Corporate governance characteristics of growth companies: an empirical study.

Ramaswamy, Vinita ; Ueng, C. Joe ; Carl, Lee 等

ABSTRACT

High growth companies face many challenges, encompassing the numerous demands of new product innovation, market shares and customer satisfaction. This paper studied the hypothesis that, due to time and resource constraints, high growth companies will find it exigent to formulate and disseminate an elaborate, structured policy of corporate governance. To test this hypothesis, a corporate governance scoring system was developed and computed for 500 firms, based on the guidelines of accountability, responsibility, internal controls, and audit procedures. A life cycle analysis was also performed to identify differences in corporate governance characteristics of "initial growth" and "revival" firms, since both groups face the same challenges of dealing with increasing sales, customers, products and innovation.

The results indicate that initial growth firms had lower corporate governance scores when compared to other firms. Revival firms showed higher scores, indicating that a well developed system of corporate governance added a much needed synergy for growth. Finally, a regression analysis indicated that certain fundamental characteristics such as Board development and Audit Committee role were equally well -detailed for growth and revival firms, but other corporate governance features such as ethics policy, shareholder value, reporting transparency and corporate citizenship were much better elaborated for revival firms.

INTRODUCTION

Within the intricate complexities of the business world, corporate governance is defined as a mechanism to maximize firm value. Empirical research over the past decade has shown a causal relationship between governance and market value. This evidence comes from both single-country studies (Black, 2001 on Russia; Black, Jang and Kim, 2006 on Korea; Gompers, Ishii and Metrick, 2003 on the U.S.) and multi-country studies (Durnev and Kim, 2005; Klapper and Love, 2004).

The advantages of corporate governance have been well documented. Good governance systems lead to better access to capital, improved performance, and reduction of risk. However, implementing effective governance systems also comes at a cost. Technology constraints, lack of financial and business understanding of the system, and the cost of implementing and communicating corporate governance policies throughout the organization are crucial barriers which many firms, especially small ones face.

In today's high risk, high growth economy, companies need to set a strong strategic course and have the capability to survive in the fiercely competitive environment. Rapid growth firms have many challenges to face, starting from cash flows, human resources, product quality, imminent deadlines and customer satisfaction. Once a successful working environment is established, a well-oiled system of corporate governance will be highly rewarding. However, in the growth phase of a company's life cycle, the tendency of management will be to focus resources on revenue increase, and the value chain that links vendors and customers through their organizations. This paper studies the relationship between firm growth, life cycle stages and corporate governance characteristics. The rest of the paper is organized as follows: an explanation of the concepts of growth and corporate governance, and their interrelationships, development of the hypothesis, description of the methodology for measuring growth, life cycle stage and corporate governance scores, the statistical tests used, and the results.

GROWTH COMPANIES AND THEIR STRATEGIES

The organization life cycle model suggests that a company moves through a predictable sequence of developmental stages over its life time. These stages are sequential in nature, and are not easily reversible. Each stage can be clearly demarcated and involve a broad range of organizational activities and structures. There are a number of models describing the life cycle of a company, but most models divide the life of a company into the following five stages:

Start--up: This is the initial stage where a business organization is formed, funds are raised, and a business plan is written.

The Growth phase: The product/service is now being marketed, revenues increase, employment and asset growth are common.

Maturity: The organization has fully developed its market and its products, revenue growth has flattened, there are declining profit margins, and debt loads.

The Renewal phase: With the injection of new management, new ideas, products and funds, the organization enters into its second growth phase, once again leading to higher revenues and products.

Decline: Due to changes in the economy, society or market conditions, sales and profits can decline. Negative cash flows and shrinking markets can lead the company to exit the field.

Different stages in company's life cycle necessitate appropriate changes to the firm's objectives, strategies, planning, organizing, controlling, technology and even the very culture of the company. Growth phases are usually the most frantically demanding areas, where the company is identifying new products, new markets, new sources of finance and therefore constantly changing strategies. It is usually identified with substantial turmoil as the company tries to cope with the changing landscape of business. The focus of the organization is on creating customer value, marketing strategies, product/service innovation and cost control. In this stage, corporate governance is a regulatory requirement, not a competitive tool.

CORPORATE GOVERNANCE

The concept of corporate governance is not new--it has been around for a long time. However, with the recent demise of companies such as Enron, WorldCom, HealthSouth, and Arthur Anderson, the business community, under increasing scrutiny, has brought a renewed focus on the importance of corporate governance. A study of these failed firms indicated that there was a lack of consistent policies, control procedures, guidelines and mechanisms to ensure accountability and fiduciary duty. A corporate governance structure specifies the distribution of rights and responsibilities amount different participants in the corporation, and spells out the rules and procedures for making decisions on corporate affairs.

The OECD defines corporate governance as follows "....the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which company objectives are set, and the means of attaining those objectives and monitoring performance."

The World Bank has a slightly different view: "Corporate governance is about promoting corporate fairness, transparency and accountability." The core values of an efficient system of corporate governance are as follows:

Fairness: Protecting shareholder rights and ensure the equitable treatment of all shareholders including minority and foreign shareholders.

Responsibility: Recognizing the rights of all stakeholders as established by law, and encouraging active co-operation between the corporation and stakeholders in creating wealth, jobs and sustainable enterprises.

Transparency: Ensuring adequate and timely disclosures of all material matters regarding the company, including its financial situation, performance, ownership and governance structure.

Accountability: Providing for the strategic guidance of the company, effective monitoring of management and its accountability to the stakeholders.

Five years after the establishment of the PCAOB, corporate governance has not lost its importance in the business field. A recent study by Institutional Shareholder Services (ISS) found that corporate governance is not just a compliance objective--it has now become a major business imperative. Companies are discovering that a good system of corporate governance enhances returns, provides for better risk management, improves investor satisfaction and reputation, and provides better access to capital markets. According to the ISS study, respondents predicted increasing importance for corporate governance.

Yet there are serious costs involved in setting up a feasible and practicable system of corporate governance. Some of the costs involved are as follows:

 Hiring dedicated staff such as corporate secretaries, experienced
 and independent directors, internal auditors, and other governance
 specialists

 Payment of fees to external counsel, auditors, and consultants

 Costs of additional disclosure

 Increased managerial and supervisory time

Further, corporate governance is not a single event, but a continuous process. Management needs to:

 Be fully informed on existing and changing stakeholder and
 regulatory expectations and determine the implications for company
 strategy.

 Assess the resources and expertise the company has to implement
 changes and determine whether it is necessary to outsource to
 external professionals

 Create/amend existing policies to create a framework that meets the
 company's specific needs

 Communicate the changes to stakeholders, shareholders and
 regulators.

This is a cyclical process that needs continual management involvement for a company to fully realize the advantages of a corporate governance framework.

In a growth environment of rapid changes, high risk and uncertainty, managerial focus is on developing effective strategies for competitive advantage, innovation and market position. A company may not have the time, resources or the leadership to formulate and institute a company wide policy of effective corporate governance, with all its attendant details. This paper examines the corporate governance policies of high growth firms in comparison with a control group to test the hypothesis that there are distinct differences in corporate governance characteristics between the groups. A life cycle analysis shows that firms experience rapid growth twice: once during their initial growth stage, and later during the renewal stage. Firms are therefore separated according to their life cycle stage, and corporate governance characteristics are compared for firms in different stages of the life cycle.

HYPOTHESIS DEVELOPMENT

Corporate governance is the set of processes, policies, laws and institutions affecting the way a corporation is directed, administered or controlled. This complicated structure of rules and regulations is there to encourage the efficient use of resources and to require accountability of those resources. Elaborate systems and processes to deal with matters such as delegation of authority, performance measures, assurance mechanisms and reporting needs require the expenditure of time, effort and resources. Growing companies usually do not have a plethora of those three things to work on corporate governance.

The growth of a company is usually associated with its ability to innovate, which implies constant changes to products, processes, and organizational and managerial practices. This requires continuous adaptation to the changing business environment, and developing sustainable relationships with other firms, vendors, and financial institutions. Evans (1987) found that young firms, smaller firms had faster growth, and also found a significant (and positive) coefficient of the interaction between size and age. Such young, fast developing firms are referred to as "gazelles."

To succeed, these companies need to set targets, determine responsibilities and monitor profitability, customers, innovation and financing. Experts suggest that, for a young company to grow, the management hierarchy remain flat rather than layered. Executives of such companies, therefore, are still trying to find a internal organizational structure that works well, and therefore will not have the time or the opportunity to set up a well defined corporate governance system. This suggests the first hypothesis for the study:

[H.sub.1]: The corporate governance scores for companies characterized as high growth will be lower than the scores for other companies.

Growth occurs in two stages of a company's life cycle. The revival stage also sees a period of great activity where product innovation, sales growth and profitability once again become crucial factors in the company's strategy to grow and survive. But these companies have already been through their maturity phase, with settled markets and customers, and have had the time to set up a workable, detailed corporate governance framework. Since corporate governance is now a regulatory requirement, the political cost hypothesis would suggest that these companies would have stellar systems. Added to this, is the fact that mature/revival companies would not have "flat" management systems, but well-developed hierarchical structures that require a good system of governance for fairness and transparency. So the second hypothesis of this study is set up as follows:

[H.sub.2]: The corporate governance scores for companies characterized as "revival" firms will be higher than the scores for other companies.

A truly effective system of corporate governance has many features that involve Board structure and effectiveness, strategic planning and monitoring, risk management, audit committees, internal control, corporate ethics, and transparency in disclosure. A new growth company may not have the resources to develop every facet of a corporate governance policy. So the third hypothesis is an exploratory study of the various elements of the corporate governance policy and its development in relation to the growth and other life cycle stages of the firm.

[H.sub.3]: The corporate governance scores for companies characterized as "initial growth" will show an unequal development of the elements of corporate governance as compared to the scores for "revival" companies.

METHODOLOGY

An initial sample of 500 firms were randomly selected from S&P 500 and S&P 600 to get a wide range of capitalization and firm age. S&P 600 firms, in general, tended to be newer and smaller than the S&P 500 firms. These firms were then measured for growth, life cycle stage and corporate governance scores.

Measuring Growth Firms

A growth company is usually defined as a company that has performed better than the industry average over a period of years and is expected to continue to do so in the future. According to Delmar (2003), a firm's growth can be measured in terms of inputs (investment funds, employees), in terms of the value of the firm (assets, market capitalization, economic

value added) or outputs (sales revenues, profits). The synergistic effects of the three facets of a firm's strategy indicate its growth position within the industry. As commonly measured,

G = [(E/B).sup.1/n]-1

G = growth of a firm

E = ending balance of the variable such as firm size or revenues

B = beginning balance of the variable

n = period over which growth is measured

The actual growth path of a company can be traced by using the various measures of input, output and value. Table 1 describes the growth measures.

The Growth Indicators were combined as follows to compute the growth measure for a specific firm.

[G.sub.f,t] = [[([TA.sub.t]/[TA.sub.t-1]).sup.1/n] * [([MC.sub.t]/[MC.sub.t-1]).sup.1/n] * [([EMP.sub.t]/[EMP.sub.t- 1]).sup.1/n] * [([ICI.sub.t]/[ICI.sub.t-1]).sub.1/n] * [([SA.sub.t]/[SA.sub.t-1]).sup.1/n] * [([NI.sub.t]/[NI.sub.t- 1]).sup.1/n]]-1

g = Growth

f = specific firm

t = year used to test the hypothesis

n = period over which growth is measured

This growth measure was computed for all the firms in the sample ([g.sub.f]) , as well as for the firms in the industry in which the firm was located. Firms with negative growth were discarded, as these firms had a low chance of survival. The industry average for the growth rate was then computed as the simple mean of the growth measure of the all the firms within the industry, defined by the three digit SIC code ([G.sub.I]). For each firm within the sample, the following variable was computed:

[G.sub.F] = [g.sub.f]-[G.sub.I]

where [G.sub.F] is the incremental growth rate for the specific firm in the sample. The sample firms were then ranked according to the incremental growth rate. Fast growth firms and a comparative sample were identified as follows:

Measuring firm life cycle stage

Anthony and Ramesh (1992) use four classification variables to indicate a firm's position in its life cycle. These variables are: dividends, sales growth, capital expenditure and years of life. Dickinson (2005) uses cash flows from operations, investing and financing to identify life cycle stages. Yan (2006) suggests that these variables should be adjusted for industry level to adjust for industry specific characteristics. This study uses the following variables to test for the life cycle stage of the firm:

Based on the above variables, a life cycle score is developed for each firm within the high growth sample, the slow growth sample, and the median growth sample, thus:

LCSC = SCYL + SCSG + SCDV + SCCI + SCCF,

where LCSC is the Life Cycle Score.

The firms are ranked according to their life cycle scores within each growth sample. The top 33% are in the revival stage, the bottom 33% are in the growth stage. Firms which have a life span of less than 5 years, and firms which have a declining sales growth are rejected from this sample because they would be in the start up stage or declining stage. Corporate governance scores are then computed for each firm in the growth samples.

Based on the above computations, six groups of firms out of a sample of 361 firms are identified as follows in Table 4.

Out of the initial 500 firms, 139 firms were rejected because they were less than five years old or in the initial life cycle stage, or because they were considered to be in the decline stage of the life cycle. Both these stages were not studied in this paper.

Corporate Governance Scores

A well-developed system of corporate governance provides a framework for decision making within the organization, setting and achieving objectives, and monitoring performance. It is a many faceted structure that encompasses the following concepts:

* Board Structure and Composition (BC)

* Board Operation and Effectiveness (BE)

* Audit Committee conduct (AC)

* Strategy, Planning and Monitoring (SP)

* Risk Management and Compliance (RM)

* Corporate Ethics--a well developed and adequately disseminated policy (CE)

* Internal Control system (IC)

* Creating shareholder value with clarity of business objectives, anti takeover measures, dividend policies, pre-emptive rights and clear lines of communication (SV)

* Transparency and Fairness in disclosure (TF)

* Corporate Citizenship that takes into account responsibilities towards consumers, employees, the environment, and other stakeholders in a corporation (CC)

The Corporate Governance Score in this study assigns 10 points to each of the above categories for a total of 100 points. Each firm in the sample is assigned a score based on the study of its corporate governance policies available on its website, proxy forms and 10--K's as follows:

CGS = BC + BE + AC + SP + RM + CE + IC + SV + TF + CC

The average score for each group in the study is then computed (Table 5). To investigate the differential impact of growth on the various components of corporate governance, the following regression analysis was performed:

GR * LC = [alpha] + [[beta].sub.1] BC + [[beta].sub.2]BE + [[beta].sub.3]AC + [[beta].sub.4]SP + [[beta].sub.5]RM + [[beta].sub.6]CE + [[beta].sub.7]IC + [[beta].sub.8]SV + [[beta].sub.9]TF + [[beta].sub.10]CC + e

where: GR is the Growth score for each firm, LC is the switch indicating whether the firm is in the initial growth stage or the revival stage of the life cycle, and e is the error in the OLS regression.

RESULTS AND CONCLUSIONS

The purpose of this paper was to explore the corporate governance characteristics of growth firms, to examine the effects of a firm's life cycle on corporate governance, and to specifically test for differences in the various components of corporate governance. Firms were classified according to their growth levels and life cycle position, and a Multiple Analysis of Variance (MANOVA) was performed on the nine groups, with growth as the independent variable. Wilk's Lambda was used to test the significance of all the groups, while Tukey's univariate tests were used to test for two groups at a time.

The MANOVA was adjusted for uneven sample sizes. Wilk's Lambda indicated a significant difference in governance scores between the groups. Univariate testing showed the following:

 The governance scores for the high growth/initial growth firms was
 significantly lower than the median growth/initial growth firms.

 The difference between the high growth/mature firms and the median
 growth/mature firms was not statistically significant.

 The high growth/revival firms had the highest scores among all
 groups, statistically different from all the groups.

 The low growth firms in all three life cycle had the lowest
 governance scores.

An OLS regression analysis had an overall R2 of 13%. The Life Cycle variable was significant, as were Corporate Ethics, Creating Shareholder Value, Transparency and Fairness, and Corporate Citizenship. The variables related to the Board and Audit Committees showed no significant relationship to the growth of companies.

The past few years have seen many upheavals in the corporate world. The rapid growth of the stock market has been accompanied by financial scandals that have bankrupted some of the biggest companies in the country. Corporate governance, which is the structure by which companies plan, operate and monitor their activities, is essential for increasing shareholder value and trust. But governance systems take time and effort to devise and implement.

This paper studied the corporate governance characteristics of growth companies in two stages of their life cycle--initial growth and revival. Analysis of variance showed that initial growth companies had lower corporate governance scores as compared to slower growth companies, while revival companies had highest scores as compared to mature companies, and slower growth companies in the revival stage. This indicates that fast growing revival companies fully utilize the advantages of a well-developed corporate governance system to augment their growth strategies.

A further analysis of the specific characteristics of the corporate governance systems showed that certain basic features of governance, such as Board structure, composition and operation as well as Audit committees were utilized by most companies--many of these features are mandatory requirements of the Sarbanes Oxley or stock exchange regulations. Other features such as Corporate Citizenship, Ethics policy, Disclosure of information and Shareholder relationship showed significant differences between growth and non-growth firms.

REFERENCES

Anthony, Joseph H. & Ramesh, K., (1992). "Association between Accounting Performance Measures and Stock Prices", Journal of Accounting and Economics, 203-227

Black, Bernard (2001), "The Corporate Governance Behavior and Market Value of Russian Firms," Emerging Markets Review, 2, 89-108.

Delmar, F. et al. (2003) Arriving at the high-growth firm, Journal of Business Venturing, 18, 189--216.

Dickinson, Victoria, (2005). "Firm Life Cycle and Future Profitability and Growth", working paper, School of Business, University of Wisconsin-Madison.

Durnev, Artyom & E. Han Kim (2005), "To Steal or Not to Steal: Firm Attributes, Legal Environment, and Valuation," Journal of Finance , . 60, 1461-1493.

Evans, David S., (1987). "The Relationship Between Firm Growth, Size, and Age: Estimates for 100 Manufacturing Industries", The Journal of Industrial Economics, 35( 4), The Empirical Renaissance in Industrial Economics (Jun., 1987), 567-581.

Gompers, Paul, Joy Ishii & Andrew Metrick (2003), "Corporate Governance and Equity Prices," Quarterly Journal of Economics, 118, 107-55

Institutional Shareholder Services Inc. (2006) "Why is corporate governance so important today?" Soxfirst.com/50226711/2006 ISS Global Institutional Study 1

Klapper, Leora F. & Inessa Love (2004), "Corporate Governance, Investor Protection, and Performance in Emerging Markets," Journal of Corporate Finance 10, 287-322.

Vinita Ramaswamy, University of St. Thomas

C. Joe Ueng, University of St. Thomas

Lee Carl, University of St. Thomas

Table 1: Growth Indicators

Growth Indicators Description

Value Total Assets (TA)
Value Market Capitalization (MC)
Inputs Number of Employees (EMP)
Inputs Investment Cash Inflows (ICI)
Outputs Sales (SA)
Outputs Net Income (NI)

Table 2: Identifying fast growth firms

Value of [G.sub.F] Variable Identified

Top 25% (125 firms) Fast growth firms
Next 10% (50 firms) Buffer zone to separate fast
 growth and median growth firms
Next 25% (125 firms) Median growth firms
Next 15% (75 firms) Buffer zone
Last 25% (125 firms) Slow growth firms

Table 3: Life Cycle Variables

Variable Description

Years of life The initial growth phase occurs
(SCYL) early in the life cycle. Revival
 occurs later

Sales growth Growth firms will have increasing
(SCSG) sales growth, mature firms stagnant,
 and declining firms will have
 declining sales growth

Dividends A growth firm will pay very little
(SCDV) dividends. Mature, revival firms
 will continue to pay higher
 dividends to avoid signaling news of
 possible decline

Capital Revival firms will have the
investment resources to invest heavily. Next
(SCCI) will be growth firms.

Cash Flows Growth firms have positive
(SCCF) operating, negative investing and
 financing. Revival firms should
 have high positive operating cash
 flows

Variable Measurement Score

Years of life 5 - 10 years 1
(SCYL) 11 - 15 years 2
 > 15 years 3

Sales growth 3 year firm sales 3 if in top 33%
(SCSG) growth--average 2 if in middle 33%
 industry sales growth 1 if in bottom 34%

Dividends Firm dividends-- 3 if in the top 33%
(SCDV) minus industry average 2 if in middle 33 %
 of dividends 1 if in bottom 34%

Capital Cash investment from 3 if in top 33%
investment statement of cashflows 2 if in bottom 34%
(SCCI) 1 if in middle 33%

Cash Flows Operating cash flows-- 3 if in top 33%
(SCCF) (investing plus 2 if in bottom 34%
 financing cash flows) 1 if in middle 33%

Table 4: Test Groups

 High Median Low
Growth/Life Cycle Growth Growth Growth

Initial Growth 36 54 27
Maturity 11 33 42
Revival 61 73 24

Table 5: Average Scores

 High Median Low
Growth/Life Cycle Growth Growth Growth

Initial Growth 63.82 72.15 57.33
Maturity 73.65 69.84 58.36
Revival 77.32 67.35 59.39