How Venture Boards Influence the Success or Failure of Technology Companies After the Term Sheet
A White Paper by
Dennis T. Jaffe, Ph. D.,
Saybrook Graduate School
Pascal N. Levensohn,
Levensohn Venture Partners
Table of Contents
Part 2: Key Relationships Of A Venture Board
A successful start-up is a smoothly functioning network of relationships. In defining the effective start-up, the venture board must develop strong working relationships with each of the key stakeholder constituencies that form the enterprise: the CEO, the top executive leadership team, and the other shareholders. They must also develop a positive internal climate in their own relationships. An effective venture balances, respects, and draws upon each of these groups, while also maintaining proper boundaries and appropriate roles for each one.
Board Process: Personal Dynamics Of The Successful Board
Some issues transcend the company's stage of development. Not addressing them sooner can create big problems later. As we've discussed before, the quality of relationships among board members may do more to determine the success or failure of a company than the level of individual skills and capabilities. The board needs to come together as a team working with the CEO and management. A key element of a successful board is its ability to manage the relationships among board members in order to utilize and direct their talents to maximum effect. In addition to personal chemistry and having respect for each other, there are some elements of the process of board meetings that help a board perform optimally.
We've identified several aspects of the board process that make a difference, plus several common pitfalls of board dynamics, which are listed in the sidebar.
Leadership, preparation and direction. A leader emerges on every board. The board leader may not necessarily be the chairman, especially if the chair is the CEO. Most often the leader is the senior or lead investor.
Ideally, the board leader assumes responsibility for making sure the board is comfortable with the background materials and preparation that the CEO provides in advance of board meetings. This may not sound significant, but it is crucial. The board must maximize every minute of its time together. If it does not have adequate materials and background in key issues that come before it, it cannot have meaningful conversations and make good decisions in real time.
Some CEOs consider this role of preparing the board to be too time-consuming. More than one CEO has mentioned to us that the time needed to prepare for board meetings took time away from operations. In general, CEOs want less frequent board meetings and more informal contact with board members. Frankly, we view such complaints with skepticism. Start-up boards are not regulators, simply making sure all the permits have been filed and the paperwork is up to date. They are collaborators, partners, and allies who also have the duty as fiduciaries to make sure the company's capital is being spent appropriately. CEOs who can't make the time to prepare materials for board members are typically not, in our experience, CEOs who are sufficiently well organized or open-minded to suggestion. They are precisely the kind of CEOs whose behavior the board should be monitoring even more closely than it otherwise might.
The board leader should insure that there is time to explore issues, that board members have the information they need, and that decisions are not only made, but enforced. Most critical, the leader should make sure that the board stays in focus and talks about the issues that really matter. One of our colleagues was involved with a networking start-up up company where the CEO would rush the board through operational issues and then try to dominate the time allotted to question and answer by bringing in various technology specialists from the company to sketch visions of interesting future products. The CEO wanted to put on a show for the board, keeping them dazzled rather than inviting exchange or drawing on their expertise. He tried to make it seem like every issue was solved or cut and dried. Instead, the board became frustrated. The board members talked among themselves, and they all felt that the CEO was actually terrified of handling unscripted questions and insecure about his own management style. A venture capitalist on the board called the CEO and confronted the issue directly. He pointed out that the CEO should not schedule guest speakers during board time, as board members wanted concentrated time to discuss the issues that arose. That led to a conversation about the nature of board meetings that ultimately produced a much more efficient and open style for the meetings.
In another company in the telecommunications space, the CEO would invariably overwhelm board meetings with dense PowerPoint slides. Advance materials were typically available no more than 48 hours prior to the meeting, and few board members could adequately digest the content in advance of the meeting. As a result, the financial implications of the company's slow sales progress were often obscured, and useful information was buried under mountains of minutiae. The length and opaqueness of the board packages became a running joke in one VC partnership and among the board members.
To address the problem, a board member took it upon himself to provide a post board meeting analysis to the rest of the board and to management, raising specific questions for the next board meeting and requiring that these questions be addressed in writing in advance of the next meeting. This process sharpened everyone's focus and forced, in a constructive manner, the discussion to turn to the most relevant aspects of the company's strategy and financial condition. As a result, management was more accountable to the board, the entire board became more in tune with the company's real issues, and nasty surprises were avoided.
Open to diverse viewpoints. It is easy for any team to become a victim of groupthink and not only ignore minority views, but also turn away from conflict. It is easy to be overly optimistic and complacent. This is another important role for a board leader - short-circuiting denial, avoidance and hidden issues by contacting the CEO and managers and persuading them to deal with issues when necessary. He should make sure he knows the opinions of the other board members, coordinates communication, and ensures that the CEO has kept everyone informed. He may sometimes have to probe or challenge information. For example, one VC reports that after several meetings where the CEO presented rosy customer prospects and meetings, the VC finally challenged his assessment, and began to surface his concerns and doubts. The result was that the CEO's rosy picture did not withstand this scrutiny.
Effective boards maintain open communication channels to the company. Scheduling managers to give presentations and get to know the board are ways to do that. But this should not mean that executives feel they have to perform a "show" for the board. The board should ask them to present as they would internally to their peers. Key point: a board needs to make it clear to a CEO as early as possible that it will enforce its right to talk directly with employees and hear from other executives besides the CEO.
This will prevent later questions about the board "going behind the CEO's back" or other such accusations. The company does not belong to the CEO, it belongs to the shareholders, who are represented by the board. The board has the right to pursue any information or data it deems necessary to understand the company's business and progress. Legitimate differences of opinion can and do exist within companies and the board has the right to understand and weigh those differing opinions.
Ability to resolve conflict. When faced with differences, some boards seem unable to resolve them constructively. Individual board members plot against each other outside the meeting, or push conflict under the table. A skilled leader, an ethic of mutual respect, and a willingness to push to resolution are important components of managing conflicts in this area. But another useful tool boards can and should use to force more straightforward conflict resolution is meeting regularly without the CEO present. At first, this might seem like secret plotting. But in fact, it is critical that the board accept that one of its roles is to regularly assess the performance of the CEO. The CEO is accountable to the board, but board members are often reticent to raise concerns about the CEO or the CEO's program with the CEO in the room. This is human nature. Unfortunately, if the board waits until there is an obvious problem before it begins meeting in private, the very fact of suddenly meeting in private can send a vote of no-confidence to the CEO during a difficult time. So, it's a good idea for the board to establish a precedent of having some private meeting time from the beginning.
Willingness to replace a CEO or key officer. Venture boards face their greatest challenges when they must change the operating and governance roles of founders. There is no point arguing that this process is something other than difficult, painful, and awkward. It's a rare CEO who can step forward without prodding to raise the issue of whether he or she is still the best person to lead a fast-changing or growing company. Rather, founding CEOs often fail to see that they are less skilled at running a managementintensive organization than they are in cultivating the initial seeds and shaping the vision for growth. At the same time, they find it difficult to let go of their growing "child" and this creates a fundamental tension with the board.
The board may recognize the shortcomings of the CEO, but be torn between recognizing the CEO's early contribution and addressing the need for change. For these reasons, many boards fail to act decisively even when the need is clear. For example, in one Silicon Valley software company, the founder raised the initial capital for the company and created a viable technology product. But he had trouble facing the realities of the market. He believed his product was so great that it would sell itself with minimal marketing and sales effort. As a condition of an additional financing round, a new VC investor required that the company start a search for a COO, which would turn into a CEO search if results fell short of plan. Even when the numbers lagged, the board still hesitated to make a CEO change. Nobody on the board was willing to be the bad guy, confront the CEO, and make a change. In the end, the new investor forced a vote to get a new CEO. Subsequently, results have been positive, confirming that the board should have acted sooner.
Replacing the CEO doesn't necessarily mean having the CEO leave the company. For example, the technical founder might become Chairman, or take on a non-CEO creative/technical role. The board has to make sure that the founder won't become a spoiler if he stays on in a lesser role, or as a director. If the former CEO's perspective prevents the company from pursuing a new direction, keeping the CEO in any role is an untenable option.
Ten Common Pitfalls Of Venture Boards
When business is booming, there is less of the natural tension that commonly percolates through top-level teams. But when resources are constrained and prospects are less certain those pressures can disable or break apart a board at just the time the company needs leadership the most. These are some of the common pitfalls that plague start-up boards. It serves as a useful self-check for both board members and managements concerned about how well the board is performing.
These pitfalls can be used as a self-test of board performance. Members of a board can confidentially assess the degree to which each of these factors is present in their board, and tally the results. Each item has some questions that can open dialogue on these issues. The process of candid self-assessment is a key ingredient of a board that is open to learning. If a board cannot look at itself, then it will likely never ask the CEO and management team to look at themselves. Some boards ask a consultant, maybe the same consultant who works with management, to interview each board member and assess their performance each year.
Managing The Board/CEO Relationship
The CEO is the company leader to the employees of the company, the public, customers, and shareholders. But as we have seen, behind the scenes the board exerts a great deal of control and collaboration with the CEO. Two aspects of the relationship are essential-the way that the CEO keeps the board informed, and the way that the VC board members mentor and support the CEO.
The pendulum now is swinging toward the CEO keeping the board more informed, and boards are engaging in a more hands-on, consultative style. As a benchmark, several VCs noted that the successful board meeting is the one with no surprises. If the CEO has not called and briefed the board prior to the meeting regarding expected difficult questions or issues, then he has not done his job. Advance knowledge allows more time for consideration and compromise, shortening the duration of the board meeting. Also, advance knowledge reduces the formal "airtime" for divisive discussions that would ultimately come to resolution anyway.
Several issues are perennial problems. For example, CEOs should alert board members about management disagreements over cash and stock option compensation in advance of board votes. This is important because these can be emotional or high stakes issues; board members need to talk to others and reflect on what to do, not jump to impulsive action. Customer pipeline issues and revenue milestones progress reports are also in a category requiring full briefing of a board in advance. Another classic issue is when a CEO suspects a key executive is going to quit or is not performing or going to make a deliverable. The tendency is for the CEO to hope and pray that the issue resolves without the board needing to hearing about it. This is a big mistake. A CEO who repeatedly delivers surprises in these areas whittles away the confidence of the board.
It's fair to ask how tight a rein a board should keep on a CEO. After all, it's only natural that a passionate entrepreneur with the moxie and drive to start a company and build it past an idea tends to see the company as his or her baby. No parent appreciates unsolicited advice from somebody who's not there every day. As we've discussed, however, the CEO has to realize that as soon as he or she seeks outside investors and a board of directors is formed, the CEO is accountable to the board.
Certain types of CEOs seem to have the most trouble with this. The first kind sees the company as a sole proprietorship, with the board and investors just incidental players who've only contributed money. In our experience, few companies with CEOs with this attitude succeed. Another problematic group are large company executives who have never worked with a board and don't see them as colleagues. Some CEOs are insecure and just not comfortable with close accountability. Promod Haque, Managing Partner of Norwest Venture Partners and also a former CEO, notes, "When I encounter a CEO who doesn't want involvement, I need to determine why. For example, is he extremely capable and doesn't need much guidance; or is he just afraid of it?"
The VC board member may be the only one who can develop the trust and has the credibility to mentor a CEO. This is especially important when the CEO is young or relatively inexperienced. Craig Johnson, chairman and co-founder of Venture Law Group (now Heller Ehrman Venture Law Group), shares a positive experience of mentoring a CEO. A senior, highly respected VC was involved with a company facing a lot of pressure for short-term strategic moves by anxious board members. The young and inexperienced CEO was tending to react to market pressures, rather than have the patience and faith in his product to wait until the company was ready to respond. The VC mentor helped him withstand the pressure and push to create a longer-term strategy. The mentor was able to support the CEO to resist the others' requests to move quickly, quietly but firmly making his case to the board to stick with their original plan.
Promod Haque gives another example of how CEO mentoring made a difference in a company:
"We funded a software company with a first-time CEO who had been a sales manager. Frequent communication with this CEO was critical, so we created a weekly half-hour call on Monday mornings, with the entire board. This lasted more than a year. This weekly call gave us a clear pulse on the company. The CEO was able to obtain feedback regarding what was emerging, and brainstorm on whatever issues he was facing. This also helped save the board members time. We didn't have to call him up separately. Instead, we had a place to provide him with resources and ideas, and we knew we would have a dialogue. Start-up companies need that sort of regular involvement. It reduces the burden on the CEO to keep up with the board. The members then don't have to call and take up CEO time individually. It uses them productively and in an orderly way."
Board-Company Dynamics: Getting Past The CEO
A new venture cannot be structured as a traditional pyramid. By its very nature, it must be less hierarchical and more team-oriented. There are only a few employees, and they are usually of a high enough level of awareness and capability, that the board should be able to solicit input, discuss issues, and encourage participation throughout the company. Command and control structures do not allow the openness, innovation, flexibility, and quick response to change that a new venture must embody.
In the best companies, CEOs do not limit access to their teams. A board member should be free to contact employees and managers directly, and to visit the company. Directors should have opportunities to meet the functional heads of each area-to quiz them, look at their body language, and see how they work. It is hard for the board to assess "people issues" if the CEO has a problem allowing board access to the team, especially if the problem is the CEO. It is counter-productive CEO behavior to insist on being present at all board interactions with their team. Effective CEOs encourage board members to communicate directly with managers (provided of course that the CEO is informed that such conversations are taking place), both formally and informally. In many cases,VCs are instrumental in recruiting key executives, and they tend to keep in touch with these recruits. The CEO should know about contacts by a board member, and should be generally informed if issues arise.
One might think that these methods indicate a lack of trust in the CEO and the company, but prudent boards exercise oversight in this way. The key is for the board member to directly share the information he or she gathers with the CEO in order to check its validity and explore together its import. For example, in one company, the VCs developed relationships with some of the second tier of managers. In talking to several of them, they heard that the CEO had a tendency to hire consultants to do projects that were appropriately the domain of the executives, which undermined their authority and morale. They felt that they were constantly having their actions reworked by actions of the CEO. By learning this, the board member was able to gently push the CEO to make sure that he gave the proper authority to his staff. Like a good executive coach, the board mentor gathers information from 360 degrees around the CEO, in order to help the CEO better learn and grow.2
Boards frequently participate in hiring key executives. Board members commonly interview prospects to appraise their skills and make sure the company is not getting a crony or clone of the CEO. In addition, experience makes some VCs good judges of character, or of the necessary skills, which the CEO may not see as clearly.
Board Accountability To Shareholders: Conflicts Of Interest And Fiduciary Duty
"I have a test I use. Can I explain my decision as reasonable and fair to any shareholder group, not just my own." - Andy Rappaport, August Capital
The board is a complex entity, even in a start-up, as it represents several types and classes of shareholders with different rights and preferences. Common shareholders are company founders, executives and employees. They receive equity for their sweat over time and according to the board's assessment of their respective contributions to the success and growth of the enterprise. Preferred shareholders, as capital investors, structure their invested capital to protect themselves against adverse performance and to participate side by side with management in the upside above certain targeted return objectives.
How do VC board members represent the interests of these different owners in a fair and objective manner? Frankly, this is an inescapable source of tension and conflict on the venture board. This led to some of the following observations, some of which are quite controversial.
The largest active shareholders and those who elect the board are in fact the same people. Therefore, the VC board member is less compelled to listen to the voice of other shareholders than his publicly traded company counterpart, but the VC board member is a fiduciary with the obligation to consider these different constituencies, even when those constituencies include secured lenders that have legal preferences superior to those of the most senior preferred shareholders. While they represent these constituents in a larger sense,VCs don't feel they have to continually talk to them, call them, or keep them informed.
This view by VCs - who consider it the CEO's job to speak with those groups -- is controversial, especially from the perspective of other shareholders. The authors believe that it is, indeed, the CEO's job, supported by the general counsel to the company, to keep these constituencies informed. VC board members should always make themselves available for a group phone call or, in rare cases, calls with non-professional individual investors. The reality is, however, that the best VCs are well known to bankers and other investors for their exercise of fiduciary duty and for their general business judgment. Successful ventures require bold leadership and decisive actions must be taken by the lead investors that they judge to be in the best interest of the enterprise. It is a fact of life that not all investors are created equally, and the investors that do the most work, have the most money at risk, and have the best track records will continue to drive the venture company's agenda. Attempts to "level the playing field" in the name of good corporate governance are surely inapplicable to venture capital.
Brooks Stough, a partner with law firm Gunderson Dettmer, stresses that the company must achieve a balance between informing investors and keeping proprietary information confidential. One of the competitive advantages of a private company is operating in "stealth mode". Investors generally have clear contractual and legal rights to information. However, he recommends that "a company should be cautious about providing sensitive information to a large number of investors, because it may be disclosed to other people who the company might not want to receive it. For this reason, fewer investors and informal lines of communication are often better for a start-up company." He notes that angel and small investors are usually associated with a VC or company founder, and he suggests that these people be kept informed informally by the person who introduced them to the company.
In a successful venture, investors achieve a win/win perspective that fairly balances the interests of all stakeholders, rather than having one set of investors fight against others to secure its own position on top of the pile. In the current environment, having invested early capital in a company has proven to be a liability and not an asset because of dilutive follow-on financings. So typically, the newest VC money to invest in the company may attempt to fully exploit their position of strength by severely diluting both management and their prior venture co-investors. Common stockholders and the friends and family of management, may be effectively wiped out in this scenario. We view this approach as extremely shortsighted and guaranteed to create deep patterns of divisiveness and ill will at the board level. We believe boards must find win/win scenarios for divergent interest groups. Pascal Levensohn in particular notes,"When we invest in a company with this profile, everyone has to take some pain together, and we have to be comfortable investing at a valuation that is reasonable, but not the absolute lowest price possible, in order to maintain the positive bond between investors that is required to create a harmonious working board relationship. As a result, we have to walk away from some potentially attractive investments because we can't overcome the gap between entrenched divergent groups to forge a win/win solution going forward."
Another common source of misaligned boards comes from different levels of risk tolerance and patience. Craig Johnson recalls a company where the lead investor was anxious, and the company had the opportunity to cash out the investors who would get a bit more than their money back. The company had long-term capability, good leadership and potential, yet the VC did not allow it to take the risk.
Johnson sees many difficulties arising from shifts in valuation at different stages of development, particularly when those figures decline. "There is pressure if you are a first investor to stay in at later rounds, even if your interest in the company has waned. This means that founders-both CEOs and VCs-must have more of a long-term outlook and commitment, and a willingness to conserve cash to avoid more rounds of financing. The VC has to stick with the company longer. And the founder, with less opportunity for a huge windfall, has to really love the company."
Director conflicts of interest that can lead to litigation may arise as a result of a new financing round. For example, a VC director may be independent from a general governance perspective but become conflicted when his VC firm may want to lead and define the terms of the next financing. Steve Bochner notes, "This is where independent directors come into play, not only looking out for the interests of all shareholders, but helping to insulate the conflicted directors from liability." Concerns regarding VC board member liability have been fueled by a well-known case involving networking equipment maker Alantec, where the founders sued their venture backers over issues relating to the dilution of their equity ownership in an insider-led, "wash-out" round of financing.
Tracy Lefteroff, Global Managing Partner, Private Equity and Venture Capital, at PricewaterhouseCoopers, sees little protection in the current system for common stockholders, who often include early founders who have made an important contribution to the company's early success but who have moved on to another project. There is no place for them at the table in follow on financings, so they get their shares devalued. They are supposed to be represented by the CEO, but in effect they are not. This is a difficult problem to resolve. One alternative Lefteroff suggests would be for the common shareholders to be allowed to participate in new financings under the same terms and conditions as the VCs through a Rights Offering, so that they could at least maintain their pro rata ownership in the company. VCs and board leaders must exhibit statesmanship and leadership even when it is not in their narrow self-interest. Lefteroff feels that too many board members do not appreciate their fiduciary duties and do not act in the best interests of the entire enterprise.
Andy Rappaport adds, "Our role as VCs is to grow some companies to greatness. If we are about to lose some money on an investment we still want the people who are talented and may be available for another venture, to feel that the outcome was fair. In one example I gave 10% of the money that we received as preferred shareholders in selling the company to management, who had done a great job. Their own stock was basically worthless. I see that as enlightened self-interest."
The most effective leverage for fairness among all the parties is the continuing role of the VC in the wider community. The VC community remains small and will contract even more over the next several years as the downturn in venture capital continues and weaker funds collapse. VCs today are more sensitive about working together and are becoming more aware of conflicts of interest, fiduciary obligations, and the need to craft win/win outcomes for their companies. Second in importance only to the integrity of a venture company's product or service is the integrity of its board. The challenge of creating an effective board is substantial, as the board is not only the conscience of the CEO and the arbiter for disagreements among different factions, it is the difference between success and failure for many emerging companies.
Conclusions & Recommendations
The premise of this white paper is that no story of how a start-up makes it - or doesn't - is complete without considering the role of the venture board. There are specific factors that create synergy between board and company and there are best practices that have evolved in the experience of thought leaders in the VC arena. Their perspective more fully articulates the start-up venture as a community comprised of several stakeholder groups including the board, CEO, management team and other investors, who must collaborate on the basis of personal trust and good governance processes. All parties must interact effectively to create a complete and successful company.
The best way to put these new perspectives to use is through the processes of board self-awareness and self-assessment. Specifically, we suggest that a venture board can undertake the following activities:
Boards and companies can use other paths to ensure that they function effectively. They can build on the personal resources that they add to their valuable financial and technical contributions. This discussion expands the understanding of these many resources to help more companies grow to achieve their potential.
Biographies of Contributors
Steve Bochner, Partner at Wilson Sonsini Goodrich & Rosati, has practiced corporate and securities technology law for more than 20 years. He is a member of the NASDAQ Listing and Hearing Review Council where he has been heavily involved in the development of NASDAQ's corporate governance reform. www.wsgr.com
Rick Fezell, Office Managing Partner of Ernst & Young LLP in San Jose, California and is the Leader of its Emerging & Growth Markets practice in the Pacific North West. He has provided assurance and advisory services for over 18 years to technology and life sciences clients and several early stage venture-backed companies. www.ey.com
Promod Haque, Managing Partner of Norwest Venture Partners, focuses on enterprise software and communications investments. Prior to Norwest, Haque spent 18 years in various technology company operational roles. www.norwestvp.com
Dennis Jaffe, Professor of Saybrook Graduate School in San Francisco, is a world-recognized leader in management and organizational change. As a visionary for programs in corporate governance, executive development, mastering change, career building, and succession planning, he has helped companies all over the world realize the potential of their work-force. He has also co-authored several books on organizational change. www.saybrook.edu
Craig Johnson, Of Counsel at the Heller Ehrman law firm, represents technology emerging growth companies. He is a co-founder of Heller Ehrman's Venture Law Group. Johnson has been involved with technology companies for decades. www.hewm.com
Steve Larsen, former CEO of Big Fix, and former venture partner with St. Paul Ventures, has been both a CEO and venture capitalist. Larsen, a 20-year-technology-industry veteran, has impressive management experience, playing key roles in marketing and business development and sales. www.bigfix.com
Tracy Lefteroff, Global Managing Partner, Private Equity and Venture Capital, of PricewaterhouseCoopers, is in charge of services to publicly held, privately owned and venture capital-funded life sciences companies worldwide. Mr. Lefteroff has been significantly involved with services provided to a number of the firm's life sciences companies and venture capital firms for 14 years. www.pwcglobal.com
Pascal Levensohn, Founder and Managing Director of Levensohn Venture Partners, has been a professional investor for more than 20 years and has worked actively with private and public companies at the board level since 1990. He has published two articles on corporate governance since 1999. www.levp.com
Andy Rappaport, General Partner of August Capital, has more than 15 years experience as a founder, investor and/or director of venture-backed startups. He has served on more than 30 public and private company boards. www.augustcap.com
Russ Siegelman, Partner, Kleiner Perkins Caulfield & Byers, joined KPCB after 7 years at Microsoft. Mr. Siegelman invests in software, electronic commerce,Web services, media and telecommunications. www.kpcb.com BROOKS STOUGH, Founding Partner of Gunderson Dettmer. His legal practice focuses on the organization and representation of startup and emerging growth companies with an emphasis on technology companies. www.gdsvfh.com
2 In some instances, CEOs have been known to exact retribution upon those who share information with directors. Boards must view such actions as an assault upon the board, itself, and take appropriate steps to make sure the employee is not penalized for offering honest commentary.