VC Representation on Boards - Reconsidering the Value of Care-Taker Directors

Marc Babinski, Partner, Borden Ladner Gervais LLP

When I meet Venture Capitalists on the street they are either running to a meeting with potential limited partners or on their way to a board meeting of one of their portfolio companies.

Perhaps in response to the memory of the harried Venture Capitalist on the run to meetings, I ask myself if his time would perhaps have been better spent by doing something other than attending a board meeting attended by other Venture Capitalists and the senior management of his portfolio companies.

To ask the question may be slightly heretical, especially from a lawyer, since the practice of requiring board representation on portfolio companies is ubiquitous and justified, in part, by the legal requirements of good corporate governance.

A look at almost any term sheet or shareholders' agreement will establish that it is a standard condition of the Venture Capitalist's investment that he have representation on the board, that the majority of directors are partners or employees of the Venture Capital firms that are making the investment and that quorum requirements for board meetings will require a minimum number of Venture Capital nominees to be present for a validly constituted meeting.

Apart from perceived legal requirements, Venture Capitalists appear to place a high value on being present at board meetings because of the expectation that it is at such meetings that important decisions about the business of the portfolio company are being made. The importance of this aspect of participation at board meetings is illustrated by the manner in which Venture Capitalists who do not have the right to nominate directors seek the next best thing: Observer status which does not confer any legal authority but which permits the representative to receive the meeting materials and attend the board meetings.

So, there is a sense that the board of directors meeting is one of the main points of contact between the Venture Capitalist and the portfolio company after the investment is made. From a legal perspective, such contact is characterized by the formal accountability of senior management to the members of the board. From a business perspective, the legal accountability is viewed by some as instrumental in eliciting maximum performance from senior management.

Typically the board of a portfolio company is composed of five directors two or three of whom are representatives of the Venture Capital investors, one of whom is the CEO and one or two of whom are independent directors with industry contacts and experience.

Legally, directors are fiduciaries of the corporation and are obliged to act accordingly[1]. At the same time, nominees of Venture Capitalists on the board are caretakers of the Venture Capitalist's investment and, ultimately, the financial interests of the limited partners who invest in the Venture Capital fund.

Not surprisingly, Venture Capital nominees are subject to conflicts of interest on the happening of such events as follow-on financings and the timing and selection of liquidity events. Once a Venture Capitalist has invested in the first round and the question of the valuation of the portfolio company arises in the context of the succeeding round, the Venture Capital nominee is in conflict of interest with respect to the portfolio company's acceptance of the term sheet for the succeeding round as his firm has an interest in obtaining the new shares at the best possible price. Similarly, in the context of a possible acquisition a Venture Capital firm that is seeking a "win" in its portfolio may be motivated to seek out and accept a purchase offer for the portfolio company which may be less than its board might reasonably expect to obtain with further investment.

In a Canadian context, the potential for conflict of interest and the existence of statutory oppression remedies in favour of minority shareholders[2] results in the practice of obtaining consents and waivers from shareholders with pre-emptive rights and the approval of follow-on financing transactions through a shareholder meeting.

Directors of corporations are also subject to personal liability for unpaid wages under corporate law and other statutes[3] which may or may not be covered by the portfolio company's directors' and officers' liability insurance policy[4].

In extreme cases when the portfolio company is in the vicinity of insolvency, the Venture Capital nominee directors will resign from the board leaving the senior management nominees to direct the affairs of the portfolio company subject to the protective provisions and the appointment of a trustee in bankruptcy.

Legal control of the portfolio company is further vested in the Venture Capitalists by protective provisions usually inserted in a unanimous shareholders' agreement or the portfolio company's charter which provide that certain fundamental actions cannot be taken without the approval of a specified number of Venture Capital investors[5].

The importance of the protective provisions inserted in the portfolio company's charter cannot be underestimated as they render any actions taken in violation thereof null and void at law. In addition, they continue to have effect whether or not the Venture Capital nominees continue to sit on the board of the portfolio company.

Arguably, the protective provisions can provide a greater degree of legal control over the portfolio company's activities than board oversight if they clearly identify the types of actions - for example issuing new shares or amending the charter to create a new class of shares - that impact the economic interests of the Venture Capitalist. In this way, the protective provisions establish an impersonal boundary to the discretion of senior management in the operation of the portfolio company's business.

Having established the typical context of legal control and governance in venture backed companies, I repeat the question asked at the beginning of this paper regarding the utility of board representation in light of the ultimate purpose of the Venture Capitalist's investment in the portfolio company: Creating returns for the limited partners that invest in the Venture Capital fund.

Admitting that the answer to the question is open to debate, my proposal is that we need to consider the value-add of venture capital beyond the money that is invested in the target company[6]. What are activities of the Venture Capitalist which will lead to successful portfolio companies and above average returns to limited partners?

Recognizing that each Venture Capitalist and limited partner may answer such a question in a different way, I would suggest that the common thread running through the different responses is the expectation that the Venture Capitalist plays a major role in facilitating the entry of the senior management team and the portfolio company's product and services into the mainstream of a specialized marketplace. What the Venture Capitalist contributes is knowledge of the various marketplaces and the judgment as to which marketplace is best suited to the portfolio company's offering.

To be successful in this task, the Venture Capitalist requires a network of contacts that is current and will assist the portfolio company in developing relationships with customers and commercial partners. In a Canadian context, this requires Venture Capitalists with strong networks in larger markets such as the United States and Europe.

In addition, Venture Capitalists can play an important role in identifying the right people to fill the personnel needs of the portfolio company. In a Canadian context, the greatest need of portfolio companies appears to be marketing and sales professionals with experience and networks in the marketplace chosen by the portfolio company. Venture Capitalists that are able to successfully assist in the recruitment of such talent do the portfolio company and their own limited partners a great service.

The foregoing functions of a Venture Capitalist are distinct from the caretaker function: Establishing and assisting the portfolio company with its internal reporting procedures, supervising the portfolio company's use of funds or "burn rate" and evaluating the performance of senior management.

Governance structures and board meetings are designed by their nature to emphasize the legal accountability of senior management to the board of directors and assist in establishing discipline within the portfolio company. This aspect of board meetings inevitably influences the process at even the most collegially and cooperatively focused board. The worst result for limited partners is where the battles at the portfolio company's board become more important than the business itself.

Maintaining and developing networks in relevant marketplaces with potential partners, customers and acquirors takes time and arguably requires sustained effort on the part of Venture Capitalists. If board commitments are multiplied by four or five and we also take into account possible obligations to sit on committees of a board we gain an appreciation of how they can distract a Venture Capitalist from making his greatest contribution to the success of a portfolio company.

If there is no disagreement that the performance of the Venture Capitalist's highest function requires a substantial expenditure of time, what can be done to counteract the forces which compel a Venture Capitalist to spend time at board meetings?

The most radical solution would be to operate a Venture Capital fund without requiring representation on the boards of portfolio companies and to rely entirely on the protective provisions to impose legal control when required. Depending on the relationship of the Venture Capital fund with its co-investors, a variation on this approach would be for Venture Capital funds to alternate with one another in requiring board representation when, for example, one Venture Capital fund is better suited to fulfill the networking function given its contacts in the marketplace most suited to the portfolio company.

The severity of sole reliance on the protective provisions could also be moderated by requiring observer status at board meetings and appointing junior members of the Venture Capital fund's staff to attend and report on them. An alternative would be to continue to require the right to nominate a director but provide for the nomination of a member of the Venture Capitalist's network who has the experience and contacts that will assist senior management in increasing the value of the portfolio company.

Finally, the Venture Capital fund can commit itself to a frequency of portfolio company board meetings of not more than once every quarter.

Whether or not any of the foregoing alternatives are adopted, a Venture Capitalist that is intentionally or inadvertently emphasizing the accountability/control aspect of his relationships with portfolio companies might be assisted by re-considering the impact of the board structure on his investment. A Venture Capitalist that refers potential employees to the portfolio company, arranges meetings with potential customers and introduces senior management to players in a marketplace in the context of an ongoing relationship with them shows that he understands the portfolio company's business and has a greater opportunity to influence senior management and the decision of limited partners to invest in its next fund.

Marc Babinski,, Partner, Borden Ladner Gervais LLP, co-chair Innovation Focus Group. The author would like to acknowledge the assistance of Tamara Despres, student at law, in the preparation of this article.

[1] For example, section 122(1) of the Canada Business Corporations Act, R.S.C. 1985 c. C-44 (the "Canada Business Corporations Act") provides as follows: Every director and officer of a corporation in exercising their powers and discharging their duties shall (a) act honestly and in good faith with a view to the best interests of the corporation; and (b) exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.

[2] The oppression remedy found in section 241 of the Canada Business Corporations Act enables a complainant to apply to a court for an order in respect of acts or omissions of a corporation or powers of the directors of the corporation that are exercised in a manner that is oppressive or unfairly prejudicial to or that unfairly disregards the interests of any security holder, creditor, director or officer.

[3] Under section 119 of the Canada Business Corporations Act, directors are jointly and severally, or solidarily, liable to employees for all debts for services performed for the corporation that become payable while they are directors, not exceeding six months wages payable to each employee for services performed. Reliance upon due diligence, financial statements and professional advisers are all available defences for a director facing liability for unpaid wages. There are also a number of other federal and provincial statutes that impose liability on directors for failing to remit wages and other related payments, including: (1) section 227.1 of the Income Tax Act, R.S.C. 1985, c.1; (2) section 46.1 of the Employment Insurance Act, S.C. 1996, c. 23; (3) section 323 of the Excise Tax Act, R.S.C. 1985, c. E-15; (4) section 36 of the Employer Health Tax Act, R.S.O. 1990, c. E.11; and (5) sections 136 and 137 of the Employment Standards Act, 2000, S.O. 2000, c.41, amongst others.

[4] It is for this reason that Venture Capital funds carry their own insurance for this purpose.

[5] In the case of protective provisions inserted in the company's share provisions it is usually provided that certain actions cannot be taken without the approval of a specified proportion of the holders of the last class of issued preferred shares.

Venture Capitalist investors would typically require that no action be taken by the company without the specified number of Venture Capitalist investors agreeing, including: (a) amending or replacing the articles or by-laws; (b) changing the authorized capital; (c) issuing further shares, options or rights; (d) purchasing for cancellation, redeeming or otherwise acquiring any of the outstanding shares; (e) declaring or paying any dividend or distribution; (f) changing the number of directors; (g) making any fundamental change to the nature of the company's business; (h) disposing or encumbering all or substantially all of the company's property; (i) incurring any single capital expenditure in excess of a predetermined amount; (j) borrowing except in the ordinary course of business; (k) becoming contingently liable as a surety or guarantor except in the ordinary course of business; (l) hypothecating, mortgaging, charging, pledging, encumbering or granting any lien or security interest on any of the assets of the company, except in the ordinary course of business; (m) assigning or otherwise disposing of any trade name, trademark or patent; (n) entering into any partnership or other arrangement for the sharing of profits; (o) agreeing to purchase or acquire shares of any other corporation; (p) appointing or replacing the auditor; (q) establishing or changing the fiscal year end; (r) determining or paying any wage or other remuneration to any shareholder, principal of a shareholder or director or officer of the company, or to any person not at arm's length with any of them; (s) entering into or amending any agreement or transaction between the company and any shareholder, principal of a shareholder or director of the company, or any person not dealing at arm's length with any of them; (t) repaying any loan, including any interest and fees, to any shareholder, principal of any shareholder or director of the company, or any person not at arm's length with any of them; (u) employing any person at an annual level of compensation in excess of a predetermined amount; (v) commencing, defending or settling any legal proceedings, except in the ordinary course of business; (w) forgiving any debt owing; (x) taking any action to amalgamate, merge or to consolidate the company; (y) making a proposal or voluntary assignment under bankruptcy; and (z) taking any action to wind-up, dissolve or terminate the corporate existence of the company.

[6] Even if those value adds are not the reason why the target company accepts the term sheet. The claim is often made by Venture Capitalists that they are "more than the money". This may matter in a competitive environment where the best companies can pick and choose between term sheets but the reality is that founders are usually happy to receive a term sheet that values their company fairly and promises delivery of funding of their business plan. The claim of "more than the money" needs to be examined closely by the limited partners considering an investment in any given Venture Capital fund.