Outside People Resources
Board of Directors
Deciding whether to have a board of directors and, if the answer is yes, choosing and finding the people who will sit on the board, can be troublesome for new ventures.*
The Decision. If your firm is organized as a corporation, it must have a board of directors, elected by the shareholders. There is flexibility with other forms of organization. However, many small firms do not have a board, and many who do fill it with friends and insiders. Our message is that the board should comprise people who are linked to key aspects of the opportunity you seek to grow. In addition, certain investors will require a board of directors. Venture capitalists almost always require boards of directors - and that they be represented on the boards. Beyond that, deciding to involve outsiders is worth careful thought. This decision starts with the identification of missing relevant experience, know-how, and networks, and of what the venture needs at this stage of its development that can be provided by outside directors.
*The authors are indebted to Howard H. Stevenson of the Harvard Business School and to Leslie Charm and Karl Youngman of Doktor Pet Centers and Command Performance hair salons, respectively, for sharing their insights concerning boards of directors.
Their probable contributions then can be balanced against the fact that having a board of directors will necessitate greater disclosure of plans for operating and financing the business. It also is worth noting that one of the responsibilities of a board of directors is to elect officers for the firm, affecting decisions about financing and the ownership of the voting shares in the company.
It can be argued that the makeup of the boards of the Internet IPOs that flooded the market between 1998 and 2000 might have been flawed because they were dominated by company executives and venture capitalists. Some argue that at least half of the board members be outside directors.8
When Art Spinner of Hambro International was interviewed by Inc., he explained that entrepreneurs worry about the wrong thing ". . . that the boards are going to steal their companies or take them over." Though entrepreneurs have many reasons to worry, that's not one of them. It almost never happens. In truth, boards don't even have much power. They are less well equipped to police entrepreneurs than to advise them.5
As Spinner suggests, the expertise that members of a board can bring to a venture, at a price it can afford, can far outweigh any of the negative factors. David Gumpert and his partner in what was originally Net-Marquee (an online direct marketing agency) chose their advisory board by focusing on "holes" that needed to be filled, while also being mindful of financial constraints. According to Gumpert, "the board continually challenged us - in terms of tactics, strategy, and overall business philosophy." These challenges benefited their company in three ways: (1) prevented dumb mistakes, (2) kept them focused on what really mattered, and (3) kept them from getting gloomy10
Selection Criteria: Add Value with Know-How and Contacts.
Finding the appropriate people for the board is a challenge. It is important to be objective and to select individuals who are known to be trustworthy. For their first outside directors, most ventures typically look to personal acquaintances of the lead entrepreneur or the team or to their lawyers, bankers, accountants, or consultants. While such a choice might be the right one for a venture, the process also involves finding the right people to fill the gaps discovered in the process of forming the management team. This issue of filling in the gaps relates back to one of the criteria of a successful management team: intellectual honesty - that is, realizing what you know and what you need to know. In a study of boards and specifically venture capitalists' contribution to them, entrepreneurs seemed to value operating experience over financial expertise.11 In addition, the study reported that "those CEOs with a top-20 venture capital firm as the lead investor, on average did rate the value of the advice from their venture capital board members significantly higher - but not outstandingly higher - than the advice from other outside board members."12 Defining expectations and minimum requirements for board members might be a good way to get the most out of a board of directors.
A top-notch outside director usually spends at least nine to ten days per year on his or her responsibilities. Four days per year are spent for quarterly meetings, a day of preparation for each meeting, a day for another meeting to cope with an unanticipated issue, plus up to a day or more for various phone calls. Yearly fees are usually paid for such a commitment. Quality directors become involved for the learning and professional development opportunities, and so forth, rather than for the money. Compensation to board members varies widely. Fees can range from as little as $500-$l,000 for a half- or full-day meeting to $30,000 per year for four to six full-day to day-and-a-half meetings, plus accessibility on a continual basis. Directors are also usually reimbursed for expenses incurred in preparing for and attending meetings. Stock in a start-up company (often 2-5 percent) or options (for 5,000-50,000 shares) are common incentives to attract and reward directors. Additionally, Art Spinner, a director of eleven companies and an advisor to two others, suggested the following as a simple set of rules to guide you toward a productive relationship with your board:13
Treat your directors as individual resources.
Always be honest with your directors.
Set up a compensation committee.
Set up an audit committee.
Never set up an executive committee.
People who could be potential board members are increasingly cautious about getting involved, for several reasons:
• Sarbanes-Oxley legislation/ The Sarbanes-Oxley Act of 2002 is
the most sweeping legislation affecting corporate governance, dis
closure, and financial accounting in more than a generation. Sections
302 and 404 require that CEOs, CFOs, and independent auditors
and committees
- Certify the accuracy of financial statements and disclosures
- Indicate in each periodic report whether or not there were
significant changes in internal controls or related factors since their most recent evaluation, and disclose all deficiencies in the design or operation of internal controls - Provide an auditor's attestation to, and report on, management's assessment of the internal controls and procedures for financial reporting
- Report that controls and procedures for financial reporting
and disclosure have been evaluated for effectiveness within
the past ninety days
Specifically, Section 404 requires an annual evaluation of internal controls and procedures for financial reporting. Under this scheme, a corporation must document its existing controls that have a bearing on financial reporting, test them for efficacy, and report on gaps and deficiencies. Furthermore, the company's independent auditor must issue a report, to be included in the company's annual report, that attests to management's assertion on the effectiveness of internal controls and procedures and financial reporting.
• Liability. Directors of a company can be held personally liable for
its actions and those of its officers, and, worse, a climate of litigation
exists in many areas. For example, some specific grounds for liabil
ity of a director have included voting a dividend that renders the cor
poration insolvent, voting to authorize a loan out of corporate assets to a director or an officer who ultimately defaults, and signing a false corporate document or report. Courts have held that if a director acts in good faith, he or she can be excused from liability. The challenge, however, is proving that a director has acted in good faith. Such proof is complicated by several factors, including possibly an inexperienced management team, the financial weaknesses and cash crises that occur and demand solution, and the lack of good and complete information and records, which are necessary as the basis for action. In recent years, many states have passed what is known as the "dumb director law." In effect, the law allows that directors are normal human beings who can make mistakes and misjudgments; it goes a long way in taking the sting out of potential lawsuits that are urged by ambulance chasers.
Harassment. Outside stockholders, who may have acquired stock through a private placement or through the over-the-counter market, can have unrealistic expectations about the risk involved in the venture and the speed at which a return can be realized, as well as the size of the return. Such stockholders are a source of continual annoyance for boards and for their companies.
Time and risk. Experienced directors know that often it takes more time and intense involvement to work with a venture with sales of $10 million or less than with one having sales of $25 million to $50 million or more, and the former is riskier. One solution to liability concerns is for the firm to purchase indemnity insurance for its directors. But this insurance is expensive. Despite the liability problems noted above, the survey mentioned found that just 11 percent of the respondents reported difficulty in recruiting board members.14 In dealing with this issue, new ventures will want to examine a possible director's attitude toward risk in general and evaluate whether this is the type of attitude the team needs to have represented.
Alternatives to a Formal Board. Advisors and quasi boards can be a useful alternative to having a formal board of directors.15 Aboard of advisors is designed to dispense advice rather than make decisions, and therefore advisors are not exposed to personal liability A firm can solicit objective observations and feedback from these advisors. Such informal boards can contribute needed expertise, without the legal entanglements and formalities of a regular board. Also, the possible embarrassment of having to remove someone who is not serving a useful role can be avoided. Informal advisors are usually much less expensive, with common honorariums of $500 to $1,000 per meeting. However, the level of involvement of these advisors probably will be less than members of a formal board. The firm also does not enjoy the protection of law, which defines the obligations and responsibilities of board members of a formal board.
But an informal group of advisors can be a good mechanism through which a new venture can observe a number of people in action and select one or two as regular directors. The entrepreneur gains the advantages of counsel and advice from outsiders without being legally bound by their decisions.
This article is part of eBook. To read the rest of the eBook (full version) please look at: venture capital