Startup companies seldom have robust governance in place prior to raising capital from angel investors. Boards of directors, if in place prior to investment, typically consist of friends, family members and early employees in the company. These directors tend to meet infrequently and are not skilled in assisting the entrepreneur in growing the venture. One condition of funding by professional investors is that an effective board of directors be installed.
Since the CEO of the company reports to the board of directors, first time entrepreneurs are often concerned about losing control of the board. Since the entrepreneur usually owns a majority of the shares of the venture, this can be a circlular argument, since the shareholders, in fact, elect the directors. Control of the company is usually negotiated and defined in the new investment documents.
Under most circumstances, the new investors will require a board makeup as follows:
- A small number of directors, usually five.
- The entrepreneur/CEO is the only employee/director.
- One or more directors selected from among the investors
- One or more outside directors with suitable experience, as follows:
- Experience in the business sector of the company
- Experience as a director in startup companies
- Experience in selling new ventures to larger, public companies
(Why an expert in selling companies on the board? The preferred exit strategy for investors is not a buy-back from entrepreneurs or other owners; rather to build portfolio companies to optimum value and then sell to a much larger corporate entity. Mergers and acquisition expertise on boards is invaluable.) As the company grows and matures, larger boards are typical.
Who should be the chairman? Perhaps surprisingly, first-time CEO/entrepreneurs are not necessarily the best choice. The chairman should be the most qualified director, that is, the director with the most startup director experience, especially those with past experience as board chair. The chairmanship is not normally a position of power, rather the director most capable of marshaling resources to advance the company; meeting communications expectations of shareholders and ensuring the directors and company meet their fiduciary responsibilities. The chair and the CEO are expected to work together with all directors to establish meeting agendas.
Boards of recently-funded startup companies usually meet at least monthly for as long as the company has negative cash flow. In fact, boards meet even more frequently during periods of crisis. Once the company becomes profitable and is growing steadily, the board may choose to meet bi-monthly and later quarterly. Occasional telephonec board meetings and director participation in meetings is not unusual, but meeting only by phone does not lead to efficient and engaged director participation.
Best practice dictates that startup boards establish two committees immediately: Compensation and Audit. For a five director Board, each committee would have three members with the chair. Each committee chair should be selected from among the three directors who are neither Board chair nor CEO.
The Compensation Committee, especially the chair, represents the Board working directly with the CEO in building and compensating the management team. The Compensation Committee is especially important during periods of transition among the management team.
The Audit Committee works with the CEO and CFO (or controller) in selecting the outside accountants and auditors and, representing the Board, meets privately with the outside accountants and auditors at least annually for a report on the accounting and finance practices of the company.
Boards constantly seek to inspire alignment of directors, employees and shareholders in the strategic direction of the company. Directors are required to represent all shareholders, not just groups of investors. Rights to board observers have often been negotiated by investors in the past, but most agree today that such observers add little to the value of the board and are to be avoided when possible. Finally, each director should regularly self-appraise the match between their personal skill sets and the needs of the board as the company grows. Occasional rotation of new directors with appropriate skills and experience can invigorate boards of young companies.
Two very important roles of boards are assisting the CEO in raising additional capital and in facilitating an exit. These are very time-consuming efforts. The CEO must assure that the company continuously meets monthly and quarterly operating goals. Directors, especially those with fund-raising and mergers and acquisition experience, can be of great service to the companies while fund-raising or negotiating the sale of the company.
The end game for angel and venture capital funded companies is building value for an exit through an M&A transaction to a large public company. The value of an independent Board of Directors with active Compensation and Audit committees is significant to the shareholders in delivering an exciting exit.
Columnist Bill Payne is an entrepreneur and angel investor. He may be reached by email at email@example.com or see his website at www.billpayne.com where his book The Definitive Guide to Raising Money from Angels is available. This is the sixth in a series of monthly articles in the Entrepreneurs’ Corner written by Bill Payne for the Flathead Beacon.
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