Board Governance in High Tech Start-Ups; - an Entrepreneur S Guide

Board Governance in High Tech Start-Ups; - An Entrepreneur’s Guide

By Andres C. Salazar Anderson Schools of Management; School of Engineering University of New Mexico, Albuquerque, NM

Abstract Recent events in the US have focused attention on the fiduciary responsibility of independent board members at a public company. This article examines the added complication of selecting independent board members at a high tech start-up where issues of conflict of interest, valuation, non-interference in direct management, exit strategy and accounting practices can be difficult for an entrepreneurial team to handle in a timely manner. Start-ups are in a unique position in that they have the opportunity to initiate a board composition that not only can serve them well in the first few years but can set the “tone” or “culture” for the expected levels of ethical behavior in the entrepreneurial team. Suggestions are made to the start-up’s founding team in the form of a checklist for dealing with several of these issues in board governance.

A. Changing Role of the Board of Directors - Recent events in the US have focused attention on fiduciary responsibility of board members in a public company. Questionable tactics in financial reporting at Enron, lucrative executive compensation packages at Tyco and numerous reports of insider trading and conflict of interest have eroded the confidence in the methodology of board oversight at public companies. News reports have placed partial blame on the lackluster performance of the US stock markets on the public’s dissatisfaction with the reliability of impartial auditing of public company financial reports and the apparent pervasive ethical irregularities by executives. The spotlight has shown most brightly on who shareholders considered the most impartial of board members and who was supposed to represent their interests – the independent board member, supposedly that individual who is neither part of management nor has substantial financial investment and does not stand to accrue great personal wealth from the company. There are mixed reviews as to the value of the independent directors forming a majority of the board [1]. Due to the urging of institutional investors, companies have moved towards having more and more independent directors[2]. The role the board plays in corporate governance is certainly becoming more pronounced as predicted in [3] and the board’s relationship with the CEO is also changing [4].

Start-ups have the unique opportunity to begin corporate governance with principles that have become important to shareholders – transparency, communications, standard and widely accepted accounting rules, and the highest ethical standards. Although start-ups begin their corporate life almost without exception as private companies, many choose to immediately follow SEC and NASDAQ rules about the role independent directors should play in corporate governance. In this way, the corporate governance transition in going from a

1 private company to a public company would be smooth and with no need for major alteration. Hence, it would behoove the entrepreneurial team (“ET”) of a start-up to seriously consider, develop and implement a plan for establishing corporate governance in the fledging company. There are many books and articles outlining the responsibilities of a corporate board member, [5] being an example. However, few authors have addressed the methodology for the selection of board members, especially in start-ups, let alone high tech start-ups. Due to the recent adverse stock market conditions and the “witch hunt” now underway in the US to ferret out unethical if not illegal behavior of company management and board members, it is timely for the ET to place more importance on board selection than ever before. Further, the selection process may become more laborious than before due to the disinterest being generated in potential board members as they see board membership as more “risky” than in the past. After all, a potential board member usually has a reputation to protect and is usually affiliated already with another institution that would not enjoy adverse publicity about its executive. Director and Officer (“D&O”) insurance policies, once rare in private companies, may become a requirement for a prospective board member of any stature, wealth and reputation to join a company board. Few public companies have braved not having D&O insurance in the past and fewer will dare continue not having such protection.

The primary job of the board directors is to provide impartial and diligent oversight of a company’s operation and management in the interest of all shareholders. Some board members, especially those associated with large holdings of stock, can and have acted as agents who ruthlessly pursue specific shareholders interests at the expense of employees, creditors or other team members. The corporation can be likened to an organism that requires a balance of nutrients and stable environment to prosper and grow. Board members are trustees who should act as caregivers to the organism so that competing interests do not inflict damage to the health and growth of the company. The trustee’s job is to actively inquire as to the condition and health of the company by receiving, reviewing and commenting on information provided and requesting additional information, when necessary, in order to act in a responsible and informed position on corporate policy and strategy matters. In the case of a high tech start-up, the issue of understanding, to an acceptable degree, the nature of the start-up’s underlying technology is important to consider in the selection process. Otherwise, that board member may be handicapped when it comes to making an important strategic decision at the board level.

B. General Qualifications for Independent Board Members – There are a few attributes that an entrepreneurial team should look for in a board member candidate. These attributes would be the same for any founding company whether it is high tech or not. Generally, the ET should look for the experienced business executive that can aid the ET in establishing critical relationships with customers, suppliers and investors including banks. The proper establishment of these relationships can mean the difference of success or failure of the start-up during

2 the early stages of its life. Relationships form an important part of the start-up’s capital, possibly even more important than a cash infusion from an “absentee” or “hands off” investor. These relationships are often based on trust, principles and values by which the company operates. The superior board member candidate is that individual that can impart and nurture that set of principles adopted by the ET for the company’s operation. In the past, being a board member, especially of a public company, was somewhat of a prestigious position, representing recognition of valuable experience and business wisdom. The prestige made up for the insignificant remuneration and manageable “risk” incurred by the position. In fact, it was often difficult to remove a director since it was seen as a “rejection” of that person’s qualifications for board membership. Quite often, the reason for membership termination was for non-attendance of meetings, disruptive behavior or disinterest in board proceedings. One attribute that may portray the prospective board member’s true temperament is that board member’s ability to communicate. Witnessing the would-be board member’s oral presentations, especially in group meetings, and a review of some his/her writings on business subjects can give insight into the individual’s mode of thinking and reasoning. Difficulty in expression either orally or in writing can handicap the board member’s ability to work with others in a group setting. It is imperative that the prospective board member demonstrate the ability to handle group dynamics in a professional manner. A tendency to dominate meetings, be vociferous or cantankerous can torpedo a board meeting.

C. Special Qualifications for a Board Member in a High Tech Company – Just as it has been reported in the literature that basic knowledge of the underlying technology area has been found to be useful in the success of a manager of knowledge workers in a technology area, so it is that a board member can exercise his/her fiduciary responsibility in an improved manner if he/she is knowledgeable in the technology area of the start-up. In the case of a possibly “disruptive” technology for which there is little experience in the marketplace, one board member candidate should be an individual who exhibits vision and has experience in breaking new ground in the marketplace through innovative sales and marketing techniques. For example, a start-up has no customers to begin with normally so it is imperative that a marketing and sales plan be developed soon after the start-up’s establishment. Hence, a board member that can provide guidance and oversight on such a critical task of the start-up would be a valuable member. Understanding the technology to some degree would provide that board member with leverage in helping the start-up with sales and marketing plan. There is certainly merit to having independent board members who have different backgrounds, such as legal, financial, technical and managerial. Care should be exercised in having too many board members from the same background. For example, in the case of a Venture Capitalist (VC) backed start-up, the VC partnership agreement may require that a member of the VC firm be a board member of any company in which it has a major investment. Unfortunately, this entails bringing on a board member who is, in the usual case, a young partner in

3 the VC firm with a newly minted MBA with little experience to offer the start-up.

D. Checklist for Selecting Independent Board Members in a High Tech Start-up – As a result of the prior discussion the following ten assessment steps form a guide for entrepreneurial teams in dealing with board member selection. The first seven steps assess the board member candidate’s suitability for general board membership while steps 8-10 specifically deal with the issue of the start-up’s technology focus. There is much activity in the initial period of starting up a company. Entrepreneurial teams are often eager to start the product or service development process once funding is secured. It is easy to put off board member selection or relegate it to the lead investor in the company. However, the entrepreneurial team may never be in such a advantageous position again to help select the best available group of people who will perform oversight of the company’s management.

Table D-1 Assessment Steps for Selecting an Independent Board Member in a High Tech Start-up

Number Attribute Areas Comment 1 Business Experience Marketing, Sales, These areas are Strategy probably most useful to a start-up 2 Communication Skills Active Listening Individual must be and Succinct able to “listen” to Verbalization the E-team’s issues and not “overtalk.” 3 Ethics & Background Impeccable ethical Avoid selection of background anyone with questionable reputation. 4 Ability to “Open Doors” Relationship with This is valuable Potential initial “capital” for customers, the start-up. suppliers, potential investors 5 No Conflict of Interest No significant Too much potential interest in conflict will ownership or necessitate financial excusing the board association member from deliberations 6 Time Availability No more than 2 Regardless of other other board virtues, absences memberships from deliberations does disservice to

4 company 7 Chemistry with Founders More so than age Difficulty in difference, relating to founding interpersonal skill team is a “no-no.” is important 8 Gen. Knowledge of Career in A degree in Technology technology technology helps 9 Specific Knowledge of User, Developer, User is most Company’s Technology Researcher needed for a start- up 10 Operational Knowledge of Executive of Sales and Technology Companies functional area Marketing of Technology products or services most helpful

E. References: [1] Lin, Laura, The Effectiveness of Outside Directors as a Corporate Governance Mechanism: Theories and Evidence, Northwestern University Law Review, Vol 90, #3, Spring 1996. [2] Colman, John M, Good Governance is Good Business, Directors & Boards, Spring 1994. [3] Various authors, Harvard Business Review, Redraw the Line Between the Board and the CEO, March-April 1995, pp. 153-165.. [4] Pound, John The Promise of the Governed Corporation, Harvard Business Review, March-April, 1995, pp. 89-98. [5] Corporate Director’s Guidebook, 2nd ed., American Bar Association, 1994.