Corporate and Good Governance in German SMEs

Corporate and Good Governance in German SMEs

Since the peak of the financial crisis over three years ago and with the spectacular corruption cases in “role model” enterprises such as Siemens and Daimler, the subject of corporate governance has begun to arrive at management levels of both privately and publically owned German corporations.

This is not only affecting companies on the stock market. The directors, managers and boards of larger SMEs are also suddenly confronted with critical investors, shareholders, staff, customers and suppliers insisting on greater transparency, professional leadership and control structures, in short: good governance.

This article examines the different components and variants of corporate governance and uses practical examples to illustrate how businesses can achieve good governance, and are thereby able to generate a decisive competitive edge for themselves.

So what is the background to the concept of “corporate governance”? Except for a few internationally recognized principles, this has primarily evolved as a country-specific concept for responsible corporate management. Introduced in the 1930s in the US, corporate governance is now understood to be “a collection of all international and national rules, regulations, values and principles which are applicable to companies and which stipulate how these should be managed and monitored”. The management team at each company is called upon to implement and guarantee “responsible corporate leadership and control” for the long term.

Corporate Governance therefore incorporates:

  • Viable corporate management Safeguarding the interests of various groups (e.g. stakeholders)
  • Transparent corporate communication
  • Appropriate risk management
  • Sustainable, long-term management decisions

Since 2002 Germany has embraced the socalled Corporate Governance Codex, which is intended to fundamentally strengthen the confidence of major (international) investor in the management of German companies.

For many years corporate governance was primarily linked to the management and information policies of major businesses listed on the stock market. However, the trend towards globalization has now forced exporting German SMEs to also grapple with the subject. These medium-sized businesses, often defined as the backbone of the German economy, are facing fierce global competition. Exposed to the unforgiving scrutiny of the world market on their corporate management, control, finance and transparency systems, they will be forced to measure up to international standards in the future. In their role as suppliers to major global corporations, the SMEs will find themselves required to fulfill increasingly stringent criteria to prove themselves sustainably reliable business partners of superior quality. In other words: they need to provide evidence of “good governance”.

What distinguishes corporate governance for SMEs?

What does good governance mean for SMEs in particular? Although it is generally accepted that SMEs now also pursue the long-term target of securing and increasing their corporate value, the path they chose differs from that of major stock market corporations. Since the economic crisis of 2008/2009, family-run companies have realized that their objective is not always achievable by a direct route, one example being continually measured growth, but may have to consciously involve temporary phases in which it is not possible to attain their main goal of value enhancement to the extent that was originally planned. There are many reasons for this, including reconciliation of interests with employees or risk considerations for long-term investments. Another difference is the structure of the company concerned. Four key properties are of significance here when it comes to corporate governance.

Identity of owner and corporate management

In many SMEs the main partners are also active members of the executive management, which virtually rules out any deficit in information. A reform of the German limited company regulations (GmbH and GmbH & Co. KG) means that partners can become more directly involved in management than shareholders and have a much greater influence through the rules of association. This close connection between owner and management can, however, trigger crises in the company, as a result of family disputes or conflicting interests between partners and similar problems.

Size and structure differences in SMEs

SMEs differ from stock market corporations in their variety of sizes and legal forms, ranging from billion-dollar retail businesses, with nontransparent structures, to tiny start-ups with established advisory board and corporate management with limited power.

Financing options

In contrast to public companies, SMEs generally have limited financing options. Their lack of access to the capitals market restricts choice and leaves them largely dependent on classic banking finance.

Corporate succession

A key milestone in long-term corporate management of family-run businesses is often the appointment of a successor. If the management is to remain in the hands of the family, this requires that there are potential candidates in the family and necessitates optimal preparation of these next generations. In larger families we often see personal conflicts arising during this phase, which might even endanger the company‘s future.

How can corporate governance be tailored to SMEs?

When we consider the wide range of individual forms which an SME can take, it becomes hard to find “the” way in which corporate governance can be tailored to everyone in this segment. A legally stipulated codex, as we have for stock market corporations, seems impractical for SMEs and would probably only generate more red tape than anything else. The regulations in company and commercial law vary to such a degree that it would be impossible to define generally applicable rules of conduct. On the other hand, how can we help SMEs to master the increasing demand for corporate transparency and quality?

We think that the best solution would be the introduction of company-specific corporate governance, which the individual companies could use to document the priority which this factor has in their firms. This seems to be a necessity in view of the rating requirements for Basel II and its many quality-related steps, which need to be taken in order, to be classified as “investment grade”. When it comes to future corporate succession, clear formulation and documentation of management and control structures could pave the way to successful leadership. In addition, individual good governance guidelines, such as mediation rules, could help to prevent or defuse any family disputes. A company codex for good governance could therefore become a key component in sustainable development and value enhancement of the company.

In the following section we take a closer look at the individual building blocks of companyspecific corporate governance (see diagram 1).

individual building blocks of companyspecific corporate governance

1. Cultural and managerial continuity

Due to the close links between management and partners, continuity is of great importance and can include a variety of challenges, particularly when clarifying corporate succession. Successors need time to grow into their roles and the
retiring person, often the founder or mastermind behind the company, also needs space to let go. It is therefore imperative that the succession is planned at an early stage and in a systematic manner. Countless businesses are thrown into distress by sudden accidents or ill health suffered by the corporate leader, due to the lack of a succession plan which can be employed immediately.

If the intention is to find a successor amongst the partners or family, the potential candidates should be introduced to their managerial duties at an early stage. The suitability of these potential managers should be examined as objectively as possible during this period and the process pushed ahead with support measures, such as coaching.

Even plans for new management from external sources should be considered and planned with care. Although the options for third party support (such as personal consultants) are manifold, the process can still be time-consuming. It is not an easy job to find the ideal person or best team. If acute conflicts are already present, structured mediation can help to pave the way to a solution.

2. Creating clear management structures
In SMEs, information is often collected centrally for the top management and decisions are made on an authoritarian basis. One person frequently decides over the heads of all others. Although this style of management facilitates rapid decision making, it should be viewed critically for its dependence on the central leadership unit. If it should become unavailable, the company is left without its head and is therefore unable to operate. The remaining organization is set up to collect information but not to make decisions.

Secondly, fast exchange of information is hindered since all data must first be sent to the top management, instead of being circulated between the departments. More and more information is sent up, creating a bottleneck in which made decisions are difficult to examine.

Good corporate governance requires that rules of procedure and management, a leadership manual etc. are set up. It is advisable to define people who can assume responsibility in the event of emergencies, when key players are unavailable. Duties should be clearly delegated and those with responsibility should be allowed to make certain decisions, so that managers are not merely the recipients of orders, but can contribute and practice running the business. This would allow information to be processed independently and prepared within a management system so that it is passed to top management in a clear, concise form. An advisory board is an ideal support tool to allow proposals to be critically examined and avoid the consequences of rash decisions.

3. Business and management instruments
The use of business instruments needs to become more professional. Good governance means that tried and tested methods still need to be examined critically and the information systems employed must be advanced and powerful enough for the future. One negative example is unsystematic planning based on updated Excel lists, which are not consistent in their structure. Standardized tools and processes help plan ahead consistently and over long periods of time. Even if a lack of strategic or planning transparency is intentional, this is detrimental to the target of good governance. Modern computer systems allow for standardized working methods and shared access of database resources, giving business partners a more professional air.

In the case of systematic risk management, two aspects are of key importance. Controlling in SMEs is often past-oriented. Forward planning and early indication of risks is not common. Suitable IT systems can be used to combat this. As mentioned above, control bodies, such as an advisory board, can also be used for risk management purposes. For example, decisions which are relevant to the existence of the company can be submitted to the partners for voting or ratified by an advisory board.

4. Sustainable corporate financing
Many SMEs aim to remain independent of external financing partners and still sustain their existence for the long term. If this is to be achieved, there are two main points to observe:

Good governance includes defining clear, longterm guidelines for finance-related decisions. Remaining independent also includes not becoming financially dependent on individual suppliers or granting customers long payment periods,
which could get your company into a tight spot. The same applies, when a company is tempted by short-term or tax-related false incentives and ignores fundamental rules of finance e.g. maturity matching of capital commitments and transfers. Investments should be financed over the long term and working materials over the short term. Optimization in the short term, such as the procurement of new machinery using an existing credit line, can endanger the long term finances for the company. This kind of mistake can be prevented with clearly formulated rules and a systematic management structure as illustrated
above.

The increasingly difficult access to the capital market as a source of finance is another key aspect for SMEs. However, classic banking is not the only solution. Instead of obtaining funds from just one bank, the load could be distributed
over several institutes. Alternatives to conventional loans which could prevent a liquidity gap include sale & lease back and the sale of accounts receivables from clients with large orders and long payment periods.

By being aware of and choosing the right type of funding for individual situations, companies can maintain their freedom of action and independence.
A balanced financing structure, in line with the corporate structure, is a clear sign of good governance.

Governance systems should also cover regulations for clear communication and processing of information with funding partners. An air of openness can really help to achieve funding in this age of Basel II stringency.

Summary

Since SMEs take on a wide variety of forms, it makes little sense to enforce explicit statutory regulations. However, clear structuring of all corporate management topics in the individual companies will make your business more competitive, both internally and externally. Management transparency inside motivates staff, while good governance viewed from outside promotes confidence on the market and can be used to approach international business partners or find potential funding partners. As we have illustrated, there is no ideal solution and the governance structure must be individually tailored to the needs of each company. The best option is to document the rules and structures in a management manual, which can then be updated and adjusted as a vital part of corporate development.

By Jürgen Kohler, Partner, Tefen Germany
Markus Deimel, Consultant, Tefen Germany

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