Most startups as they mature get better and better people on their boards of directors. In this context, “better and better” means people that can really help the company grow from a strategic and operational perspective. Impartial, independent, outside directors. They are independent from the founders, independent from the management team and independent from investors. You can search “independent director” on Wikipedia if you like. The definition is not a topic of controversy. The terms “independent” and “outside” are used interchangeably. And there is a ton of literature (from blog posts to books) about the value that good independent directors can and should bring to a startup. Here is my take (and trust me, probably nothing I write here is new):
- Balance: independent directors bring balance to a startup board. Often there is inherent tension between professional investors (VCs) and founders. This is unavoidable and happens all the time. I am NOT talking about constant tension. That would be a big problem. I am talking about tension over particular issues (like salary adjustments, stock option grants, strategic direction, etc.). Independent directors will bring balance to whatever the topic is that is causing the tension. Good for the founders and good for the investors. A good outside director will be happy to be in the middle and bring balance.
- Connections and Exits: often independent directors have networks that can be incredibly helpful connecting the startup to others in the industry/sector. Think of top level customer relationships. Think of top level exit discussions. These are just examples. Independent directors are usually compensated (often with equity) so they are motivated to directly help. I suggest looking for people that recently retired from key “company” relationships. Make a list, track them down and recruit.
- Mentorship: Independent directors ideally should be great mentors to the founders, and probably to a lesser extent, the startup’s investors. What better person to bounce an idea off of than an independent director who does NOT hold any purse strings.
- Credibility: Getting a decently well-known (in the sector) independent director can bring lots of credibility to the startup and its team. This is common sense. The benefits of the credibility boost are enormous. Doors open, conversations are easier, business happens.
So, with just these 4 points above (and there are lots more – again, just google “independent director”) you might think that every startup would have at least one independent director! Well:
- Not that easy to find: Good team members, be they management or directors, are not that easy to find. In my experience it can easily take 6 months or more to find the right person. BTW, investors often recommend people to be independent directors. That is fine, but can upset the “balance” function that I explained above. I recommend that the founders source the independent. Sure, the person will ultimately typically need to be mutually agreeable to the lead investor and founders but having the founders source the person strikes the right balance in my opinion.
- Founders are hesitant to find due to control issues: this is unfortunate, but it happens often. Yes, every time the board grows by one person there is inevitable decrease in “founder control” due to voting. Each director gets one vote so the math is simple :)). The key though is that “control” mentality signals insecurity. Insecurity signals a lower chance of having positive high level strategic team building (so team building with the top executives and top board members). Lack of top level strategic team building typically leads to sub-optimal exits. The funny thing is that investors think very highly of founders who build great teams both in management and at the director level. Control mentality gets in the way at both levels as “the best” hires might not be sought out. Anyway, this is a very sensitive topic obviously. But think about the best companies you know and then look at the management teams and boards. The evidence is pretty compelling.
Have a great holiday season!
Entrepreneurship at Cornell (which I run with a great team) just held one of our big annual conferences called Summit. Summit is in NYC. The photo gallery and speaker videos will be posted in about 10 days to the Summit site. We had some fabulous speakers and tried out “real time” audience Q&A with hand held microphones. That actually worked out very well and the speakers seemed to truly enjoy the unscripted questions. Summit is held at the Times Center in midtown Manhattan. The venue auditorium holds 380 and we had over 520 registered. Just like an airline!
One of my favorite speakers of the day was Barry Beck, the co-founder of Blue Mercury. His Q&A was hilarious actually and he really opened up on some of his experiences. Anyway, in his prepared remarks, he commented on the concept of DROOM. I had never heard this acronym, but Barry quickly told us what it means: Don’t Run Out Of Money. Obviously smart advice for any company. Unfortunately though it seems to happen all the time!
An acronym that we use at CVF often is SOM. SOM = shit out of money. Maybe we will start using SOOM intead. Suffice it to say that good DROOM planning will avoid the SOM situation. DROOM planning is one of the CEOs main responsibilities (add to hiring a great team and being a great leader to round out the top 3).
Barry’s acronym will stick with me. I will be using it and passing it along often.
I have posted a few times on management carve out plans (back in February 2011 and November 2011; wow, time flies!!).
Our portfolio companies routinely adopt carve out plans when the founders/employees equity values are not likely to provide enough incentive to get a company to an exit. This typically results when the company has raised a lot of money and the preferred stock liquidation preference would absorb an out sized portion of the exit proceeds. It can also result from straight forward dilution. Regardless, I am a big fan of carve out plans. There is just no way to get a good exit without a motivated management team and employee base.
Some great carve out plan materials were recently shared with me so I thought best to “memorialize” them in a blog post. Law firms often make startup “legal issues” materials available to help management teams better understand the startup landscape. So, thanks to Fenwick & West for putting these together. The first (Carving Up the Pie Using Change in Control Carve-Out Plans to Incentiviz… ) is a very well written memo on carve out plans in general. The second (Liquidity_Bonus_Plan_-_Board_Meeting_Slides) is a power point presentation that a startup board might review when adopting a plan. I am not giving legal advice……
Have a great weekend.
Howard Morgan (co-founder of First Round Capital and currently chairman of B Capital) spoke at Cornell this past Wednesday. Howard received his PhD from Cornell in operations research in 1968 (I was 3 years old!). He has a wonderful experience set (see this Cornell article).
I have seen Howard speak a bunch of times, and I enjoyed this recent one the best. He gave some really interesting data driven insights on VC and startups, like that timing is the #1 factor in startup company success, with team being the #2 factor. So…..the element of luck is huge as timing is often a factor of luck. I have seen many companies that have almost failed, then struggled to survive for a few years and then hit it out of the park as the market ultimately caught up to the company’s product offering. Timing, timing, timing! Howard noted that his idealab co-founder Bill Gross gave a super and short TED talk on this topic. Worth watching.
On the non-data driven insights, Howard mentioned a few times that that his personal relationships with startup management teams is one factor that drives him to keep being a VC. He simply enjoys the interactions and working relationships. We have all heard that the management teams are crucial to success – execution is king and only a good management team can execute. But taking this to the level of personal relationships is pretty interesting.
It boils down personal chemistry. For Howard, if he does not see himself developing a positive working and personal relationship with the startup management team then an investment won’t happen. I completely agree. And I have to admit that this factor has not always been #1 on my decision list. It should be. And will be.
The startup team/investor relationship is a long one. Often 10 years or more. Make it worth the effort.
It is highly typical for a startup to have small investors on its cap table. Founders often raise money from friends and family and other angels. That is all well and good….and 100% normal. Without friends and family and angels there would not be many companies for VCs to look at!
The treatment of the friends, family and angels (FFA) as the startup matures and raises larger rounds of financing over time is interesting. And sometimes founders want to protect the financial interests of FFAs. This is completely understandable but not always possible. Here is a quick guide.
- If FFAs only invest at the beginning and do not make any follow on investments as the company raises more $$ then the only real way FFAs make money when the company is ultimately sold is if the company keeps raising future rounds at higher and higher valuations (and IPO exit may provide upside if the stock price increases over time after the IPO). In this situation, the FFAs are diluted from an ownership percentage, but enhanced economically. In short, they own a smaller piece of a larger valuation pie. In my experience, this works about 1 out of 20 times. So not very good odds. Startups often get stuck, restart, pivot/change/move, etc., causing valuation bumps. Or the economy tanks or stock market tanks moving valuations down at inopportune times for the startup.
- So, the best thing for FFAs is to continue to invest, particularly in down rounds (where the price per share is lower than previous round). When asked, I always give the same advice: if you are investing $1 today, reserve $2 for future rounds because you never know what is going to happen.
- If FFAs do not continue to invest and the company hits bumps (again – this is the norm), then the company ends up with unhappy FFAs and the founders feel responsible (understandably so). The weight of this responsibility is very real.
So, do VCs care about the FFAs? Sure, we care about prior investors. We have even done deals where we come in for a Series A or Series Seed at a valuation LOWER than what the FFAs paid, and then literally convert the FFAs investment to the lower valuation security to protect them. Personally, I like everyone to be on the same page starting out.
But once we invest, do we care about protecting FFAs? The short answer is that we completely believe that ALL investors (including FFAs) should have preemptive rights (just the right to invest in future rounds on a pro rata basis). And as stated above, I think they should use these rights. But if they do not use them and do not invest in future rounds then it is challenging for participating investors to be very concerned about non-participants’ dilution.
Also, note that the Board of Directors of any company owes the same fiduciary duties to all shareholders. So when faced with a choice of approving a down round (typically bad for non-participants) or seeing a company go under for lack for financing, the director’s choice is not typically difficult. It is better for all shareholders to fund the company.
Anyway, lots of interesting dynamics.