Let us now use an example to understand the relationships among shareholders, managers, and directors. Berry Wong and Emily Chan were university classmates. They joined together to set up a business for developing mobile device apps for wealth management. In doing so, they have invited John Mitchell, a university alumnus whom they met in recent gathering to join the business. Both Barry and Emily will invest in the business and take up the position of CEO and CFO respectively. John only wants to contribute his expertise as an employee and takes up the position of Chief Operating Officer. The new company would be set up as a company limited by shares because both Barry and Emily expect to grow the business and invite more investors to come on board. Face value of each share is $100 and Barry and Emily agree to take up 200 and 100 shares respectively. Both of them become shareholders and also employees of the company, while John remains as an employee only. The new business has also attracted two university students, Paul and Mary, who each takes up 30 and 20 shares respectively. The two become shareholders but not working as employees of the company. Now that we have the information about shareholders, let us try to find out the percentage of control and status of each person by completing the following table. Here are the answers. On a day to day basis, Barry, Emily, and John, manage the company's business and be remunerated for their work. They are generally referred to as managers of the company. Every year, the company generates profit or loss and report such in its financial statements. Shareholders like Paul and Mary or Barry and Emily themselves may or may not receive dividends because this is a matter to be decided by the company. If the company has been making profits continuously, but distributing only part of them, the undistributed profits will be accumulated as retained earnings, which will be recorded in an account separate from share capital. Notice that retained earnings will be put under the name of the company for its disposal even though it belongs to the shareholders. Therefore, it is often regarded as another form of investment made by shareholders in the company, except that this is actually earned by the company using the shareholders invested capital and kept by the company, presumably for future expansion. On this note, it may seem that shareholders like Paul and Mary do not have a direct control over their invested money when the limited liability company has it's separate legal personality. How can share holders exert their rights if they need to and how can they're interests be protected? To answer this question, it may be easier to first look at the bigger picture of the company by considering what might be the concern of each person in the company. In the above example, as Barry and Emily are bold investing their money in the company and managing the company as CEO and CFO, they should be able to monitor the company's activities and see to the well-being of their invested money. They should have little concern about their interests. As for John, he is only an employee of the company and as COO, he participates in the company's decisions but not having to worry about any investment in accompany. His concern is perhaps only about securing his job. Whereas for Paul and Mary, they are both shareholders of the company who have put in their money but not being involved in the company's decisions. For both of them, they have to entrust the investment to people like Barry, Emily, and John because once becoming share capital, Paul and Mary's money will be controlled and used by the company, which are not decided by shareholders. This will lead to a classical principle agent problem in a limited liability company, wherein shareholders are the principals who invest their money in the company. They want to ensure that the company's managers, who are the agents, always make decisions conducive to their best interests. Otherwise and with limited liability, company being a legal person separate from its owners, shareholders interests may be compromised. To ensure their shareholders interests can be protected, company laws prescribe that a board of directors should be appointed by shareholders and put in charge of making company's decisions which managers have to follow. The appointment or re-appointments of directors will be done by shareholders voting at general meetings. That must be held annually, as required by company laws. The duties and powers of directors are also spelled out clearly in the laws. Therefore, we have the board as the mechanism to mitigate principal agent problems of company so that the shareholders' wishes can be brought to the company. Who then should be appointed to the board? Ideally, they should be people who have the knowledge, expertise, and trust of shareholders for directing the company and his managers towards achieving company's goals. This graph depicts the structure of a company in regard to its ownership and management. The upper rectangle represents the shareholders and the lower big squared, delineates, the limited liability company. Shareholders are separate from the company by virtue of the legal personality of the company. Now inside a company, the circle represents the board of directors and the triangle represents the managers and other employees of the company. As you can see, the directors are separate from managers because directors make decisions while managers execute such decisions. They are generally referred as non-executive directors. There is, however, an overlapping segment, where the directors are also managers of the company. Who are they and why? Ideally, decision-making by directors should be kept away from managers, in order to avoid bias of managers in making decisions that may involve their personal interests. However, the firsthand input from CEO and CFO like Barry and Emily or other managers working in the front line are also valuable to the board in their decision making. Therefore, shareholders like Barry and Emily would like to appoint themselves and also other managers to the board. This can be done by way of shareholders voting at annual general meetings. The appointed directors, who are also managers of the company, are called executive directors. It is not uncommon to see both EDs and NEDs presiding over a board, yet it is usually expected that the number of EDs is restricted. Another arrangement is to invite managers to join the board meeting only when needed for providing the firsthand information for the board decisions. What if the NEDs are connected indirectly with the company by way of say business relations with the company or the NED is a retired CEO of the company, would that be a concern to you? Under these situations, NEDs are further identified as independent entities or connected NEDs. Usually just referred as NEDs. It is usually expected that the number of independent NEDs should be greater than connected NEDs. When it comes to matters that a connected NEDs may have conflict of interests, they should declare the interests, abstain from voting on the decisions, or even excuse themselves from the discussion of the matters. The proper functioning of the board rely on the leadership of the chairman of the board. The chairman should be elected by the directors and usually takes the lead in nominating prospective directors for election to the board and proposing agenda items for discussions and board meetings. Under the leadership of the chairman, the directors are required by laws to discharge the duties to the shareholders. The framework of proper functioning of the board in directing businesses of a company is termed as corporate governance. Details of corporate governance will be introduced in the later modules.
