Explorative study into the relationship between innovation and corporate
governance within Dutch SMEs.
By Leonid Yevimovich Dvortsin
MscBA Master Thesis
Explorative study into the relationship between innovation and corporate
governance within Dutch SMEs.
By Leonid Yevimovich Dvortsin
Supervisor: Dr. Theo Postma Second supervisor: Dr. Hendrik Snijders
University of Groningen
Faculty of Management and Organisation Cluster Strategy and Environment
“Let our book serve to the dispersion of gloom of ignorance even in this silent corner of the earth for knowledge of the world is collected grain by grain, and no grain happens to be superfluous”.
Leonid Solovyev
Foreword
Writing a master thesis is a major element of the master's programme. According to the university's study guide it is embedded in previous research and literature on the topic of the thesis, includes a theoretical elaboration of the research problem, and also includes an empirical test of some implications of the theory. In view of the current developments and the dramatic changes over the last decades, acting successfully in today's business environment requires a better understanding of human behaviour in complex contexts. Academics in the business sciences thus face a growing need to develop relevant new theory adding to the total body of knowledge (Srnka and Koeszegi, 2007). This master thesis is an explorative study in cooperation with Mr. Postma, associate professor strategic management at the University of Groningen, who acts as the first supervisor of this thesis. The role of the supervisor is to guide the student during the course of the project (www.rug.nl, 2007). According to the same study guide for the master programme of strategy and innovation the student is asked to complete a scientific research project in the field of strategy and innovation.
Therefore in this thesis I am trying to find whether the here above mentioned topics have new and significant implications for the fields of strategy and innovation. In my opinion this subject can be seen as rather relevant for the corporate strategy formation and innovation processes within any firm whether by applying, partially or not at all corporate governance policies, making strategies, and developing and implementing innovations, as corporate governance can influence these subjects in great manner and this way contribute to further understanding of the relationship between innovation and strategies through application of corporate governance policies.
My acknowledgements go out to my supervisor Mr. Theo Postma, our cooperation has been a very long process towards my graduation. I experienced it as very informative and pleasant and would like to thank you for the patience and personal involvement. Also critical remarks and ideas from my second supervisor Mr. Hendrik Snijders ware highly appriciated, thank you for the willingness to be my second supervisor. Also I would like to thank my unofficial supervisor and a helping hand at the department, Truusje Cordes. My gratitude goes out to all the companies and their CEOs who found time to meet me and answer my interview questions. The empirical part of the reseach was actually the most interesting part of the reseach to conduct in my opinion. A big acknowledgement goes out to my friends and classmates, you helped me to finish this thesis and kept me motivated to graduate.
Probably I will have to do some convincing of naysayers. But if this explorative study can result into interesting findings, the experimentation could provide a blueprint for other Dutch small and medium sized entreprises wrestling with the question how to combine innovation with corporate governance systems.
Table of contents
Foreword ... 3
Summary ... 6
1 Introduction ... 7
2 Research design... 10
2.1 Statement of the research problem: ... 10
2.2 Research framework:... 11
2.3 Visualisation of the conceptual research model ... 14
2.4 Methodology ... 15
3 Theoretical background... 21
3.1 Corporate governance defined... 21
3.2 Influence of the institutional theory ... 24
3.3 Corporate governance in the international context... 27
3.4 Corporate governance in the Netherlands (local context) ... 28
3.5 Innovation... 33
3.5.1 Technological and non-technological innovation ... 34
3.5.2 Radical and incremental innovation ... 35
3.5.3 Innovation in the Netherlands ... 36
3.5.4 Innovation and SMEs ... 38
3.5.5 Innovation and Dutch SMEs ... 39
3.6 Bringing corporate governance and innovation together ... 40
3.7 Summarising conclusions on the literature ... 42
4 Results ... 45
4.1 Cases... 45
4.2 Relationship size of the company and the boards ... 50
4.3 Role of the board ... 52
4.4 Management team ... 54
4.5 Ownership structure ... 56
4.6 Strategy... 58
4.7 Innovation... 60
4.8 Relationship between corporate governance and innovation ... 62
4.9 Conclusions ... 67
5 Conclusions and discussion... 69
Bibliography... 75
Appendices ... 80
Appendix A: code book... 80
Appendix B: interview questions corporate governance and innovation... 82
Appendix C: Additional theoretical background... 84
C.1 Agency theory... 84
C.2 Shareholder and stakeholder views ... 85
C.3 The board ... 88
C.4 Corporate governance codes... 89
Key words: innovation, corporate governance, Dutch small and medium sized companies, boards, and shareholders.
Summary
This thesis discusses the relationship between innovation and corporate governance. Such theories as agency and institutional theory, shareholder- and stakeholder views have been used in order to explain the subject of corporate governance. The subject of innovation has been explained through application of different approaches towards innovation: technological versus non-technological, radical versus incremental, innovation at large firms versus small and medium enterprises, etc.
In this study the research subject has been narrowed down to the relationship between innovation and corporate governance within Dutch small and medium sized enterprises. In order to asses whether corporate governance influences innovation within the Dutch small and medium sized enterprises a conceptual model has been developed, which has been tested through a number of case studies.
1 Introduction
Plato once said the beginning of the philosophy is amazement. According to Brock and Evans (1989) one of the ways that science progress is by developing theories that can explain the various empirical regularities we see around us. The importance of innovation has been acknowledged and covered in literature for some time now. The debate about corporate governance is much more recent and also has been covered quite extensively in the literature but interestingly enough refers to the literature on innovation only sporadically. Therefore the combination of innovation and corporate governance into one research subject forms a fertile area of research (and amazement) that is new and interesting to study. The aim of this thesis is to research and examine the relationship between innovation and corporate governance. Corporate governance is a structure of rights and responsibilities among the parties involved in the ownership and management of the firm (Aoki, 2000 in Aguilera and Jackson, 2003; Krafft and Ravix, 2005). The purpose of corporate governance is to discuss the conditions by which firms are maximising profits and consequently, their market and (shareholder) value (Quere, 2004). The need of good governance does not limit itself to companies quoted on the stock exchange markets. Also for the non-listed, medium and small sized companies, and (semi)-public organisations corporate governance is an important topic. Without trust of their clients, citizens or their most important investor(s), the government, the legitimacy of firms seems to be unfounded (Hooge, 2005).
Chanaron (1998, in Go-Feij, 1999) states that competitive pressures and globalisation of markets have provided the impetus of innovation. According to Go-Feij (1999) innovation is the creation, development and introduction of new products / services or product / service components or of new procedures or processes to benefit the share- and stakeholders within the company. Go-Feij (1999) adds that innovation, as often defined by OECD, implies newness (compared to the new situation) and commercial success of implementation, which could lead to increased profits, revenues of market shares or in cost reduction.
and innovation: small and medium sized enterprise’s employees generated more innovations per million employees than large enterprise’s employees.
It has been indicated by previous research conducted by Hoskinsson, Hitt, Johnson and Gorssman (2002) that there are effects of institutional ownership, heterogeneity and internal governance on corporate innovation and strategies. Also Zahra (1996)found that there is relationship between governance, ownership, and corporate entrepreneurship within organisations. Go-Feij (1999) suggests that innovation involves a variety of different types of investment, besides the research and development spending which is normally associated with innovation. So the challenge for the corporate governance (and financial) system is to provide adequate financing, advice, and monitoring for all these activities, and to get the right balance among them (Go-Feij, 1999). As has been emphasized by O`Sullivan (2000 in Quere, 2004) the potential conflict, between the companies and their shareholders, is particularly important with regards to firms` strategies in innovative investments.
Both corporate governance and innovation face the same difficulty, they are not easy to trenchant; and to identify the economic significance of their content due to their ambiguous character in the definition (Quere, 2004). Therefore in chapter 3 both subjects are explained in detail, where corporate governance is complemented with relevant agency and institutional theories. Aguilera and Jackson (2003) suggest that agency theory is “undersocialised” (too little attention for people) and institutional theory is “oversocialised” (too much attention for people) thus it is important to include both of them into the theoretical background of this study.
According to Quere (2004) one can identify at least three different institutional levels that have to be taken into account for qualifying innovation processes: the firm and its internal organisational design, the industry (referring to development blocks or industrial complexes) and the nation (the macro-institutional infrastructure). The same propositions go for corporate governance as firms must adapt to multiple features of their environment (Fligstein and Freeland, 1995 in Aguilera and Jackson, 2003). Corporate governance needs to be understood in the context of a wider range of institutional domains (Aoki, 2001 in Aguilera and Jackson, 2003) in the same way as the innovative processes.
the field of studies that concentrates its effort on the link between innovation and corporate governance.
Writing a thesis is not a tractable process especially when one is trying to discuss inscrutable topics but I have tried to structure this thesis by describing and discussing different topics in the most logical order. It follows a so-called hourglass model (Trochim, 2006), which means that it starts with a general theoretical base, narrows down the specific subject of the study and empirical research and generalises at the end again.
“Though this be madness, yet there is method in it.”
Polonius, a character from William Shakespeare’s Hamlet.
2 Research design
2.1 Statement of the research problem:
The aim of this thesis is to analyze the relationship between corporate governance, innovation, and strategy within Dutch small and medium sized firms. This research aims at finding how corporate governance institutions might stimulate or thwart innovation.
(Main) research question:
• How does corporate governance influence innovation?
Sub-questions:
• 1) What are the characteristics of corporate governance and innovation?
• 2) Why is corporate governance important for innovation?
• 3) How do corporate governance and innovation relate to one another?
• 4) What corporate governance factors seem to be of importance to stimulate innovation?
2.2 Research framework:
In order to answer the above questions it is necessary to develop an essential supporting research framework, which is based on sound academic theory and research, and is systematically presented on the next pages. The main concepts of this study are described briefly in order to discuss the conceptual research model.
Corporate governance:
Tylecote and Ramirez (2006) define corporate governance as the system by which companies are controlled and directed, and made accountable to shareholders and other stakeholders. Shen, Hsu and Chen (2006) divide corporate governance in three parts: board structure, ownership structure, and information transparency. In my conceptual model I see the latter as an implicit characteristic that is influencing all of the other components of this conceptual model therefore there is no special attention for information transparency. In this study I chose to apply the definition of Tylecote and Ramirez. The presence of top management can be seen as an important factor as it can provide the impetus for innovative change, organisational performance, and strategic decision-making (Hambrick and Mason, 1984; in Auh and Menguc, 2005).
Boards:
Boards play a very important role in corporate governance as they are there to monitor the performance of the management team on behalf of the share- and stakeholders. One of the most powerful and important ways a board can influence the direction and performance of the company is through its decision control (Fama and Jensen 1983). There are two types of control that impact the innovative potential of an enterprise: financial and strategic controls (e.g., Hoskisson and Hitt, 1988; Baysinger and Hoskisson, 1990; Hitt, Hoskisson and Ireland, 1990; in Gabrielsson and Politis, 2006).
Top management:
Managers are the stakeholders occupying positions of strategic leadership in the firm and exercising control over business activities (Chandler and Daems, 1980 in Aguilera and Jackson, 2003). As already has been mentioned top management teams with diverse skills, knowledge, and background are important for innovativeness within any company. Aug and Menguc (2005) indicate that top management is human capital possessed by an organisation. Note that according to them just having human capital is not enough to generate innovativeness, they plead for social capital such as appropriate organisational infrastructure, networks and relationships and / or common work rules or contracts, and this social capital can on its turn be seen as parts of corporate governance. The main factor influencing the innovation processes in firms or organisations from the top management perspective is the diversity of management. Aug and Menguc (2005) identify functional diversity where the skills and professions of managers differ, educational diversity, and experience in years and work diversity with the demographical influences and differences in the background and pay.
Shareholders and stakeholders:
Innovation:
Many scientists writing on the subject of innovation have come up with their own definitions after the first economic definition given by Schumpeter to innovation as a form of new combination of already existing thing(s). Wijnberg (2004) proposes that innovation is something new which is presented in such a way that the value will be determined by the selectors. Also Wijnberg (2004) suggests that the most common distinction with respect to types of innovation is between product and process innovations. Organisational innovation is often added to these two basic types.
2.3 Visualisation of the conceptual research model
The conceptual research model represents influence of corporate governance on innovation through the corporate governance institutions: boards, top management team and share- and stakeholders. My presumption is that the described concepts presented in figure 1 affect innovative processes within firms through control, ownership structure and composition, role of the top management, etc.
Fig 1: Conceptual research model
Top management Shareholders and stakeholders Strategic control Financial control Board Owner Influence Groups C o rp o ra te G o v er n a n ce In st it u tio n s
2.4 Methodology
Literature review:
Two major reasons exist for reviewing the literature (Sharp and Howard, 1996 in Saunders, Lewis and Thornhill, 2000). The first reason is that the preliminary search helps one to generate and refine the research and the second reason is the critical review of literature (Saunders, et al., 2000). The process of critically reviewing the literature means that one is studying the literature published on the chosen research topic, in order to identity any other research related to one's topic that might be applicable, enhance the subject knowledge and help to clarify the research questions further (Saunders, et al., 2000).
Motivation of the case study approach:
The overall research approach adopted in this thesis is defined as a case study design. A case study can be defined as the development of detailed, intensive knowledge about a single case, or a small number of related cases (Robson 1993). Eisenhardt (1989) adds to the former that a case study is a research strategy which focuses on understanding the dynamics present within single settings. According to Yin (1984) case studies can involve either single or multiple cases, and various levels of analysis per case and mutually between the cases. Multiple cases are a powerful means to create theory because they permit replication and extension among individual cases, which can be used for independent corroboration of specific propositions. This corroboration helps researchers to perceive patterns more easily and to eliminate chance associations (Eisenhardt, 1991). I chose for the multiple case study approach strategy, as it seems to be an established way of performing explorative research and addressing the research questions applicable to my field of study and research. In this thesis each case stands for one specific company where I held interviews with the directors, owners, and / or the members of the executive board.
Data collection method:
exploratory studies by Saunders et al., (2000). The qualitative data are useful for understanding the rationale or theory underlying relationship revealed in the quantitative data or may suggest directly theory which can then be strengthened by quantitative support (Jick, 1979; in Eisenhardt, 1989).
A list of themes and questions, to be covered, has been prepared in advance but these may vary from interview to interview in their appearance, order, depth, and specific context (Saunders, et al., 2000). According to Saunders et al., (2000) semi-structured interviews may be used in order to understand the relationship between variables, such as those revealed from descriptive studies, such as those of Hoskisson et al., (2002) and Zahra (1996), which triggered this research. Based on literature review and previous research interview questions have been put forward for judgement to the supervisor and adjusted in accordance to his comments. After the first interview the questions were adjusted and improved once again to remain the same until the end of the data collection period.
The nature of questions and the ensuing discussion made it useful to record the data by means of a digital voice recorder, summarised, and returned to the interviewees for feedback and comments or improvements. The interviews took place on one-to-one base and where conducted face-to-face.
The appropriate number of cases depends upon how much is known and how much new information is likely to be learned from incremental cases (Thomas, 1990; in Eisenhardt, 1991).
Sampling:
The cases described in this paper have been selected in a non-probability sampling manner. Non-probability sampling provides a range of alternative techniques based on my subjective judgment. According to Saunders et al. (2000) in the exploratory stage(s) of research projects, such as a pilot survey, a non-probability sample is the most practical way to approach research and that is also why I apply this type of sampling in this explorative study. Often it is not possible to guarantee that the sample will be statistically chosen at random in an explorative study. Also it is impossible to specify the probability that any case will be included in the sample (Saunders et al., 2000). Therefore non-probability sampling provides a suitable alternative approach.
ambiguous. I used both purposive as well as snowball sampling techniques to obtain the cases. Purposive sampling is used when working with small samples and allowed me to select the cases, which seemed to be particularly informative through coverage in the Dutch media as being innovative (Internet, professional magazines, newspapers, etc.). Within purposive sampling I applied the heterogeneous (companies from different sectors of the economy) sampling procedure to collect the information and to explain the key themes that can be observed in the fields of innovation and corporate governance. According to Saunders et al. (2000) this way of sampling might appear a contradiction, as a small sample may contain cases that are completely different, representing extremes within the field of study. Patton (1990) argues that this is in fact a strength. Any patterns that do emerge are likely to be of particular interest and value and represent the key themes and document certain uniqueness of the cases (Saunders et al, 2000). Saunders et al. (2000) warn that such samples cannot, however, be considered to be statistically representative of the total population, and in my case representative for all the Dutch SMEs. Snowball sampling was used, as it was difficult to identify cases in the desired population of innovative Dutch SMEs. Snowball sampling works in three phases, which I followed in my collecting of cases: at first to contact one or two cases in the population; to ask the cases to identify any further interesting cases; and to ask these cases to identify further new cases. Saunders et al., (2000) indicate that such sampling has a representativeness problem as the respondents identify other potential cases which are similar to themselves but this risk was reduced since all the companies come from different sectors and the companies were geographically dispersed as well all over the Netherlands. In result this provided a study rich with inside information and interesting cases.
Selection:
The goal for the empirical part of the explorative study was to find and study at least 15 case studies / companies. In this thesis I study 16 companies, as has been mentioned above, spread over different sectors and geographic regions within the Netherlands. Thereby the research concerns Dutch companies which are not listed on the stock exchange market. Formulated more precisely the companies meet the following selection criteria:
Criterion 1: the company must be Dutch, meaning established in the Netherlands and a company that produces a substantial part of its products or services and R&D and innovative projects in the Netherlands.
than or equal up to 50 million Euros or a balance sheet total of less than or equal to 43 million Euros. I use the definition provided by the European Union because Netherlands is a member of the EU.
Criterion 3: the company is generally considered as being innovative in its conduct of business or providing innovative products or services. This has been either confirmed by the Dutch media or stated by the companies themselves.
Table 1: overview scores table of the companies in relationship to the selection criteria:
Cases: Criterion 1 Criterion 2 Criterion 3
Case A Yes Yes Yes
Case B Yes Yes Yes
Case C Yes Yes Yes
Case D Yes Yes Yes
Case E Yes Yes Yes
Case F Yes Yes Yes
Case G Yes Yes Yes
Case H Yes * Yes
Case I Yes Yes Yes
Case J Yes Yes Yes
Case K Yes Yes Yes
Case L ** Yes Yes
Case M Yes Yes Yes
Case N Yes Yes Yes
Case O Yes Yes Yes
Case P Yes Yes Yes
* = the amount of employees of the company described in the case H fluctuate between 240 and 255 employees depending on the projects, time of the year, illnesses and other work related factors.
Tactics for case-analysis:
According to Eisenhardt (1989) the importance of within-case analysis is driven by the staggering amount of data to be analysed within case study research. Due to the open-ended research problem the volume of to be analysed data is daunting. However, Eisenhardt (1989) suggests that the general idea is to become intimately familiar with each case as a stand-alone entity. This process allows the unique patterns of each case to emerge before any over rushed conclusions or incorrect generalisations could be made. Also it provides in-depth knowledge and familiarity with each case in the multiple case analyses and promotes, encourages and favours cross-case comparison. I chose to apply three different but in my opinion complementing tactics, as suggested by Eisenhardt, to search for cross-case patterns in order to answer the main questions of my thesis.
The first tactic is to select categories per each case, as developed in this thesis. This means that for each case mutual relationships between the selected entities, which have been indicated in the research framework and theoretical background, have been studied and measured through the interview questions and accessible information about the cases. These categories are represented in the tables presented in the results (4) chapter of this thesis. The second tactic suggests that the cases should be analysed on their similarities and differences among each other, as such “breaking down” of cases into details can lead to breakthroughs or shred light on small and subtle details. The results of this tactic can also be found in the results through representations in tables, which present the scores of all the cases on the same categories. Similarities and differences have been studied between the cases: comparisons over the columns in the tables; and within the cases: comparisons over the rows; in order to get better understanding of the results. This has been done by means of comments accompanying the tables in the results (4) chapter and partially in the discussion and conclusions (5) chapter.
In order to develop and arrive to meaningful results and related tables a code book has been developed. The code book explains the variables that have been studied, their content and measurements. The code book can be found in the attachments as appendix A. The actual interview questions can also be found in the attachments as appendix B, though they are in Dutch.
3 Theoretical background
3.1 Corporate governance defined
Figure 2: Gli effetti del Buon Governo, source: University of Siena.
Governance has proved to be an issue since people began to organise themselves for a common purpose. How to ensure that the power of organisation is harnessed for the agreed purpose rather than diverted to some other purpose, is a constant theme (Clarke, 2005), in business and economics studies and practice. And the above image in figure 2: Gli effetti del Buon Governo or Impact of Good Governance, (a fresco painted between 1338-40 by Ambrogio Lorenzetti, from Palazzo Publico, Siena, Italy) is a good example of this fact. The palace was built in the 14th century as a seat for the “Council of the Nine”, the governing board of Siena. It symbolises the proud, power and freedom of the citizens of Siena. The Sala della Pace of the Palazzo Pubblico, the space in which the “Council of the Nine” met, contains the boasted allegorical representations of the good and bad governance.
According to Gillan (2006) the definition of corporate governance differs depending on one’s view of the world. Corporate governance research generally provides two options: a broad and a narrow definition.
narrow because it approaches the governance issues solely from the shareholder point of view, which on its turn has been developed from agency theory and transaction cost theory. A broader view has been presented by Tylecote and Ramirez (2006) as they define corporate governance as “the system by which companies are controlled and directed, and made accountable to shareholders and other stakeholders”. This definition can be seen as broad because it approaches the governance issues from a stakeholder point of view. This broad definition corresponds with the perspective provided by the Organisation for Economic Co-operation and Development (OECD) (1999) which sees corporate governance, as “the set of relationships between a company’s board, its shareholders and other stakeholders”. It also provides the structure through which the objectives of the company are set, and the means of attaining those objectives, and monitoring performance, are determined. Hermes, Postma and Zivkov (2006) conclude that both the shareholder and the stakeholder view stress the relationship between providers and users of resources within the company.
According to Mallin (2004) these different definitions serve to illustrate that corporate governance is concerned both with the internal aspects of the company, such as internal control, and the external aspects, such as an organisation’s relationship with its shareholders and stakeholders. She also considers corporate governance as an essential mechanism to help the company to attain its corporate objectives, and monitoring performance plays a very important role in achieving these objectives. This supports the statement made by Gillan (2006) that irrespective of the particular definition used, researchers often view corporate governance mechanisms as falling into one of two groups: those internal to firms and those external to firms.
Figure 3, adapted by Postma (2002) from the World Bank (1999), graphically represents the external and internal relationships of corporate governance here below.
Figure 3: Corporate governance level playing balance sheet model. Source: Postma (2002), as adapted from the World Bank.
already back in 1932. In the figure above this situation is depicted by the shareholders, board and management boxes and arrows in between them. When management and shareholders are the same party (e.g. small and medium sized enterprises (SMEs)), control rights are automatically in the hands of shareholders. However, according to Clarke (2005), the subject of corporate governance has wider implications for all of us and is in particular critical to economic and social well-being. There are two reasons for a wider importance of this subject for the societies in general. First, in providing the incentives and performance measures to achieve business success, and second, in providing the accountability and transparency to ensure the equitable distribution of the resulting wealth (Clarke, 2005). Also according to Clarke the significance of corporate governance for stability and equality of society is captured in the broader definition of the concept offered by Cadbury (2004, in Clarke, 2005): “Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations, and society”.
Hermes et al. (2006) explain in their study on corporate governance codes that the diversity of social and economic environments of countries may lead to diversity with respect to how corporate governance is understood and defined. So before going further into the details of the Dutch corporate governance we must understand what causes these differences. Therefore in the next two sections we will first discuss the institutional theory and subsequently discuss the corporate governance in the international context.
3.2 Influence of the institutional theory
described above forms the framework in which human action takes place and the quality of the institutional foundations of the economy and the state is paramount in determining a society’s welfare (Greif, 2005).
According to North (1990) institutions reduce uncertainty by providing a structure to everyday life. North goes on by stating: “In the jargon of the economist, institutions define and limit the set of choices of individuals. Institutional constraints include both what individuals are prohibited from doing and, sometimes, under what conditions some individuals are permitted to undertake certain activities. ... They are perfectly analogous to the rules of the game in a competitive team sport” (North, 1990). Unlike the rules in team sports, however, these guidelines often arise “spontaneously”, as by-products of individual choices, rather than deliberately through collective action (Hayek, 1967, 1973; in Klein, 1999). Greif (2005) finds that because individuals do not always recognize what will be socially beneficial they are not motivated to effectively pursue socially beneficial behaviour in the absence of appropriate institutions. Therefore corporate governance might be a useful tool for ensuring of beneficial behaviour within the companies and between the companies and their share- and stakeholders.
It is impossible to understand the formation of institutions, their consequences for performance, or their appropriateness for the circumstances without understanding the political forces that drive institutional evolution (Greif, 2005). These general differences among the institutions of capitalist economies actually matter for economic performance of particular firms within the different countries.
Djankov et al., (2002) argue that an important property of a successful institution is its invulnerability to subversion by powerful citizens. People will attempt to influence any system to their own advantage, thereby benefiting themselves at the expense of others. According to the authors controlling such subversion is necessarily costly, and may require different approaches in different circumstances. Peaceful, relatively equal societies can adopt decentralized, community rules in areas such as dispute resolution, because local justice is more efficient and there is relatively little risk of it being subverted. For example, one could think of such countries as Sweden, Finland or Luxembourg. Less orderly, more unequal societies, in contrast, could not rely on enforcing community rules plus they often face the problem of enforcement of rules, because local justice is likely to be subverted by powerful interests. Instead, they must rely on the more centralized rules promulgated by the authorities, which can withstand attempts at subversion, even when such rules contradict the community’s ideas of justice and fairness (Djankov et al., 2002). Here one could think of such countries as Russia, India or China.
Socially beneficial institutions promote welfare-enhancing cooperation and action. They provide the foundations of markets by efficiently assigning, protecting, and altering property rights; securing contracts; and motivating specialization and exchange. Good institutions also encourage production by fostering saving, investment in human and physical capital, and development and adoption of useful knowledge. They maintain a sustainable rate of population growth and foster welfare-enhancing peace; the joint mobilization of resources; and beneficial policies, such as the provision of public goods (Greif, 2005). Djankov et al., (2002) conclude in their paper that identifying the appropriate institutions is both a challenge and hope for all of us.
3.3 Corporate governance in the international context
The developments and definitions within the field of corporate governance should be placed in the international context as corporate governance forms part of a global context with legal, cultural, ownership, structural and other differences despite the advanced globalisation processes.
The everyday economic practice has been and is affecting the development of corporate governance and should be viewed in the conjunction with the legal systems, and capital market developments as well as the ownership structure of particular countries. As for example in Italy most of the businesses, from small to big ones, are family owned while in the Netherlands there is more diversity on the types of ownership structure between small, medium, and big enterprises.
La Porta, Lopez de Silanes and Shleifer (1999) indicate that the Anglo-Saxon world in general and United Kingdom (UK) and United States of America (USA) in particular have a common law system which tends to give good protection to shareholder rights; whilst civil law countries such as the Netherlands and most other European countries tend to have less effective legal protection for shareholder rights, and more emphasis may be given to the rights of the stakeholders. Also the work of La Porta et al. (1999) suggests that the countries which have a civil law / code often have a limited protection of minority shareholders; in addition these countries often have a relatively more concentrated share ownership structure rather than a more dispersed shareholder base countries such as UK or the US. This aspect should be borne in mind when analysing the corporate governance of Continental European countries and their approach to corporate governance versus the Anglo-Saxon approach (Mallin, 2004). Franks and Mayer (1995 (in Mallin, 2004)) use the terms “insider” and “outsider” systems to differentiate between the two types of ownership and control structures, in the outsider system there is dispersed ownership of corporate equity amongst a large number of outside investors, as in both the UK and the USA, whereby institutional investor ownership by pension funds, insurance companies, etc., is predominant. In contrast, in an insider system, such as in many (European and other) countries applying Continental approach, ownership tends to be much more concentrated, with shares often being owned either by holding companies, banks or families (although the state may still play an important role in France, for example).
participation mechanics; board structure, roles, and responsibilities; supervisory body independence and leadership; board committees; and disclosure.
For an in-depth theoretical discussion of agency theory, shareholder theory, stakeholder theory, boards and corporate governance codes I refer to appendix C. Now that we have discussed the main issues in the field of corporate governance we can describe corporate governance in the Netherlands.
3.4 Corporate governance in the Netherlands (local context)
The development of corporate governance is bound intimately with the economic development of industrial capitalism: different governance structures evolved with different corporate forms designed to pursue new economic opportunities or resolve new economic problems (Clarke, 2005). In the context of the Dutch corporate governance it is worthwhile mentioning that the first recorded instance of a non-financial company with a diffuse share capital was the Dutch East India Company (VOC) established in the early seventeenth century. More than 1000 investors put their money into it, and where thus rapidly confronted with the key corporate governance issues (Frentrop, 2003; in Clarke, 2005). So far for the historical intermezzo, let us now look at the present day situation in the Lower Lands.
The Dutch system of corporate governance contains three key sets of actors: management and supervisory boards, shareholders, and other stakeholders (i.e., financial intermediaries, workers, and other firms (van Ees and Postma, 2004).
decisions proposed by the board of directors concerning the strategic choices to be made by the company. So the large companies in the Netherlands, which are listed on the Amsterdam Stock Exchange, apply the above governance model, which is based on the two-tier principle and where the board of directors and supervisory boards meet several times a year.
Goodijk (2005) indicates that the Dutch corporate governance system in combination with the typical Dutch system of labour relationships has its specific characteristics with a strong focus on consensus, trust, and the involvement of stakeholders. He observed that the Dutch supervisory board has traditionally had a rather exceptional position and responsibility, that of monitoring and advising the board of directors not only on behalf of the shareholders but on behalf of the company as a whole. It is very important in the Dutch corporate governance system that the supervisory boards control the boards of directors in the best interests of the company, operating freely from the shareholders as well as the stakeholders.
Another very unique characteristic of the Dutch corporate governance system existed until recently, October 2004 (Goodijk, 2005) to be precise, when the co-optation practice by the local supervisory boards has been banned due to the introduction of the new law and corporate governance code (Code Tabaksblat). The co-optation model allowed the supervisory board to appoint its own members. The structural regime (Structuurregime) applied to the majority of listed public limited liability companies (Naamloze Vennootschappen) (van Ees and Postma, 2004). This provided the supervisory boards with great independence but on the other hand this situation neglected the rights of the shareholders / investors to influence and control the management and functioning of the company.
The Dutch parliament, in accordance with the advice of the social and economic council (SER), decided to change the co-optation system by giving the shareholders the right to formally appoint the members recommended by the board, and by giving the works` council the right to select and nominate up to a third of the board members (Frentrop, 2004; and Goodijk, 2005).
trust in the Dutch financial market and the local companies a new commission was formed, which became known by the name of its chairman: Mr. Tabaksblat. This development was in line with the wider corporate governance developments that took place at that time. The European Commission presented its action plan in 2003 on modernising company law and enhancing corporate governance in the European Union with the goal to enhance the rights of the shareholders. “Shareholders own companies, not management – yet far too frequently their rights have been trampled on by shoddy, greedy and occasionally fraudulent corporate behaviour. A new sense of proportion and fairness is necessary” (Frentrop, 2004). The European Commission did not want to make a European code but provided a list of subjects which should be included in each code per country. According to Frentrop (2004) the concept of the new code followed roughly the guidelines of the European Commission. Specific Dutch recommendations were with respect to the rewards and remuneration of the directors, their legal position and possible “golden handshakes” (gouden handdrukken), as well as the restricted number of the positions to be hold in different supervisory boards. To conclude with the words of Morris Tabaksblat, the chairman of the latest commission on corporate governance in the Netherlands: “The Dutch corporate governance code is based on the best practices from abroad”.
The code is based on self-regulation with legal support on a restricted number of issues. It applies the comply-or-explain rule, which means that the listed companies should comply with the code or explain in their annual reports to their share-and stakeholders why they did not comply with the Code Tabaksblat.
In this paper I focus my research on the Dutch small and medium sized enterprises (SME) therefore we should also consider the influence of corporate governance institutions on these companies as they play a very important role in the economic prosperity of the Netherlands. According to the ABN AMRO Bank the SMEs account for 50 % of employment and for 50% of the Dutch gross domestic production. Hessels and Hooge (2006) found that 99% of the privately owned businesses in the Netherlands are SMEs. Up to 90% of these companies can be classified as small, with 0 to 9 employees and 10% having 10 and more employees.
not-listed companies are big and therefore any general suggestions or any directives or guidelines would be either good-for-nothing or impossible to give. Also the SMEs represent such a diverse group among themselves that it is impossible to apply one particular code suitable for all companies according to the ABN AMRO Bank publication. Still some SMEs do apply the corporate governance code. The interpretation and application of governance depends among others on the question if the company has issued shares and if there are several shareholders. A small part of SME companies, 14%, (ABN AMRO Bank, 2006) has issued shares. Of all SME companies 8% have several (more than 3) shareholders (ABN AMRO Bank, 2006). Also it was found that some SME stakeholders doubt the usefulness or need of internal supervision in SMEs. In practice an average of 3% of companies has a supervisory board (Hessels and Hooge, 2006). ABN AMRO Bank found deviating percentages for bigger SMEs (medium-large enterprises): 88% apply at least one corporate governance structure (see appendix D) and 41% applies two or more structures (see appendix D). For an overview of all the different structures in the Netherlands please refer to the appendix D. The research conducted by the ABN AMRO Bank showed that companies see strategy, organisational structure and succession as most important themes of corporate governance and internal processes, organisational culture and innovation as less important corporate governance topics (ABN AMRO Bank, 2006).
suitable form of the corporate governance. Filatotchev and Bishop (2002) found that when firms are evolving along their corporate governance life cycle, control is transferred in steps from original owners and monitors to a new (and) group of outside investors. Further on Filatotchev and Bishop (2002) also conclude that from a dynamic perspective, corporate governance factors may be affected by strategic actions and outcomes, and the choice of the various governance options could be associated with changes in organisational strategy and firm performance.
3.5 Innovation
Figure 4: View on the port of Amsterdam, source: www.staand-werken.nl
The above image in figure 4 represents the view on the port of Amsterdam. It is a painting from the beginning of the 19th century with the first steam boat that visits Amsterdam; the painter places the innovation at the background. Prominent on the forefront is the royal Dutch sailing ship. The innovative steam boat is represented less prominent and is seen by the painter as less important. The steam boat has sailed empty-handed back home, to the United Kingdom.
DelBianco (2007) add that innovations also occur in forms of (new) business models and supply chains. Besides these forms Jacobs (2006) introduced a new category of innovation known as transaction innovation. This is an innovation in the fields of publicity, marketing and sales. It can be seen as a new way of bringing products under attention of the potential customers and selling them. As concluded by Jacobs (2006) some innovations can combine elements of all these types.
Somewhat paradoxically, innovation is often about destruction – rendering the present and old-fashioned. This process was described as creative destruction by economist Joseph Schumpeter. According to Christensen (1997; in Cox and DelBianco, 2007) innovation can lead to breakthroughs that re-shape an entire industry in a matter of a few years or even months. Jacobs (2006) indicates that successfully innovating means changing the attitudes and behaviour of people or what Jacobs calls preferences to their cultural value systems. He goes on by saying that without change in their behaviour and thinking people will not "connect" and will even reject the innovation. "Shortly, there is no economic value creation without cultural value creation, or at last value change, literally "revaluation" (Jacobs, 2006).
3.5.1 Technological and non-technological innovation
Technological innovation has become the major driver of economic progress. Raw materials and capital were the building blocks for the economic growth during the industrialisation of the 19th and the 20th centuries. Today, innovation occupies the central role once accorded to raw materials as a determinant of economic success (Cox and DelBianco, 2007). Technical innovations frequently lead to non-technical innovations in other industries but on the other hand this is by far not always the case (Jacobs, 2006), and non-technical innovations can exist and / or originate by itself. In all discussions about the knowledge-based economy, innovation is always associated with technology, and only sparingly with culture but according to Jacobs (2006) innovation is more about culture than about just technology.
innovation are more abstract and often intangible and therefore more difficult to recognise, measure, and / or comprehend.
3.5.2 Radical and incremental innovation
Amabile (1983) supports the selection issue introduced by Wijnberg by stating that the innovativeness can be judged by domain-relevant experts. Innovativeness can than be judged on a number of dimensions such as magnitude, radicalness, novelty, and influence on organisational effectiveness (West and Anderson, 1996). West and Farr (1990 in West and Anderson, 1996) define innovation in a broader perspective as the introduction and application, within a group, organisation, or a wider society, of processes, products, or procedures new to the relevant unit of adaptation and intended to benefit the group, individual, or wider society . Both the definitions given by Wijnberg and West and Farr are suitable to be applied and used in my thesis, as they seize the entire spectrum between a individual and a wider, societal application of innovations.
marketing activities. Of course this type of innovation is more risky and harder to achieve in any market or industry. Incremental innovations can easily be defined as products that provide new features, benefits, or improvements to the existing technology in the existing market. An incremental new product involves the adaptation, refinement, and enhancement of existing products and / or production and delivery systems (Garcia and Calantone, 2002). Existing products that are continuously enhanced by new features often provide platforms for innovation by others (Cox and DelBianco, 2007). One could for example think of the new features constantly being added to the mobile phones or digital cameras.
Garcia and Calantone (2002) refer to existing technologies being introduced on the new markets as niche creation by specific firms and to new technologies being introduced on the existing markets as new product or service innovations, which lead to new radical changes and can therefore be seen as radical innovations.
In the following section of this sub-chapter I will discuss the national innovation systems and look at the situation in the Netherlands in this context and look at the innovation and SMEs and Dutch SMEs in particular.
3.5.3 Innovation in the Netherlands
Nooteboom (2000) and Whitley (2000) suggest that innovation outcomes, on the level of companies are to a large extent determined by cooperative relationships with other firms, and that these relationships are conditioned by institutions that vary between the countries. Innovation is thus the result of numerous interactions by a community of actors and institutions, which together form what are termed national innovation systems. Increasingly, these innovation systems are extending beyond national boundaries to become international. Basicaally, they consist of the flows and relationship which exist among industry, government and academia in the development of science and technology. The interactions within this system influence the innovative performance of firms and economies. Of key importance is the “knowledge distribution power” of the system, or its capability to ensure timely access by innovators to the relevant stocks of knowledge (Hillman Chartrand, 2002).
rankings. Van den Bosch and Volberda (2006) explain that this rising in the rankings has been caused by significant improvement in macro economic policy, good scores on quality of the infrastructure and quality and functioning of the institutions with increasing investments in the higher education. Nevertheless the authors remain critical and unsatisfied about the improvements made by the Netherlands. Switzerland and the Scandinavian countries, which form the top 5 of the GCI, show that excellence in higher education and an unambiguous focus on innovation, are the engines of productivity increase and improvement of the competitive position and the Netherlands seems to leave these subjects in the lurch. In order to improve this situation van den Bosch and Volberda (2006) suggest that the Netherlands should compete on adding value while the dominating focus today is still cost reduction and related innovations.
Spending on research and development (R&D) has reached about 2,3% of GDP in the Organisation for Economic Co-operation and Development (OECD) area (Hillman Chartrand, 2002) of which the Netherlands is a member. The Netherlands lags behind some of the world’s richest countries, including the US, Japan, France and Germany, when it comes to spending on R&D Financial Times, 2007). The most recent figures, for 2005, show that the EU spent 1,84 % of GDP on R&D, substantially less than the USA and South Korea. Japan led international funding for research, at 3,18%. Finland and Sweden were the two European Union member states, which spent more than the union's target of 3% of GDP on research. Germany, Denmark and Austria were also big investors in R&D, while the UK and the Netherlands were hovering around the European Union average with 1,8% (Financial Times, 2007). The most important R&D Dutch companies are the so-called big five: Philips, Shell, Akzo Nobel, DSM and Unilever, these companies count for more than 80% of the total industrial R&D (Go-Feij, 1999).
According to Hillman Chartrand (2002) investment is being mainly directed to high-technology goods and services, particularly information and communications technologies. Computers and related equipment are the fastest-growing component of tangible investment. The findings of another WEF (2007) annual report show that the Netherlands stands on the sixth place in the world on the rankings of most innovative countries in the field of ICT in 2007 (in 2006 the Netherlands was number 14). The ranking is based on an annual study into the innovative climate, the skills of individuals, companies and government and the use of information and communication technology in 122 countries.
and Volberda (2006) suggest that these investments become only cost-effective and profitable when companies adapt their organisations (into flexible forms), management (entrepreneurship), and planning of labour (working smarter) or in other words invest in non-technical and social innovations as well, as these factors stipulate 75% of innovation success. Hillman Chartrand (2002) agrees with Van den Bosch and Volberda by stating that equally important are more intangible investments in R&D, the training of the labour force, computer software and technical expertise.
From the above it can be concluded that the Netherlands is lacking behind some of the leading countries in terms of R&D investment but on the other hand it scores quite well on the overall innovativeness rankings as can be seen from the reports presented by WEF. Still there is room for improvement; companies should pay more attention to non-technical innovations. Also the Dutch government could play a more important role in this process by providing more financial support to innovative firms and ideas.
3.5.4 Innovation and SMEs
What is the role of SMEs in the innovation discussion? According to Nooteboom (1994) there are reasonably systematic indications that small business plays only a limited role in major scientific and technological breakthroughs. But prosperity follows not from major inventions taken by themselves, but from their implementation, application, differentiation and adaptation along their technical trajectories (Nelson and Winter, 1982; Dosi, 1984, 1988 in Nooteboom, 1994) in a process of fanning out subsequent innovations` applications and improvements (Nooteboom, 1994). Other research results on innovation show that smaller firms are at least as innovative as the larger firms (Brock and Evans, 1989), as already has been mentioned in the introduction chapter. Brock and Evans (1989) found interesting results for the relationship between firm size and innovation: SMEs’ employees generated more innovations per million employees than large enterprise’s employees.
and Calantone (2002) innovations do not occur just during the production development phases but also may occur during the diffusion process in which a product or process may undergo continual improvements and upgrades. SMEs are flexible due to their size and entrepreneurial mindset, so they are able to react to and create these new innovative spin-offs from and during the diffusion phase of already exiting or new products / services, process and even organisations. And fourthly, SMEs are often able to develop close relationships with their customers, suppliers and stakeholders, which allow them to cater to the exact needs of the customers. Van der Geest and Heuts (2006) suggest that due to these close relationships SMEs can even make the customers initiative takers in terms of providing new ideas for innovation.
3.5.5 Innovation and Dutch SMEs
3.6 Bringing corporate governance and innovation together
Now that we have described the two topics separately it is time to combine the two in order to show that this thesis, the topics of corporate governance and innovation are not just trendy separate subjects in today’s world of economics and doing of business but on the contrary are indeed very relevant and connected matters for the people and companies interested in further economical, social, cultural and technological growth of the contemporary society.
companies. Hoskisson, et al., (2002) together with van der Geest and Heuts (2006) and Zahra et al., (2000) who have focused their research on medium sized companies found more or less similar results, which will be discussed in more detail here below.
Hoskisson et al., (2002) found that different types of owners have different and potentially conflicting preferences for corporate innovation strategies and that these differences are mainly based on their time horizons and incentives. Generally speaking owners have two functions to fulfil: choose in which project to invest their money and / or scarce resources and to monitor the performance of the invested resources. Owners coming from within the company tend to have long-term innovation development strategies and plans while external owners like to plan and invest in new innovations on a short-term strategic basis in order to achieve faster return on their investments and a bigger and faster cash flow. They tend to attain innovation not from within the firms but from outside sources via mergers and acquisitions to which Krafft and Ravix (2005) refer as predator strategies. These predator strategies allow faster entries into markets with proven technologies and brand recognition as well as more certain earnings on the short run (Kraft and Ravix, 2005; Hoskisson et al., 2002).But the situation is not totally black and white as a further distinction between the groups of external investors should be made. It is known that banks and investment funds want to see fast returns from their investments while institutional investors such as pension funds tend to have and prefer long-term orientation and incentives for example to actively encourage new product development (Hoskisson et al., 2002) for example.
Hoskisson et al., 2002). There is a big disadvantage in using such information as it reflects only the past, the present and / or only company’s near future performance. Inside directors have an advantage over the outside directors as they do have access to the rich information and possess the specific knowledge of the company’s situation and its innovative projects. Therefore, Zahra (1996) concludes that inside directors likely have an advantage through better information on which to base their strategic decisions when uncertainty and risk are involved. But inside directors might also be blinded by their interior orientation and miss chances offered by the external world and suffer from the “not-here-invented” syndrome. The inside directors in large companies generally do not own large blocks of company’s stock if any at all. Therefore the boards of these large companies establish contractual relationshipships with managers involving compensation and incentives and, as such, managerial ownership has been used as a governance tool that aligns the interests of managers with those of the other owners (Hoskisson et al., 2002). Zahra et al., (2000) suggest the same approach of alignment through ownership although they also state that in medium sized enterprises the inside directors do own stock and often in large portions. Rediker and Seth (1995 in Hoskisson et al., 2002) suggest that perhaps there is less need for outside directors when inside board members` interests are aligned with those of the owners. According to Zahra (1996) in general strong, vigilant boards of directors can encourage managers to support and pursue entrepreneurial activities.
3.7 Summarising conclusions on the literature
The main goal of corporate governance is to regulate the relationship between the people who own the company and the ones who run it. Corporate governance has been quite diverse in its forms, application and enforcement due to the historical, economic, social and institutional developments and differences between the countries. Though generally speaking there is a recent trend towards more conformance, at least between the European countries under the pressure of the public interest and foreign (and) economic policies of institutions such as the European Commission.
the middle, between the two approaches, with a system where companies can choose whether they are going to have a two-tier or an one-tier board model.
As has been described in appendix C.3 boards are the most important implementers, mediators and executors of the corporate governance system within the companies, as they are responsible for monitoring and control of the managers and management teams on behalf of the shareholders. Also boards should look at the company from a broader prospective, including the stakeholder view. In order to assist the boards in their functioning or in some cases in order to force boards to adapt there is a variety of different corporate governance codes present in different countries. These codes represent the best practices concerning the corporate governance issues. See appendix C.4 for more on codes.
The Dutch corporate governance system can be classified as Continental European corporate governance system for the large companies listed on the Amsterdam Stock Exchange acting under the structural regime while the smaller companies are free in their choice to apply the Dutch corporate governance code, comply with it, and they are free, as well in choosing to use one-tier or two-tier boards. Further on, the Dutch corporate governance distinguishes itself from the rest of Europe by a strong focus on consensus between all the involved parties. This often means that decision-making takes longer time but that the results satisfy or at least suit all the parties. The Netherlands developed its own governance code: Code Tabaksblat, which is basically based on self-regulation. It applies the comply-or-explain rule, which means that the listed companies should comply with the code or explain in their annual reports to their share-and stakeholders why they did not comply with the Code Tabaksblat. Previous studies have shown that the majority of the big companies in the Netherlands apply the code while the majority of the smaller companies do not apply the code.
Research conducted by Filatotchev and Bishop (2002) indicates that corporate governance is not an exogenous mechanism which solely provides checks and controls over the efficiency with which companies are run. The authors suggest that a firm's governance system may be seen as an equilibrium response to an individual firm's strategic needs and its competitive environment (Demsetz and Lehn, 1985; in Filatotchev and Bishop, 2002). And in a competitive environment it is the innovative and smart company that survives and manages to be ahead of its competitors.
Top management Shareholders and stakeholders Strategic control Financia l control Board Owner Influenc e Groups Co rp o ra te G o v er n an ce In st itu tio n s
Process, product or organisational innovation(s)
Figure 5: Conceptual research model
difficult task, the developments are time consuming and there are many different types of innovation. One could think of all the different types and approaches: product, process, technical versus non-technical, radical versus incremental, etc. Another difficulty might be perceived in the fact that most innovations fail while just a few become successful.
Of course, innovations, which become successful, repay all the efforts both financial as well as emotional ones invested in the innovative projects. The Netherlands performs relatively well in terms of innovation and competitiveness. The spending on research and development is rather low compared to other developed countries so there is still a lot of room for improvement, not only according to the scientific criticisms but also to the entrepreneurs themselves.
Different corporate governance factors can influence a company’s innovative performance. These factors are not to be underestimated and have been supported not only through theory but also by empirical research and findings. In the literature we can find examples of such factors as the ownership structure and the diversity and the background of the owners / stock holders, and relationships and composition of the inside (from within the company) directors and outside (external) directors, financial versus strategic control etc.
Therefore in the conceptual model developed in this thesis I look at the relationships, which may play important role(s) in corporate governance and innovation at Dutch SMEs. Is the board presence important for innovation within a company? Who is responsible for innovations and innovation initiatives? Is the decision control function of the board (if such is
