You're more than the 'hall monitor'

STRATEGY You re more than the 'hall monitor' How directors contribute to strategy development determines the real value they add to a company. But governing strategy means asking tough questions and putting the proper 'scaffolding' in place. BY MIKE KIPP I T IS HARD TO HAVE a conversatioii about governance without getting the impres- sion that the board is the "hall monitor" in the affairs of an organization. The busi- ness press, the analysts, and the critics seem single-mindedly focused on oversight — driven by SOX, related-party transactions, options back- dating, and executive compensation, among other concerns. Heads nod with exaggerated solemnity as someone says, "You have to be ready to ask the tough questions." It's as if managers were errant children in need of adult supervision. (And, in- deed, some are.) But here's a tough question for directors them- selves; How does the board add value? yioi^ spe- cifically, what is the board's role in developingznd governing strategy? This is far from an academic concern. A recent McKinsey study surfaced the discomforting find- ing that "less than 25% of directors know their company's strategy" and "less than half are knowl- edgeable about the 4 or 5 key initiatives underway at any given time." No wonder CEOs often see their boards as too conservative and too uninformed to contribute to strategy beyond receiving goo(/inten- tions and good news. So, as directors we're good with Section 404. Are we done? No. Compliance is "table stakes"— only a precondition to placing the kinds of "bets" that add value over time. Series of ongoing choices One of the board's key responsibilities is to guide strategy, policy, and core ideology. This goes beyond simply knowing\\\c "game plan" to actively and ap- propriately pflrf(dp(Um^ in robust dialogue around aspirations and direction. Directors who truly add value also know that strategy goes beyond the col- lective enthusiasm to "grow the business." They see it as a series of ongoing choices about customers, competitors, and competencies — a "pattern of response to market needs, consciously selected in light of probable shifts in the environment, rela- tive competencies of the firm, and the contingent moves of intelligent competitors" (definition of strategy from The Intelligent Enterprise, James Brian Quinn, Free Press. New York, 1997). Clearly, the CEO is the chief strategist for the company. Boards shouldn't kid themselves on this. Strategy development, though, is the product of a conversation between leadership and the board, starting with the CEO and proceeding as a kind of "volley." As with all good conversations, it is fueled by good information and good questions. Leadership's opening salvo always raises gover- nance choices that will ultimately guide strategy and inform its execution: the adequacy of capital structure, the implications for various stakeholders, the implied compro- mises and risks, etc. These should be teased out of the working hypothesis and deliberated by the directors and management in what might be called "generative dialogue." That's where the real tough ques- tions come in. the ones that invite reflection rather than closure. They don't pull answers out of someone's "mental inventory" but breathe life Mike Kipp is an organizer and director of American Home Bank, just named to the Inc. 5000 list of high-growth companies for 2007. HB is also a founding director of Hope International Capital Corp. As a consultant, he works with boards and management on issues reiated to strat- egy, governance, and executive development (www.mikekipp.coml. FOURTH QUARTER 2007 49 STRATEGY The board should own the objectives — not the strategy. into the issues themselves. They are legitimatized precisely because they defy simple resolution. They take the conversation to the place where busi- ness judgment lives and value gets added {or de- stroyed). As in this scenario: "Thirty-five percent of our turnover is unprofitable and half isn't growing, so how come 90 percent of our balance sheet is com- mitted to a North American business that's got nowhere to go but down?" No one may be hiding these "inconvenient truths" but they may be lan- guishing for a whole variety of legacy reasons that can be confronted only at the governance level. A tough scenario for a bank board Let me personalize this even more. For nearly five years, a board that I am involved with, American Home Bank, has watched subprime, Alt A, no-doc, in- terest only, and other innova- tive "products" — products introduced in part to drive home ownership beyond 60 percent consistent with a Clinton administration poli- cy on facilitating home own- ership — challenge our differentiation strategy in new construction lending. Given our mission "to help people afford, buy and enjoy the home of their dreams," we applauded this policy even as we wor- ried about the fundamentals. As the home owner- ship index approached 70 percent, $1.5 trillion in transactions — more than half the total for 2006 — "left" the traditional mortgage-lending business as we knew it. We kept our powder dry and held the question of our participation in offering riskier loan products through every board and three annu- EXHIBIT1 Boundary Conditions Legal, Moral, Ethical Constraints Aspirations Ethical Discretion Basic policies 'Strategic Hypothesis' a! shareholder meetings, all the time being chided by those who felt that our growth lagged industry standards. None of us knew the answer, regardless of how it was asked, but board and CEO alike were convinced it was the right tough question. To successfully partner around such questions, both directors and executives must: • Be aligned around the value proposition — why the business gets "hired." • Have a common view of the mechanics of the business model. • Know how customers "use" the business. " Understand how value is created or destroyed for all parties. " Grasp the key choices involved in strategy. This is a great "punch list" for board develop- ment, by the way. The answers can be brought into sharp focus through the use of three deceptively simple frameworks — boundary conditions, rules of engagement, and a context map. Boundary conditions Boards govern best when they establish and main- tain a set of boundary conditions that embody their vision and values, the aspirations that capture their stakeholders' best hopes, their preferences regard- ing key tradeoffs, and a "working hypothesis'* on the path to their "preferred future." As Exhibit I points out, boundaries also define the discretion the CEO can exercise pursuant to those aspirations. A gov- erning board that struggles to be civil rather than dear on these matters sets the stage for what will inevitably become a strained working relationship. The boundaries framework keeps conversations about relative risks and self-imposed constraints from coming off the rails. It also greatly facilitates the recruitment process for a new CEO, informing both the board and the candidate. Rules of engagement This is a set of explicit agreements on "how we work together" — how business is conducted, how members interact with management, how decisions are made, and how difficult conversations are car- ried out. These agreements are often "baked in" to formal bylaws and committee structures. They are best developed against the backdrop of a few simple principles: • Governance is a form of ownership, not an ex- tension of management. • Boards need frank, unfiltered dialogue. • 1 he board speaks with one voice or not at all. • Trivial "board packages" invite trivial discus- sion. • Board deficits drive board development. These are common sense but uncommon practice. In a world that loves SWOTs {analy- sis of "strengths, weaknesses, opportunities, and threats"), directors have been curiously exempt from the assessment of their own deficits. Compa- nies and their constituents are well served by'Vules" that engender periodic evaluation and continuous improvement. And as for the value-adding power of sound policies, boards can save hours of well-in- 5O DIRECTORS a BOARDS STRATEGY tentioned manipulation by agreeing to speak with one voice or not at all. Finally, the practice of a standing executive ses- sion in the spirit of frank and unfiltered dialogue takes the"uhoh"out of calling them. The context map Both boundary conditions and rules of engagement are developed tor a particular context. In the final analysis, tliey are intended to ensure alignment be- tween governance and management and fidelity to the interests of the market. Exhibit 2 reflects the defining attributes of any context and the relation- ships among its parts. An informed board should be clear on the nuances of each and their impact on the range of available options. Until board mem- bers fully understand their context and agree to shoulder responsibility for its internal contradic- tions, they will be unable to separate their preju- dices from their business judgments. The "map" enables them to appreciate the complexities of their situation and have the conversations necessary to enjoy success. A fine point With this foundational scaffolding in place, the value of the board in strategy is its perspective. Utter detachment serves no one, but excessive iden- tification with a specific game plan disempowers the CEO and dilutes accountability. To put a fme point on it, the board should own the objectives— not the strategy. Examples of this in action: • Tbe directors of a financial services firm insist- ed on a sustainable 5 percent market share to pre- serve customer "share of mind" in a consolidating industry; strategy was left to executive discretion. • The board of a privately held parts manufac- turer aspired to an enduring 15 percent return on equity, noting its openness to alterations in the business model to get it. • Trustees of an industrial products firm sought to attain the status of a Fortune 500 firm, setting the table for a decade of acquisitions and organic growth • A supplier to municipal utilities was directed by its board to grow its business to at least 15 percent of corporate turnover in the interest of achieving "material significance" within tbe portfolio. Board members should also be aware of the potential for "contaminating" their perspective witb tbeir personal risk profile. The long-tenured retail executive may have wonderful insigbts for the software firm selling into his space but a vastly different point of view on the risks and rewards ap- propriate to the industry in wbich he now exercises governance. Tuning a board's perspective to the rigbt channel is the job description of tbe chair. In this regard, directors are a bit like meteors circling tbe orga- nizational planet: Too far above it all and they are likely to float off to a ceremonial distance until cri- Context Map Market Situation Stakeholder Intentions Executive Leadership Capital Structure Team Competencies sis brings tbem down; too deep and they burji up in tbe atmosphere, dissipating their well-intentioned energy in a spate of micromanagement. One last test Once in place, strategy sbould pass the test of yet another set of tough questions: • Have we got tbe capacity to execute on our best intentions? • Is tbe talentiwaihhle lor key initiatives without de-focusing our baseline? • Are our systems and infrastructure robust enough to carry tbe shift? • Are the interests of management aligned with tbe interests of ownerships • Wbat's the earliest evidence thai will validate our cbosen course? • How will we measure success... and make course corrections'? On tbis last, tbe board should always bave stra- tegic matters on its standing agenda: readings on tbe "dashboard," progress in key initiatives, and changes in the "context map" for tbe business. Regardless of sector or corporate structure, gov- ernance is indeed a form of ownership; for owners, the development and governance of strategy should always be given equal-or-better billing with compli- ance and oversight. • The author can he contacted at mike@mikekipp.coin. FOURTH QUARTER 2007 51

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