights (especially on accountability) to the party with them.

The sentiments of the Combined Code “…promote partnership and trust, based on mutual understanding” are worthy objectives for the relationship between directors and shareholders, but worthless unless the relationship is underpinned by real accountability where the shareholders have the ability to influence management’s behaviour or even, if necessary, fire them.

3 February 2008