June 14, 2005
Tilting at Windmills, Backed By A Board: Corporate Governance for Early-Stage Companies
by Erica Grieder and Sandie Taylor

• The Benefits of Boards
• Building the Best Board
• Compensation Counts
• Future Challenges

Entrepreneurs are not known for their love of law and order. But according to speakers at the 21st Century Governance for Early Stage Companies conference, held June 9-10, the benefits of good governance far outweigh the costs of the compromises involved.

At the conference, which was sponsored by The University of Texas at Austin’s IC2 Institute, School of Law, and Herb Kelleher Center for Entrepreneurship, speakers discussed how boards, directors and legal requirements can shape an early-stage company’s trajectory over the long haul.

The Benefits of Boards

Spending the night in a hospital and spending the night in a hotel are two very different experiences. But for one hospital’s board of directors, the similarities proved illuminating.

“Someone had the bright idea to argue that we were selling beds and rooms, just like a hotel,” remembered Wade Monroe, an Austin-based investor and consultant who spoke on a panel discussion about the role of directors in early-stage companies. Following up on that intuition, the hospital added a hotel industry executive to its board. “No one ever thought we were would be running the business like a hotel, but he had some great insights.”

As Monroe’s example shows, directors bring key outside perspectives to early-stage companies. According to Hal Shear, the president of Board Assets Inc., a good board can be a considerable strategic asset. Boards, Shear acknowledged, can be distracting, time-wasting and ineffective. But on balance, he said, they have more benefits than drawbacks.

Experienced directors can help forestall mistakes, for example. As an entrepreneur on your own, Shear said, “You can make fundamental mistakes in the beginning that cause you trouble all the way down the line."

An impressive board of directors can also help sooth anxious investors. Venture capitalists expect entrepreneurs to be somewhat optimistic. Krishna Srinivasan, a principal at Austin Ventures, said that he is drawn to entrepreneurs who “believe they can do something super-disruptive and different.”

”That passionate drive, almost bordering on the side of charging a windmill—that’s a key trait of a founder,” Srinivasan continued.

Still, a quixotic entrepreneur backed by a level-headed board can attract more investments. “In this day and age, if you don’t have your corporate governance in place early, you pay a price,” Shear said. He meant the warning literally. Investors, Shear estimated, value a company without a board 20 to 30 percent less than they would value the same company with its board already in place.

Board directors can also take over tasks that entrepreneurs themselves would rather avoid. When he was preparing to leave one company to start another, Mike Frost, the CEO of ColorSciences, was happy to let his directors find his successor. “I don’t have a teenage daughter, but it was like meeting a guy who wanted to date my teenage daughter,” said Frost, remembering those first encounters with his would-be replacements.

Another benefit of having a board stems from the fact that CEOs of early-stage companies, unlike CEOs of big-cheese companies, are not surrounded by flocks of underlings, aspirants and hangers-on. “I don’t know about you, but I find that being a CEO of an early-stage company is very lonely,” said Shear. Given that, a board of directors can provide some much-needed contact with the outside world.

In any case, having a board is inevitable. “When you sign that paper and incorporate, you have a board, even if this statutory board is just you, your wife and your father,” said Shear.

Because having a board is inevitable, Shear suggested, entrepreneurs should accept the encroachment on their independence and concentrate their energies on building the best possible board.

Building the Best Board

The value of a particular director to an early-stage company is tied to her personal attributes, industry experience and concurrent professional affiliations. Before installing an investor as a director on a company’s board, for example, its founders have to carefully consider that person’s commitments.

“Venture capitalist directors bring certain attributes to the table that you have to recognize,” said Shear. “They’re trying to make you successful, because they have a lot of money and ego tied up in your success.” Such directors are a good source of professional contacts, and can anticipate a company’s cash needs.

That being said, Shear added, “venture capitalists also have responsibilities back at the ranch.” CEOs need to be cognizant that some directors may have conflicting fiduciary concerns, and be willing to ask a director to recuse herself when necessary. In light of that concern, several panelists said that they preferred to have independent directors.

Many panelists said that a company’s directors ought to have relevant industry experience. “You don’t want board members who don’t know their business,” said Barry Kulpa, a principal in Ventiri Ventures. Prior to becoming an investor, Kulpa was the CEO of Huttig Building Products, where he said, he sought directors “to help us fill in the gaps on our management team, to add expertise to the company so we could get to the next level quickly.”

Others emphasized that directors should have experience as directors. “The ideal director in an emerging company is experienced on well-functioning boards,” said James Darazsdi, the president of Rainmakers Management Consultants.

But this experience, he added, should not preclude their ability to respond to change. In the wake of Sarbanes-Oxley, for example, Darazsdi expects the relationship between the CEO and the board to become more contentious than it has previously been. As a result, “Independent directors should have the guts to be a pain in the neck.”

Even more important than a director’s track record, according to panelist Manoj Saxena, is his character. “The most important thing is strength of character,” said Saxena, the chairman and CEO of Webify Inc. “You need someone who will be honest with you, straightforward with you.”

Jim Hammock, the chairman of the board of directors of Hire.com, said that honesty is equally important from the point of view of the investor. “The things you’re going to go through with a start-up—if the CEO’s not honest, you’re done,” he said.

Rob Adams, a managing partner at Tejas Venture Partners, added that selecting a director is much easier than “deselecting” one. Paraphrasing Tolstoy, Adams noted that “dysfunctional boards are all unhappy in their own way,” and that rehabilitating a board gone awry is more difficult than building a functional board in the first place. Although picking the best directors may be an arduous process, then, it merits considerable effort.

Compensation Counts

One primary responsibility of a company’s board of directors is deciding how to compensate executives. While most executives are at least tangentially interested in being well-compensated, an early-stage company, especially prior to its initial public offering, may be cash-poor.

Mary Bass, a partner at Spencer Stuart, conducted an informal survey of partners at private equity firms prior to the conference to hear how they address executive compensation. “One firm said, ‘We give them options and an annual hunting trip.’ So there are lots of different ways to compensate directors,” she said.

In a discussion on this sensitive and highly scrutinized subject, several panelists agreed that compensation should be closely and overtly tied to performance. To that end, Myron Sheinfeld, a director at Nabors Industries, argued that compensation committees should seek outside expertise. If a board is independent of the investors and managers making the buck, he said, it will be more likely to offer long-term incentives linked to performance than short-term payoffs.

Short-term payoffs can also be performance-based as well, added Laura Kilcrease, managing director at Triton Ventures. “Cash compensation should vary based on financial performance, as well as non-financial performance, such as bringing a product to the customer and hiring,” she said.

One way to explicitly link performance to compensation is through tally sheets. Compensation consultant Steven Hall, a partner at Pearl Meyer & Partners suggested that directors enforce tally sheets, which add up everything that is paid to executives, from minor perks to salaries. Bernard Black, a professor at UT Austin’s School of Law, added that these tally sheets need to be fully and simply disclosed to the public to keep board members accountable.

“At the corporate level, executive compensation is in crisis,” Black said. “If boards don’t know how to say, ‘no’ and ‘enough,’ the government will have to step in, and in some cases it already has.”

Because the board is ultimately responsible for executive compensation, Sheinfeld added, it’s essential to be well-informed. “Don’t rubber stamp something if you’ve got questions,” he said. “For heaven’s sake, inquire.”

Future Challenges

Directorships are sometimes thought of as high-profile, low-pressure sinecures. In his keynote address, Edward S. Knight, the executive vice president of and general counsel for NASDAQ, disagreed with this assessment, saying that the Sarbanes-Oxley legislation has added new challenges to the role.

“Public officials are emerging from the shadows of Enron to create a new environment for the corporate world,” Knight said. “They’re mandating more disclosure.”

For an early-stage company, Knight continued, compliance can be difficult to manage. Even if the books are not to be cooked, the complex documentation that precedes disclosure as described in Section 404 of Sarbanes-Oxley can be expensive.

Such costs are marginal relative to the operating budget of a large company, but for a cash-poor early-stage company, they can be crippling.

Companies with more than a billion dollars in annual revenue, who represent 95 percent of this country’s total market capital, can easily absorb the costs of compliance, said Alex Davern, a partner at KMG. But below that revenue level, the impact is enough to be “strategic.”

As a result, Davern said, Section 404 amounts to a “disproportionate tax” on small businesses, which drive job growth in the United States. And because the Sarbanes-Oxley legislation was drafted primarily with the exigencies of big business in mind, Davern added, small businesses are suffering for no particularly good reason.

“Smaller companies are significantly lower-risk to the capital markets [than billion-dollar companies], but their cost burden is significantly higher,” said Davern. “We need to recognize reality, and scale the regulations accordingly.”

“I think with a change in leadership in the Securities and Exchange Commission,” he added, “there is some hope that we may see some common sense in DC.”

 

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