“Corporate Governance.” Perhaps the term seems out of place in a journal devoted to entrepreneurship? Entrepreneurship, whether found in a start-up or an established company, implies innovation, strategy and corporate renewal. Corporate Governance, by contrast, is seen as a “soft” form of corporate regulation that restricts and perhaps confines management. Moreover, decades of studies of different corporate governance approaches have not produced a consensus on whether and how corporate governance matters for corporate performance. On the other hand, as Ken Bertsch, the former head of the Society of Corporate Secretaries, once pointed out, “How could it not?”

In fact, effective corporate governance is essential for creating entrepreneurial organizations that are built to thrive. Corporate governance describes the relationship between all stakeholders that determines the strategic direction of the organization. Understanding the systems by which the company makes strategic decisions, executes its business plans, and holds management accountable offers insights about whether the firm has the capacity to innovate, execute, and create long-term value.

Historically, companies’ governance has been judged according to the formal rules, such as board structure, compensation plans and voting rights – what some call the “hardware” of corporate governance. The virtue of studying “hardware” is that precise and comparable information is available from the company’s regulatory filings. While there is value in this approach, there are limitations as well. Apparently well-designed governance structures can mask deep conflicts of interest, as in the well-known cases of Enron and Lehman Brothers, or less dramatic but nevertheless significant weaknesses that may signal a long-term risk to shareholder value.

Corporate governance “hardware” matters to the extent that it facilitates quality interactions among corporate stakeholders – the “software” of corporate governance. But the tools to evaluate “software” have until recently eluded researchers because outsiders lack a robust perspective on the discussions that take place among managers, boards, and shareholders — much less the company’s engagement with employees, customers, communities and regulators. However, an emerging body of studies are beginning to address this limitation by assessing the quality of the firm’s relationships and its impact on performance. Here we consider a few recent studies that shed light on what makes good corporate governance.

Although listing standards and most investors expect that boards include a majority of independent directors, the literature has not definitively linked independence to higher shareholder value. Listing standards consider directors “independent” if they lack conflicts of interest arising from an employment, familial or business relationship with the company. Formal independence does not guarantee that a director will be capable of providing independent perspectives or judgment necessary for effective board leadership.

A recent working paper from the European Corporate Governance Institute [1] considered individual directors’ relationships more broadly, including their professional, educational and social networks. The paper found that boards that directors with stronger social networks were associated with higher firm valuations. The study posited that these “powerful” directors’ external relationships made them better informed, more able to avoid groupthink and more willing to dissent. In other words, it was not enough to be legally independent; directors add value to the company when they are in a position to behave independently.

Another important aspect of corporate governance is the firm’s relationship with its external stakeholders, including employees, regulators, communities, and the environment, which can all exert significant influence on a firm’s key strategic decisions. Many advocates of corporate social responsibility claim that good relations with stakeholders can be seen as a proxy for good management.

A recent study[2] provided direct evidence for this hypothesis by examining the relationship between high quality management and corporate social responsibility practices. The study used a dataset of company responses to a survey about the use of 18 management techniques that had been shown to correlate with strong firm performance. The study found that companies whose top executives use these best management practices are more likely to invest in positive social responsibility practices as well.

These studies complement the research of shareholder engagement and firm performance.

Some institutional shareholders engage directly with portfolio companies to advocate action on corporate social and environmental impact. The effectiveness of these engagements has been difficult to track because these dialogues tend to be confidential. However, two recent studies[3] have begun to shed light on this practice. The Dimson, et al, study considered the results of thousands of individual cases of shareholder dialogue, while Flammer looked specifically at shareholder proposals that received majority support. Both studies demonstrate that successful shareholder engagements (either because they receive majority shareholder support, or because they result in policy change) are associated with improved operating and financial performance.

Historically, investors have inferred corporate governance practices from formal board structures that may or may not accurately signal the quality of firm decision-making. Together, these studies begin to open the “black box” of corporate governance, suggesting ways that investors may be better able to evaluate a firm’s capacity for long term value-creation by more directly understanding the quality of a company’s management practices and relationships with their stakeholders.

It only with an infrastructure of trust and material transparency that today’s innovators can realize the true promise of entrepreneurship.

John K.S. Wilson is the Head of Corporate Governance, Engagement & Research at Cornerstone Capital Group and an Adjunct Assistant Professor at Columbia Business School.
[1] Fogel, Kathy and Ma, Liping and Morck, Randall, Powerful Independent Directors (January 9, 2014). European Corporate Governance Institute (ECGI) – Finance Working Paper No. 404/2014. Available at SSRN.
[2] “A Good Horse Never Lacks a Saddle: Management Quality Practices and Corporate Social Responsibility,”Najah Attig,Associate Professor, Canada Research Chair in Finance Saint Mary‘s University, Halifax, Canada, February 07, 2012
[3] Dimson, Elroy and Karakaş, Oğuzhan and Li, Xi, Active Ownership, June 4, 2013, (available at SSRN) and Flammer, Caroline, Does Corporate Social Responsibility Lead to Superior Financial Performance? A Regression Discontinuity Approach, October 2013 (available at SSRN.)