Even if a business has strong financials, talent is not enough – integrity is needed. Master investor Warren Buffett’s position on business performance has been: “In looking for people to hire, you should look for three qualities: integrity, intelligence, and energy. And if they don’t have the first, the other two will kill you.”  Given his track record, good corporate governance seems to be an essential part of long-term business success. Whether we go back to Michael Milken and his securities fraud, or more recently to Enron and Bernie Madoff, we have a wealth of examples of how poor checks and balances led people with intelligence and energy to behave in ways that clearly lacked integrity and cost many other people millions of dollars.

A 2003 joint Harvard and Wharton study entitled Corporate Governance and Equity Prices found that companies with good corporate governance generated superior future returns and higher profits and sales growth. The study created a “Governance Index” (G-Index) for each company based on the number of these 24 anti-shareholder provisions the company possessed. The higher the index score, the worse the company’s stock performed. Using data from 1990-1999, the study found find that companies with a low G-index score (i.e., a “democracy” portfolio) outperformed companies with a high G-index score (i.e., a “dictatorship” portfolio) by a statistically significant 8.5 percent every year. By 1999, a one-point difference in a company’s G-index score was associated with an 11.4 percent drop in a stock’s market value. Further, firms with weak shareholder rights were less profitable and suffered lower sales growth than comparable firms in the industry.

A 2009 joint Yale-Harvard study finds that the outperformance effect has waned in recent years as investors have learned about the importance of good corporate governance and adjusted the stock prices of good and bad companies accordingly.

In other words, bad corporate governance is now discounted in stock prices. Small-cap stocks and privately held businesses, where data is less available, seem to dodge the scrutiny of the large-cap stocks and purchasers of their stocks can take a “ding” on the regular.

How can we change the pattern in small to medium businesses?

1. Better corporate governance measures in privately held businesses should include a progression towards true, independent boards.
2. The boards should be evaluated on an annual basis (check out the Center for Board Excellence.)
3. Matters such as compensation, family members in the business, succession plans, etc. need to be discussed in board meetings and action plans developed.
4. Organizational development principles should lead to better talent management and the assignment of shared decision-making outside the CEO’s office.
5. Internal controls need to be examined and improved to mimic best practices of a public company in a Sarbanes-Oxley environment.