Boardroom Dialogue

Minimizing director turnover

One of the results of my survey on boards of private equity-backed companies could be news to several VC's out there: boards of financially successful companies had a lower turnover of directors. In the survey respondents profiled a specific board and indicated the level of the exit or its current financial performance if there had not yet been an exit. In looking at the nearly 200 boards, there was an average of 1.4 directors leaving the board in the relatively short life of these boards. (For those not familiar in the industry, the board is typically overhauled at the exit.)  Some boards had higher turnover and more of those ended badly for investors.

While some of the churn is anticipated because of new financings, there were a number of other more unexpected reasons the directors left, such as the departing director's lack of interest or time (the two are related), and a director being  asked not to return.  For the latter, I heard this echoed in comments from a VC who mentioned that the outside or independent director from industry was only needed for a year and then he would replaced, sort of like he was used up. I suppose that if you're only looking to use the person's contacts then yes, he/she is easily used up in a year. However, that is exactly the problem attitude that leads to a weaker board.

Why does high director turnover lead to weaker boards and correlate to weaker financial outcome for investors? It takes time to find a new director (months) and another chunk of time to get up to speed on the inner workings of the company and the board itself.  This can be a year. More importantly, boards that feel that a short stint from a director is useful have missed the point. If someone seen as useful for a short time -- he/she is a consultant and should be hired as such.  The role of a board member is not project specific. Indeed, there is a hint that such a person is somehow subordinate in that boardroom -- other reasons why SARBOX's stance on board members getting consulting contracts applies to good governance in general. The board members  should form a group of peers  to oversee and guide the company over the longer term, acting in the best interest of the company and all its shareholders -- more on that in another posting. This peer group is not a bunch of friends, but knows each other well enough to constructively disagree. Any departure or new arrival of a board member means a period of adjusting before the group can reach its effective level of open frank debate. And as you all know, time is of the essence for these companies.

Take your time

This posting is a plea to entrepreneurs not to rush taking on investors or board members.  Since in private investing taking on investors usually involves taking on board members as well, both should be done with care -- getting rid of a board member can be nearly as impossible as getting rid of a ornery shareholder (yes they do exist).  And when they are one in the same....you can imagine the nightmare.

What does it say about an investor who gives you a check after your first meeting? Probably says the same thing as it would say about a person who agreed to marry you after the first date. Indeed, as Hugh Cullman of Silicon Alley Venture Partners has stated so well in many presentations on venture investing, getting married and getting funding are very similar. His speech is far more amusing than my recap here, but the point remains -- an investor who is planning to add value will take their time in looking at your company.  From my experience, it is 8-12 weeks sometimes more, rarely less before an investment passes all the due diligence, deal terms are worked out and the investor(s) and entrepreneurs have clarified how they will work together post-closing. While the investor (s) are doing this process, it is an ideal time for the entrepreneur to get to know them as well.

The most simple and logical form for the working relationship is the investor takes a board seat. Of course, if there are a number of investors involved, as there usually are in venture investing, then there is a choice of board member. The one who did most of the due diligence digging and/or hard ball negotiating  -- the lead investor -- is usually the one that pops into mind for the board seat. However, it could be that they are a deal addict and will focus their time and attention on the next deals and not on "dull" board meetings. Too often, an entrepreneur takes a passive role and the investor that squeaks the most  gets a board seat.  Such a board could end up full of strutting peacocks. Ask yourself, does this investor have the time, motivation, mentality and experience for a board role? If you're not sure of the answer, open the discussion and agree to a process for how the board can replace an investor representative if, for example, they fail to attend a number of board meetings or have a conflict of interest. 

Remember, you're in it together for the long haul, so take your time.

The Delicate CEO Transition Issue

Pascal Levensohn, an experienced venture investor in California, has published a new white paper on the delicate issue of CEO transition in venture-backed companies, and it is available on his web site. As his interviews and own experience shows, CEO succession is a natural part of a company's evolution; the CEO who goes all the way to a billion dollar company is the very very rare exception. He outlines the warning signs and best practices for managing the transition.

The job of the board is to watch for these signs and come to a consensus on how to proceed. What may surprise some is how often board members do not agree on whether a transition should take place. Some directors fear the devil you don't know more than the devil you do.  And board members should carefully evaluate whether the challenges a company faces are ones the founder CEO can develop through with coaching or augmenting the management team.

Companies can and do die while the board argues about this issue. The issue of who is the right CEO and their appropriate compensation is one of the top two sources of disagreement -- the other being valuation.  In my survey on boards of venture-backed companies, the most frequent reason a founder CEO is replaced is because of his or her inexperience with the size to which the company has grown.  Amongst other things, how to recruit and manage others is usually not part of the skill set of start-up entrepreneurs; large company people have those skills and entrepreneurs are not large company people.

The problem is not only experience but often attitude as well.  Defensive behaviors, as is often evidenced in the board meetings, are a clear red flag for me. Building in a CEO evaluation process into the board calendar provides a good mechanism to at least get the subject on the table. But even prior to an investment, one can pick up key signals.  Entrepreneurs who crave a controlling shareholding often are the ones who don't see that they are missing key skills when the company grows beyond the $ 5 mln revenue mark.  If they don't feel that having 20% of a growing is better than 55% of a stagnant one, then the investors are in for a rude awakening. Of course the entrepreneurs need to have a huge amount of faith in their company as well as themselves.  But faith to the point of deafness is detrimental.

As Pascal states "the feeling of betrayal is rooted in the poor communications between the (investors) and the founders about the natural evolution of venture companies."  Betrayal can be felt by both entrepreneurs and investors.  In the positive aura of the closing "honeymoon" inexperienced investors often overlook having the discussion with the entrepreneur about "what if you're not the right person to lead this company to where it needs to go".  It is a tough discussion and it is much harder to start after the investment is in.  Key to it is an effective board in place that can manage these expectations, take on the needed dialogue and do it in a fair and clearly objective way.

The Active Investor

During a talk recently,  Bo Peabody, author of "Lucky or Smart" and founder of Village Ventures and Tripod, mentioned that one of the things that entrepreneurs don't understand about VC's is that they really don't want to run the company. He pointed out that indeed they don't have time for it, and are busy with at least a few other portfolio companies and are really jazzed about the next few deals. Investors of many types, including angels, do count on the management being there to do their job, at least at the beginning of the relationship. Passive investors (yes, they do exist) may not even meet with management post-investment let alone have a seat on the board.

However, those active investors do get involved. Most often it is a board seat through which they evaluate, coach, advise, and assess a whole range of issues. From my survey (see survey report "Shining a Light") on boards of private equity-backed companies, a typical number of board meetings is 5-8 per year with a noticeable portion having more than 9 per year. Outside the board meetings the investor director is also searching for good candidates, dealing with financing issues and actively supporting the company in other ways. Adding in these other activities, the majority of these board members spend 10-30 hours a month on a portfolio company. 

It is not all just support when the CEO wants it. They are routinely monitoring the performance of their investment. Some entrepreneurs find this borders on "running their company", especially since most investor directors are querying what is happening with financials and sales on a detailed level.  These reporting requirements are usually spelled out in the investment documents. So, entrepreneurs, read the fine print and if you can't live with the involvement or monitoring by your active investor, then don't take their money. 

New insights on liabilities

Last week Dan Bailey, expert in Directors & Officers issues at  Bailey Cavalieri LLC gave a great presentation here in Connecticut on the special liabilities facing those in the private equity world. In particular he was addressing what happens to employees of private equity or venture capital (PE) firms who also sit on the boards of their portfolio companies. Yes indeed, the claims are increasing, and they are predominantly from other shareholders in the portfolio company.  He pointed out that the PE representative, because of their experience and sophistication, is likely to be held to a higher standard and thus more of a target. Indeed, the PE firms with controlling interests (either through shares or loan covenants) are especially liable for claims -- they are viewed as the deep pockets by the dozen or so litigation firms aiming at them.

In particular Dan pointed out that a PE representative, as a member of a portfolio company's board has a different duty and responsibility to the company itself and that that representative needs to keep that duty separate from their allegiance to their employer. Since it is hard to prove that a single person has performed these roles separately, it is best to have two different people fill the two roles -- one person sit on the board who is not an employee of the PE firm, and one at the PE firm who fulfills the shareholder role. He also recommended that the PE firms seek strong independent directors as a means to reducing liabilities.

He is not the only lawyer seeing the need for this. This morning, Holly Gregory of Weil, Gotshal & Manges,  a renown governance law firm, also highlighted that an investor's agenda and a board member's agenda are two different things. A board member cannot take direction from an employer, whether a PE firm or a corporation, in regards to how they perform their duties as a director of another company. If they do, that shatters their duty of loyalty to that company and after that large liabilities loom.

Time to exit

I was recently talking with a Belgian investor friend of mine about timing of exits. A company where we had both been investors had ultimately failed but there had been two offers for the company in an earlier stage, a year or so before the bankruptcy. In late 2000, early 2001 the world (in Europe) did look rosy and the other investors did not want to sell, convinced that the company needed to grow further to maximize sale proceeds. In hindsight, we all wished that a sale had happened well before the cash ran out.

Is there a best approach to the exit timing? Should one take the first offer that comes along? My guess is that it much depends on the stability of the company going forward. In the heyday of the early 2000's we assumed that further financing could easily occur. We were very very wrong.  Even if a company has larger VC investors, it doesn't mean that a follow-on round will happen. VC's rightfully can and do change their opinion on the whether investing more money into one company is a better place for their LP's money than investing in another company. This issue is one which entrepreneurs typically miss. They often can't imagine one of their investors not continuing to invest.  My survey  (see survey report in my web site)   showed how strong this tendency is, with more than half of the management respondents indicating that they expect investors to continue to participate in follow-on rounds.

Exit timing and valuation level is a hotly disputed area among board members. An investor board member may be under pressure to get a quick sale for reasons unrelated to the company such as starting to raise a new VC fund. Often these pressures are unknown to the entrepreneur and can take them by surprise. The pressures differ by investor and change over time.

Ideally, a board of a VC-backed company should discuss and update regularly a set of exit "scenarios" which would include an assessment of what it will take to get there including milestones and follow-on financings, as well as likely trade sale buyers, and trends in IPO and M&A markets. It is time to take these kind of discussions into the board meetings themselves with the entrepreneurs or founder shareholders present, rather than in bilateral telephone calls between the VC's.

Jeff Bussgang's 5 reasons entrepreneurs don't like VCs

In reading Jeff Bussgang's 5 reasons entrepreneurs don't like VCs, I was reminded again of the common misunderstanding that perpetuates among entrepreneurs. They believe a board is there only to help them. It is not. It is also and essentially to monitor what is going on at the company on behalf of shareholders. Yes, value add is perhaps what the VC spent most of his/her time selling the entrepreneur on, but at the end of the day, the little time the VC has will be spent often just on the basic monitoring.

Reason number one was: "Board room M.O.:  show up late, pound on the Blackberry, look up and ask a question that was answered 2 hours ago." That is a clear sign of a sloppy, ill-prepared, over-committed board member who ideally should be replaced. Since most boards won't do that, remember for next time, entrepreneurs, to look deeply into the eyes of the prospective investor, know what their time committments and what their board habits are before you sign the deal.

The EVCA's Guidelines

The European Venture Capital Association has just come out with their guidelines for corporate governance in the management of privately-held companies. It may, however, not be worth your time to read it. The document seems to be more of a cut and paste of guidelines issued for large public companies, with much verbage on risk assessment procedures and hiring specialist help for regular cost benefit analysis. Given the risky nature of much of private equity and in particular venture capital investing, there usually isn't time, nor money, nor staff to analyze and produce reports on risk assessment. In capital-raising the risks are typically spelled out and those in the PE industry are usually aware of the huge range of risks they face.

More interesting is EVCA's older research much of which is free to download.

You get what you pay for

So, there are still many a VC as well as entrepreneur out there that thinks that with a few options on common stock that you will entice an experienced well-connected (and thus busy) person to take the time to be on your board.

Maybe the entrepreneur thinks, "Well, I don't really want them on my board. That would be giving them too much control. Just some advice when I need it would be fine"

Some free advice can be worthwhile, but it is not repeated. You want them to be there over a longer time period -- years even. To get true value out of the relationship, the advisor or board member will need to get to know all about you and your company -- all the warts, worries etc. You need to structure the relationship.

Whether you create an advisory board or a full fiduciary board depends on a variety of issues such as number of shareholders, and whether you're seeking new funding. In either case you should plan on compensating that person for their time, just as you pay yourself some level of a salary (when the business is established). You can be creative, as Susan Stautberg does when she handles an advisory board; for a luxury hotel group, the advisory board members get to stay at one of the hotels for free. You can add options to add icing to the cake, but common share options alone can lose their appeal if layers of other preferred shares are piled on top. Generally advisory boards are paid per meeting, if it is the kind which is holding planning or strategy sessions.

The fiduciary board role has added risks and responsibilities (see legal issues). You need it to be there in fair weather and foul. When you have other shareholders besides you and other managers, a board with non-executives is an essential part of doing business properly. 

For what it is worth, here are some benchmarks. From the annual NACD's study small public companies (revenues from $50 to $200 mln)  range in total compensation for board members from $14,000 to north of $100,000 per year both cash and stock-related.  Valuing the stock portion for private companies is much harder, so to give you and idea on the cash portion, it ranges, depending on the industry, from $10,000 to $40,000 . These numbers include both annual cash retainer and board meeting and committee fees. I would lean toward the annual cash retainer with, if applicable, additional fees for serving on committees and not the board meeting fees so that no one is tempted to cut back on board meetings as a way to save money. In tough times, the board will need to meet more often.

What really gets paid for those lonely independent directors of VC-backed company boards? Too little for them to stick around when the going gets tough.  Any company that has attracted venture money and pays a CEO tens if not hundreds of thousands can and should pay the outside/independent director who does not represent a venture firm or class of stock.  A ratio to CEO pay of 1:10 would be in the right ballpark.

Also, popular but not headed in the right direction is the tendency to create a consulting contract for the outside director. That tends to make the consultant director part of the management team delivering certain work -- a fine arrangement if you need more management but not what a board of directors should be in the habit of doing. 

A better way to recognize that independent directors are often more involved would be to create a board committee or working group in that area -- say Sales and Marketing -- and pay the director(s) in that group a higher committee fee for their greater time committment. As a board committee it reports to the full board, thus keeping the line between management and board intact. Remember, you can't judge you own work.

As a new director

If you're joining your first board of an organization, whether public, private company or non-profit, you may be wondering about etiquette. When is it appropriate to ask a question, or make a comment and when not and how to do it? Here are a few pointers:

1. Before your first meeting you should take advantage of getting meetings with other directors and managers and ask them as many background questions as you can to get yourself up to speed. If the company or organization doesn't come with these appointments, ask for them yourself.

2. Be aware of and respect the agenda. The Chair and CEO have (hopefully) put some thought into the agenda and what needs to be covered at that meeting. Even better is an indication of the time on the agenda that the Chair expects the item to take so if it is a 10 minute item you know that you won't have the opportunity to dig into deep philosophical questions behind it. You should, however, indicate if you feel you would like to learn more about the issue off-line or if you feel that the item should be revisited at another point in time. This latter comment should then be minuted so that the board remembers to revisit it.

3.  As a wise person once said (and I'm looking up the name), feel free to disagree but don't be disagreeable. Tone and how you phrase your comments are key to keeping yourself an effective member of the board. Too many non-constructive, negative or cynical remarks can drain the board of energy to get things done. On the other hand, too many sweet positives wastes time and dangerously misleads. If you don't have anything to add that is relevant, then don't feel you need to say anything. Watch out for cultural issues too -- there will be differences across countries. For example, the Dutch are generally much more blunt than Americans from my experience.