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How Should Privately Owned Firms Structure the Board of Directors? - How Should Privately Owned Firms Structure the Board of Directors? - ... http://knowledge.emory.edu/article.cfm?articleid=701 Published: July 30, 2003 in Knowledge@Emory While the recent Sarbanes-Oxley legislation on corporate governance requires publicly traded companies to retain the services of independent directors on their board, privately held firms are not bound by the same rules. Nonetheless, says Edward Hess (http://www.goizueta.emory.edu/faculty /faculty_bios_temp.asp?bio_id=2570), a distinguished executive in residence and executive director of the Center for Entrepreneurship & Corporate Growth at Emory University’s Goizueta Business School (http://www.goizueta.emory.edu/), in the day-to-day of running a privately owned firm, an independent director with a successful business background can play an invaluable role by offering an outsider’s perspective on a company’s affairs. They can act as an industry maven when one is called for, a financial expert when internal or external auditing concerns arise, or as an important contact to gain new customers and outside funding sources. More importantly, Hess notes that for private companies transitioning through the various stages in the development of a business, an independent director can help alleviate the growing pains along the way. “You often need successful business builders who have “been there and done that” to help you along in the process,” he says. “There is no need to reinvent the wheel. Independent directors can help in transitioning the entrepreneur and owner of the business from simply being a “doer” and on to a manager and ultimately to becoming a leader.” (An independent director is generally defined as a board member without a financial stake in the company or a personal tie to any one of the company’s shareholders, founders, management or staff.) Andrea Hershatter (http://www.goizueta.emory.edu/faculty/faculty_bios_temp.asp?bio_id=2546), assistant dean and director of the BBA program and a senior lecturer in organization and management at Goizueta, notes, “In general, larger privately owned companies are more likely to have formal boards of directors, while smaller firms are likely to have advisory boards. A key difference between the two is the control and voting rights of the board, which may be substantial in the case of a board of directors and entirely insignificant in the case of an advisory board.” Without formally stipulated control or voting rights, advisory board members become “less effective in terms of providing checks and balances,” Hershatter advises. Also, the compensation for an advisory board member may be negligible, while that of an independent director can be quite significant. The main benefit of having an independent voice on hand is that it serves to balance out the sometimes-myopic decision-making that occurs in closely held enterprises, notes Hess. This narrow focus can plague family-owned and run businesses, especially as they deal with the “emotional overlays of personal relationships,” he adds. Additionally, an air of informality can sweep though a privately held firm, serving to undermine the controls put in place to make the business work and grow effectively. An outsider’s eye becomes particularly key in these situations, with the independent director or advisory board member taking on the role of mentor or serving as a needed sounding board. It doesn’t matter if the business is a startup or a more mature privately held concern, adds Hershatter, “A good board will keep the company focused on its goals and competencies, and knows when to push for growth and when to urge caution in moving too fast.” 2 of 5 4/11/2010 5:14 PM How Should Privately Owned Firms Structure the Board of Directors? - ... http://knowledge.emory.edu/article.cfm?articleid=701 But despite all of the benefits from having independent directors on hand, Lauren Burnham, a partner in the corporate and securities groups at the law firm of Morris, Manning & Martin, says that the normal evolution for a startup private company is for it to begin life as a closely-held and controlled firm, without the benefit of an independent director or advisor. This is especially true for family-owned businesses. The board of directors of the company may be entirely represented by those individuals with a financial or personal stake in the company, or with some sort of relationship to the current management or executive team. Interested investors, from the founders to venture capitalists to possibly family members of the founder, may occupy all of the places on the company’s board of directors. But, Burnham cautions, “It is always good to have outside advice, when you are able to get it. Any time a company has more than one shareholder, particularly when one or more shareholders have made a cash investment in the company, the directors need to worry about their fiduciary responsibility to shareholders, even at a privately-held firm.” Eventually, the better run and thought-out privately owned companies grow, and are then able to attract and pay for the services of an advisory board and/or independent directors. Having a number of independent directors in place does offer some level of credibility to the decisions made by the company’s board along the way. Unfortunately, in the normal course of business, “even the most innocent of transactions may one day come into question,” says Burnham. For example, in the earliest stages of a privately held company, the founders may have no other choice but to obtain funding from an interested party, such as a spouse, sibling or friend, notes Burnham. This often happens when more traditional forms of funding, such as from a bank or a venture capital firm, may not be available, due to the poor financial condition of the business, the newness or speculative nature of the concern, or general market conditions. If you have independent directors on board, you have the advantage of an outside voice to comment on the nature of the various transactions made, and to confirm that transactions with insiders are in the best interest of the company and all of its shareholders, says Burnham. While the potential and scope of shareholder legal actions at privately held companies may not match those at their publicly traded counterparts, the threat is still real. According to Stuart C. Johnson, a partner and the co-chair of the corporate practices group at the law firm of Arnall Golden Gregory, “If there is more than one person who owns the company or more than one employee, there is always potential for conflict.” In fact, closely held business situations can provide fertile ground for allegations of self-dealing, whether real or imaged. Having active and independent voting board members in place can help to remove some of this taint. Market pressures may also force the owners of privately held firms to adopt several provisions of the new Sarbanes-Oxley law, designed for publicly traded businesses, as ‘best practices’ for the corporate governance of their own companies, notes Burnham of Morris, Manning & Martin. “We counsel private companies to establish an audit committee and a compensation committee of the board of directors and, when possible, to include independent directors on these committees. In the case of an audit committee, the independent directors help oversee the company’s relationship with its outside auditors, help monitor the independence of the outside auditors, and lend credibility to the financial statements. Similarly, the independent directors on the compensation committee can lend credibility to the company’s compensation structure for senior management, since they do not personally benefit from such compensation structure, as an interested director might.” 3 of 5 4/11/2010 5:14 PM How Should Privately Owned Firms Structure the Board of Directors? - ... http://knowledge.emory.edu/article.cfm?articleid=701 Johnson of Arnall Golden Gregory also notes that as the owners of privately owned companies look to exit the business, independent directors will then become especially important. The exit strategy could include taking the firm public, in which case all of the various financial reporting requirements and corporate governance concerns would come into play for the company, and would require it to take on independent board members. But, with the IPO marketplace still in the doldrums, often the alternate exit strategy involves the private company being bought out by a public concern. In this case, the management of the private firm would still be wise to consider appointing independent board members and to make other changes to the business early on, in order to avoid limiting the company’s attractiveness to potential buyers. As Johnson notes, “In this present environment, a buyer may discount the price it will pay for a private company, or it may decide not to bid on a private company at all, if the private company does not have a formal corporate governance system with independent directors, or it has not otherwise implemented Sarbanes-Oxley controls. Corporate governance, board composition, and financial and operational control issues now clearly have an affect upon the marketability and attractiveness of a private company.” At times, outside financing sources, from traditional credit facilities to venture capital firms, will look for an independent voice on the board of directors. Gardiner Garrard, founder of the venture capital firm Total Technology Ventures, notes, “Independent directors bring along useful contacts, especially for earlier stage privately held companies. They can also bring their knowledge base into the business.” He notes that venture capital firms do generally look for the board of directors to be comprised of a mix of institutional investors (including representation by his own firm), company founders, and mutually agreed upon outside directors. However, Garrard adds that privately held firms today are faced with quite a conundrum in going public.
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