This is the first of a two part series on the effect of Venture Boards on young companies. You can read the entire article by visiting our Encyclopedia. VC Experts enables practitioners all over the world to implement best practices through our premium content sections, contributed by experts from the best professional firms in the world. Access it today.
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
This white paper discusses the proper corporate governance role a Board should play in a start-up venture capital-backed organization. It is a best practices document designed to facilitate trust between CEOs and venture Board Members while keeping clear the unique and valuable role each plays in the life of a start-up.
Venture capitalists' ("VCs") wide experiences, social network, mentoring and other resources are of at least as much value as their capital in nurturing new ventures. We believe that the quality of the interpersonal relationships between VCs, other Board Members and upper management is the key to enterprise success.
How A Venture Board Adds Value To The Enterprise
From the beginning, a Venture Board should be designed to add value to the enterprise. In addition to crucial start-up capital, the best venture capital Board Members provide three additional kinds of capital:
Attributes Of Successful Venture Boards
Boards that provide the greatest value to their companies have the following qualities in their operation:
The Role Of The Venture Board At Different Stages Of Development
The Board, and the roles and behavior of its members, evolve with the venture in three developmental stages:
Desirable Personal Attributes Of Strong Venture Board Members
To effectively address the needs of the emerging enterprise, the most effective Board Members exhibit the following personal qualities:
The Ten Common Pitfalls Of Venture Boards
There are many causes of failure in a new venture, but some of the preventable ones include the following pitfalls that belabor Venture Boards. This white paper includes a self-test for the presence of these negative qualities in a Board:
Key Relationships Of The Venture Board
The success of the venture board rests on how it develops three sets of key relationships:
Conclusions And Recommendations For Venture Boards
The challenge for a new venture is to be aware and sensitive to the issues we raise. This paper concludes with several concrete suggestions that Boards can implement, including:
Most of the literature we read about entrepreneurial ventures and business start-ups comes from the perspective of the company founder and CEO. Books and articles chronicling the early days of companies from Apple to Amazon are presented as the sagas of visionaries who forge a dream, idea, or technology into business reality despite waves of setbacks. In these tales, the heroic CEO brings together talented individuals to form a management team that works day and night to craft an idea into a viable product and makes the business work.
For venture capitalists and other directors involved in these start-ups, such accounts often have a distinctly Rashomon-like feel; the facts are familiar and the names are the same, but just as in Rashomon, Kurosawa's classic film exploring different points of view, the interpretation can differ markedly.
This paper discusses the development of a start-up through the lens of the venture capitalist ("VC") and the board of directors, rather than the traditional lens of the CEO and management team. The popular casting of VCs in minor (or even "un-supporting" roles) overlooks the essential contribution active VCs can and do make in emerging companies. VCs' wide experiences, social network, mentoring, and other resources are of greater value than their capital in nurturing new ventures. We believe that the personal relationships and how the key people work together-the process-is the key to enterprise success. Consequently, we feel that the inability or unwillingness of a CEO to accept and utilize the value VC board members bring to a new venture can contribute to the downfall of an otherwise viable company.
This paper will discuss the proper role a board should play in a start-up organization. It will trace the three primary development stages during which the venture board adds its most critical value. It will also address the classic challenges that bedevil boards and CEOs, such as communication and trust issues, effective meeting management, and handling a change at the top of the organization. This paper is designed as a best practices document to facilitate trust between CEOs and venture board members while keeping clear the unique and valuable role each plays in the life of a start-up. While many of our comments are aimed at illuminating the responsibilities and roles of a board for CEOs who may tend to chafe at attentive supervision or resent the checks and balances a board must offer against their authority, we also have tried to balance this discussion with a frank analysis of where boards overstep or shirk their responsibilities. VCs must mediate between safeguarding their personal investments and simultaneously exercising their fiduciary duty to consider the best interests of all of the company's shareholders. Unfortunately, many venture boards are reluctant to confront their own shortcomings, leading to potentially onerous consequences affecting all of their constituencies.
With the downturn in financial markets that began in March 2000 and the extraordinary contraction in venture investing, it's never been more important for venture boards and management to embrace fundamental governance processes to maximize the probability of a successful outcome for their portfolio companies. What's more, few VCs see a clear "Next Big Thing" on the technology landscape. That means they are looking for companies that are attacking important, existing problems with solutions that deliver measurable return on investment (ROI) to customers. Clearly, execution, discipline, and efficiency have replaced sizzle and big budgets as the hallmark of the best start-ups. Just as clearly, those qualities rarely develop without an engaged and attentive board.
As part of our research, we interviewed a group of experienced players in the Silicon Valley venture capital world. These included venture capitalists with extensive board experience, lawyers, and CEOs of both start-ups and companies in turnaround stages of development. These players have been involved with the launch of scores of successful companies. They have also witnessed first-hand the devolution of companies that did not survive the intense, harrowing early development phase. One of this working paper's authors (Dennis Jaffe) is a consultant who has worked with many start-ups and closely held businesses in areas of governance, strategy and leadership. The other (Pascal Levensohn) is a venture capitalist widely experienced in funding start-ups and serving on venture boards.
Part 1: How And Why A Venture Board Adds Value To The Enterprise
Business visionaries live in a universe that orbits around their inventions or ideas. Founders imagine that their innovations are primed to transform entire industry segments, markets, and even society. These entrepreneurs typically are talented, dogged, persistent, and creative. They form the core of the business growth engine.
But their strengths can also be their weaknesses. Their belief in the vision can obstruct their appreciation of the details and processes necessary to make it happen. Their optimism can lead to over-promising and under-delivering. They often lack perspective yet chafe at oversight.
Persistence and perseverance, qualities vital for success, can kill a venture if the visionary surrenders good judgment to his will to succeed. That's why one of the most crucial developmental steps in the life of a good company is the assembly of a good board to complement as well as counterbalance the CEO. "A CEO has to be a person who follows a very deep and narrow path, and focuses on one issue, a single set of objectives. The board member, on the other hand, is a person who likes to take a broad view, has a lot of interests and wants to do several tasks at once. It is a different style. The board provides a check and balance on the skill and intensity of the CEO," observes Andy Rappaport, a partner with August Capital, a Silicon Valley based venture capital firm.
Indeed, however talented and visionary its founder may be, a company that aims to pioneer or exploit big, exciting markets must ensure that it has access to wisdom and experience beyond that of a single individual or small group of founders. In addition to crucial start-up capital, the best venture capital board members provide three additional kinds of capital: social capital, in the form of access to networks they can tap for recruiting or business services or partners; intellectual capital in terms of providing insight from their experiences that will help the CEO navigate complex situations and anticipate challenges and crises; and interpersonal capital, or a willingness to serve as a sounding board and/or mentor to the CEO1.
Not only are there different dimensions to the roles the board members play, their roles shift and grow as the company develops. "A great board cannot make a great company but a bad board can kill a good company," notes Andy Rappaport. A bad board can be characterized by meddling or, conversely, indifference; by letting personal agendas overwhelm the board's fundamental charter to represent and protect all shareholders; or by not having the courage to face crises head-on and make hard decisions - including the removal of the CEO or other management personnel when necessary. Moreover, what represents a crucial board or management asset in one phase of a start-up's life may be eclipsed in the next by a new and overarching need. A board must constantly perform self-checks to ensure that it is keeping up with the real-time needs of the company - not rewarding past efforts.
We will discuss the roles of the board during those three distinct phases at some length. But before we get into the phases and evolution of a start-up, let us start with a wish list based on attributes we have identified as the hallmarks of effective board members of start-ups:
Attributes Of Successful Venture Boards
Boards consider and advise on all kinds of different situations that a company faces. However, Russ Siegelman, a former Microsoft executive who is a partner at the venture capital firm Kleiner Perkins Caufield & Byers, offers a more fundamental comment on the role of boards. He points out that at its most basic level, "The board makes only three types of decisions-to invest, to hire the CEO and to fire the CEO." In other words, the bulk of a board's work is advisory, not operational. The board is not a shadow management team waiting in the wings to rescue the existing management team or roll up its sleeves and actually operate. It is there to offer guidance - but also to pull the plug when necessary if management cannot act on that guidance or assemble its own effective team to get the job done.
The Evolution Of A Successful Venture
Venture backed startups evolve over time and the roles of both management and the board must adapt as well. Each stage demands a more complex mix of personal and business skills in the company and from the board. This section explores the stages of venture development from the perspective of the required skills, capabilities, and contributions of the board.
Many VCs view the developmental process as having three stages:
First, the seed/startup stage, when a company has no revenues and is principally engaged in research and development and organization- building. In this stage the goals are to define target customers, craft a business model, and develop the competency to execute it. It is usually a technical, inward-focused stage. This initial stage is the time to establish a cost-conscious culture.
Second is early commercialization, which includes pre-commercialization, working product refinement, and initial revenues. This stage continues to require a high level of active VC involvement as the company executes on its business plan. At this stage, the focus is on developing relationships with customers, entering the marketplace, and testing the product or service. During this stage the company is also adding capabilities such as sales and business development to the management team.
Third is the productivity/expansion stage, when a company has significant revenues and an expected liquidity event for investors is less than twenty-four months away. At this stage the company develops cash flow, production capability, and tests the product in the marketplace on a large scale. It also prepares for the exit of the initial investors.
Complicating this model, every company will face some sort of crisis as it moves through each of these stages. Spotting, defining and resolving these crises are often the work of the board.
The embryonic venture chiefly focuses on research and development. Before a venture gets funded, the structures of the board and management team are fluid, emergent, informal, and incomplete. At this earliest stage of a company's evolution, it is essential for a positive relationship to develop between the founding entrepreneur (who may represent several co-founders as the designated board representative and CEO) and the key lead venture investor(s): we believe this is a key success factor for the company. The goal is to establish a level of trust between the founder and the lead venture investor that equates to alignment of purpose.
A delegation, often including the founder and a key manager, may present an idea or a prototype to the VC firm. While some entrepreneurs start this process believing they are seeking only funding, the meeting and relationship-building with the VC should be a window into other potential resources that the VC can provide. For example, the venture capitalist may know talented executives looking for new positions who would be good fits for the start-up's growing list of needs; or, the venture capitalist may have experience in the business segment the start-up hopes to address, and can offer new and valuable insights.
The process of shopping the idea helps the founder and the team develop their ideas into a business plan. These presentations are not just sales sessions: they are also explorations of feasibility. The prospective VC can add value to the venture even at this stage by asking questions and exploring different possibilities. It can be uncomfortable for an entrepreneur, but a founder benefits from the more distant and even critical perspective of the prospective investor.
There's no question that this stage can be an exhausting and frustrating experience for the company founder. It is a fact of the marketplace that desperate entrepreneurs see money as something rare and valuable, and VCs see good ideas as commodities. The VC is in the business of turning down hundreds of people a year. The CEO may be facing criticism and disinterest from many funding sources. However, when a VC says "No" to a prospective portfolio company, it can be a positive learning experience for the entrepreneur if the VC provides constructive and concrete reasons for passing on an investment. It's important for an entrepreneur to listen carefully rather than defensively, even when the news or feedback is hard to hear. Steve Larsen, formerly of St. Paul Venture Partners, who has been both a CEO and a VC, says he makes a point of giving a prospect clear, direct, and honest feedback about his reasons for rejecting a given deal - thus giving the entrepreneur the chance to either adjust the business plan or prepare more effective counter arguments to the same objections at the next meeting with a different prospective investor.
Let's assume for now, however, that the parties find mutual benefit in deciding to work together. In the ideal scenario, the VCs and CEO push forward in a spirit of respect, collegiality, and honesty. Very commonly, however, the seeds of trouble are already brewing. The negotiations may have been difficult and frustrating for the CEO. Very likely, he or she had hoped to retain more equity or raise more funding in the seed round. For example, the former CEO of a retail franchise venture in which one of the authors was involved, felt from Day 1 that his venture investors took too much equity, and also were planning to push him out. In fact, his investors were trying to help him learn about retailing, a domain in which he had virtually no experience. They encouraged him to take the role of technology visionary. However, the CEO maintained an attitude of resentment and kept the investors at arm's length. He was negative with the board, and ultimately that did lead to his removal.
There are plenty of cases where both parties have behaved in a mature, professional manner and wiped the slate of whatever power plays and disappointments may have occurred during courtship, however. The authors are aware of another start-up whose seed round negotiations were filled with acrimony as the founder played rival firms against each other, almost to the point of driving the lead investor away. The VCs were concerned that the company was going to be a management headache, but pushed ahead because the technology was so exciting. At the first board meeting, the CEO made a point of stating that he had been aggressive in working for the best deal because he believed so strongly in the company and wanted it to succeed. Now, he said, he was prepared to go forward as a team. His willingness to make such statements in a forthright manner set an excellent tone for the company and for what became a no-nonsense, very effective board.
After completing a first institutional round of financing,VCs typically join the board as directors elected by the preferred shareholders. The first joint task of management and VCs is to staff up the company by recruiting talented employees and defining their roles, and attracting one or two other investors to syndicate the risk of the newly born enterprise. The optimal size for the start-up board in the seed stage of development is between three and five people. This breaks down into one management representative and two venture investors, or two management representatives and three venture investors.
According to VCs with whom we spoke, several characteristics are essential to the successful growth of personal chemistry between the entrepreneurial CEO and the VC board members. Most importantly, both sides must be open to listening to the other. This is what lays the foundation of a good board and a good working relationship between management and the board. While confident, each must have the ability to see that the other party has resources, experience, and ideas that might represent acceptable or even preferred ways of doing things. These qualities of personal maturity cannot be wished into reality or legally compelled. A passive or uninvolved investor not willing to commit the time to prepare and give the best thought to a variety of concerns is a real liability in the cause of forming an optimized relationship between management and the board. However, so is an overly defensive or arrogant business founder/CEO unwilling to candidly confront problems, listen to counsel, and use other resources that might divide or limit his power over the company.
When such qualities are apparent early in the relationship, the parties observing the negative behavior should be up front and assertive in pointing out the problem and urging frank discussion aimed at diffusing it. The VC/founder relationship is not a direct authority relationship in that the power to make most decisions still resides with the founder/CEO. But the board has the power, and indeed the duty, to hire and fire the CEO if it believes he or she is not acting in the best interests of the shareholders.
Similarly, a CEO faced with many business challenges but an indifferent or disengaged board member must be prepared to confront that board member and ask for the board member to discuss his or her intended commitment and engagement. If the CEO does not feel he is getting what he needs from his board, it is the CEO's responsibility to press the issue. CEOs need to work cooperatively with lead investors to either replace non-performing board members or to break the pattern of passivity. More often than not, these board members need to be replaced, using the next financing round as an opportunity for them to exit gracefully. If these problems appear this early in the relationship, they can only get worse unless both parties confront and resolve the situation.
As a company recruits the next layer of management (including the sales and service organization, the chief financial officer, and a senior marketing officer), the process of building a real company out of a promising idea or technology begins. As the company enters the early commercialization phase, it continues to demand more active participation from the board.
In the aftermath of the technology bubble bursting, a fundamental shift has occurred in the venture capital industry toward greater risk sharing in various financing rounds. While this has created new alliances among venture firms, it has also created unlikely co-investors in some cases. Often, venture investors seek to not only syndicate risk but also to obtain independent valuation validation by a new venture investor. As a result, subsequent financing rounds often create a situation where the company is revalued and where a new VC joins the original seed investors. With the new VC's investment may come a board seat and new expectations or changes to the company business plan or strategy.
It is not unusual to see a commercialization-stage venture board with three VCs, each representing the largest investor in each series of preferred stock offerings (the A, B, and C rounds); plus two insiders (the CEO and one other member of the management team, possibly the CTO or a co-founder) whom the common shareholders elect. As a company grows, a successful board is likely to add new independent members with domain expertise in the company's industry sector or with financial experience. Sarbanes Oxley requirements have accelerated this process among private companies, particularly if the company contemplates an Initial Public Offering (IPO) in its future.
According to Rick Fezell, who is the San Jose Office Managing Partner and Emerging & Growth Markets Leader for the Pacific Northwest practice of Ernst & Young, "the trend of establishing private company audit committees in response to Sarbanes Oxley has begun. This subset of the board should consider fulfilling its responsibilities as required by public company audit committees under Sarbanes. A premium is being placed on recruiting private company board members who are both willing to serve on audit committees and who qualify as 'financial experts' under the guidelines."
To be effective, the board must draw on resources from individuals with the appropriate skills-for example, the VC who is a brilliant software engineer may not be the best choice to lead a merger and acquisition evaluation or build complex models that analyze capital structures. In this phase the networking expertise of a VC can come into play. Steve Larsen recalls being recruited to serve on a company's board by a VC investor. "The VC and I knew each other and had previously worked together. When she put money into the company she felt the company needed an A+ marketing executive. . . The CEO was a techie, who didn't know how to recruit a marketing executive. The CEO just didn't know that side of the business. I came on and did a bunch of things the CEO would not have known how to do."
Friction commonly arises at this stage in the company's growth, and by far the most significant source involves adding or replacing team members. The CEO often wants people who make him comfortable, or executives with whom he has worked in the past. However, it is the board's role to broaden the CEO's perspective and add talent that the CEO might not be able to envision. Successfully recruiting the most effective executives for the business execution and revenue growth phases of a company's evolution often requires moving founding entrepreneurs out of senior management and senior operating positions and into more supporting roles.
Replacing personnel or adding a COO is a very delicate and thorny process, often fraught with emotion. Many founders find it particularly galling to be passed over or found wanting in their skills at precisely the time when their fledgling companies experience rapid revenue growth and performance above plan. It is an emotionally difficult time for founders because the sweat they have poured into the research and development phase is the foundation for the success the company is currently enjoying. They may view the situation as one of betrayal by the VCs. This is a delicate inflection point in a company's history where VCs' intellectual capital comes into play.
The VC who has seen time and again what young companies need as they develop can anticipate the next phase and its challenges, while entrepreneurs envision the company's success as the inevitable result of them personally shepherding the start-up to the finish line. To manage this transition process successfully, the VC board members must focus everyone's attention on the necessity and inevitability of change. Business reality is far less orderly and never as sequential or neat as an engineer or software programmer would like. It is messy and requires adapting to shifting dynamics of the marketplace and within the company's own ranks.
We have found that focusing the management team on the alignment of economic interests between investors and entrepreneurs is essential to managing this process successfully. As long as the VCs protect the economic interests of the founders who have made major contributions to the company, the blow to the entrepreneur's ego can be softened by the recognition that the best team in business execution may not necessarily be the founding team. It is the combination of the two, and the successful hand-off from the first to the second, that can generate substantial economic rewards for all of the constituencies involved.
The VCs are not the only players actively preparing the company for success at this phase: Best of breed venture companies have strong CEOs with strong personal contact networks. In the commercialization stage they, too, can make a significant addition to the long-term health of the company by recruiting one or two notable independent board members with real industry standing and relevant capabilities. It's important to point out that it has become difficult to recruit high caliber independent directors. In the late 1990s, independent directors used to be lured by very attractive stock option grants in the seed round, but today they will serve mainly out of respect for the company and its CEO. These recruited members can provide additional balance on the VC perspective. We typically regard that as a good thing, although some VCs resist it.
Steven Bochner, a partner with Silicon Valley law firm Wilson Sonsini Goodrich & Rosati who has recently worked with NASDAQ on applying governance reform to public companies, sees pro-active companies seeking independent directors earlier in their development. "What you are starting to see is more sensitivity to the concept of board independence, at an earlier time. Directors who can provide an independent perspective and also insulate the board from liability." Bochner agrees, however, that it is difficult to find the incentives to recruit truly independent directors who have no tie to the VCs or to the CEO.
As we've seen, the transition out of the early commercialization stage can be a tumultuous time for the company. Typically, there has been a significant increase in personnel, many of whom have come from beyond the founders' circle of contacts. Similarly, as the board develops, the skill set required from VC board members will also develop. The board should bring in members with complementary, not competing, skills. The effective venture board thus polices its own composition as well as that of the management team.
At this stage, typically three to five years from inception, the company has achieved significant levels of revenue and perhaps achieved profitability The VC board member has been rewarded by the success of the company and is now looking ahead to exit options and helping the company become self-sustaining. While the CEO may be occupied with the company's performance, the VC board members are motivated to look for exit options, such as a sale, an IPO, or a merger. Therefore, they must also be looking for their own replacements on the board. Independent directors who are likely to remain on the board after an IPO often become more active at this time. Board members skilled in structuring exits through mergers and acquisitions also may play an increasingly important role.
When a liquidity event is achieved through an IPO, some VC board members may continue on the board while others may exit. While the path VCs take may often be a function of their skill sets (VC seed investors often prefer to spend time with younger companies), the decision to stay on a public board has become more complex for VCs across the board given the director liability and other provisions of Sarbanes Oxley.
It is not uncommon for the period surrounding the exits to be characterized by developments some would term crises. These can take any number of forms. Most recently, for example, thousands of venture companies have required triage and complex financial engineering to reset management equity option incentives, realign the interests of venture investors, and attract new capital for mere survival. In other words, the collapse of the IPO market and declining investment in technology across the board created widespread financial crises. Patching up and bailing out enterprises that have taken on red ink is a timeconsuming and difficult challenge that has stretched the resources of many venture capitalists. In some cases, the best option ends up being liquidation at cents on the dollar. In others, it becomes clear that while a company has valuable technology or market share, its prospects are limited by what it doesn't have - say distribution, or access to global markets, or a more complete product line. In those cases, company founders may vow to hold on and keep building, while more experienced VCs may feel that the time has come to sell.
Any of these situations can be termed crises-or opportunities. Good boards constantly and proactively assess viable exit options. For example, we are aware of a company that had limited cash resources but a robust customer pipeline. However, there were no guarantees that the customer pipeline would convert to cash and accounts receivable before the company either ran out of cash or required another equity infusion. The problem the company faced was that, despite solid prospects, none of the existing investors were prepared to write another check to fund the company's operations. Management felt uncertain about the future, and key executives were at risk of leaving the company for fear of their own financial security. One board member focused the board and management on an analysis of the reality of the situation. The board developed the consensus that an orderly sale of the company prior to reaching the crisis point was the only realistic way to move forward. Disagreements among investors were settled as everyone realized that no financing support existed around the table and that any new investor would most likely penalize all of the prior investors. As a result, a far more serious crisis at the company was avoided.
A critical point about crises is that they tend to trigger defensive behavior at just the moment when a team effort is needed. The CEO may want to protect the board from the information, feeling he or she can turn things around. Too often, entrepreneurs and VCs alike get hung up on hoping for a low probability event to occur that will shift the balance of a bad situation. When the board indulges in such hope-based behavior, it's ignoring the reality that pursuing too many options simultaneously reduces the likelihood of an outcome that minimizes downside risk. Even experienced investors sometimes forget that failing to make a choice and maintaining the status quo is a choice in and of itself.
Personal Attributes Of Strong Board Members
At heart, a board is a team. And just as any team is influenced and enhanced by certain types of personal qualities and skills, there are certain personality traits that tend to be highly correlated with good board members. Among them:
1 Every CEO should serve on a board separate from his or her own company. This helps CEOs take a broader, more strategic view and also understand why board members act as they do. CEOs become better operators when they have experience of their own at the board level.