Venture Capital: Planting The Seeds Of Governance


Experienced venture capitalists know that once an investment is made, the success of the deal will not be found in the legal documentation. Success will turn on the company's ability to implement its operating plan and respond to unanticipated problems or competitive threats in a timely, effective way. Communication and cooperation between management and a board of directors can help maximize a company's chances of performing effectively in these areas, and can make the difference between success and failure in early-stage companies.

Although venture capital transactions frequently involve contractual rights dealing with board matters and financial information--such as provisions for board representation, distribution of monthly financial information and consent requirements for certain non-ordinary course transactions--typically, little time is spent on setting up structures to facilitate communication between a board and management, or even evaluating the extent to which existing board members and management appreciate the importance of their roles.

Governance Issues
The development of initiatives to assist in creating an effective relationship between management and the board has been one of the primary concerns of corporate governance advocates. The corporate governance movement has received much attention in the press, with notable companies such as General Motors Corp., IBM and, more recently, H. J. Heinz Co. either acting or being pressured to act by activist shareholders to replace executives or restructure their boards in response to perceived lackluster performance.

Although corporate governance in this context involves large public companies and activist shareholders pushing for change, many of the initiatives to strengthen communications and accountability between boards and management also can be applied to growth-stage companies and are applicable in a venture capital context. Problems plaguing public companies, such as the lack of timely or detailed information being supplied to the board or the lack of director participation and evaluation mechanisms, can be even more critical in growth-stage companies because of the lack of substantial or diverse sources of revenues or flexibility in production processes, which would otherwise help absorb bumps in the business plan.

Venture capitalists and their counsel should consider basic steps in connection with funding early-stage companies, including educating management and directors as to their respective roles and duties; establishing working board committees or designated director oversight functions to establish effective communications and monitoring; and putting in place a systematic approach to evaluating the performance of both management and the board.

The Education Process
The first step is to educate both the board and management team with respect to corporate governance issues and the importance of effective communications. It should be assumed that neither the company's officers nor its directors are fully versed in their respective duties and roles. Depending on the stage of the company, either a brief informal discussion on the topic or a fuller presentation and discussion at a board meeting would be an appropriate introduction. A brief memorandum prepared by counsel or a reference source, such as the Corporate Director's Guidebook published by the American Bar Association, should also be distributed. Depending on the level of interest, there are many other materials and articles available.

In addition to discussions relating to the duties of care and loyalty, there should be particular emphasis placed on the importance of the quality and timeliness of information flow by management and the active participation and contribution of the directors. It is important that both management and the board understand their obligations. Many directors do not fully appreciate that they are entitled to, and must insist on, accurate and sufficiently detailed information, delivered reasonably in advance of a meeting to allow meaningful review, and that without it they cannot fulfill their duty of care. Many managers and directors do not fully appreciate that a board should insist that directors attend meetings and be active participants in order to provide meaningful guidance to management, and that the board should be viewed as a resource available to, as well as an overseer of, management.

In early-stage companies, the education process also should be used to emphasize the importance of trust and cooperation. Many entrepreneurs who have accepted venture financing are reluctant to share bad news, and feel a responsibility to solve problems on their own. Many venture capital investors feel that if only management had provided more timely information, they might have been able to help avert or mitigate a problem. Although it should be clear that management has undertaken a responsibility in accepting outside funding and is accountable for performance, it is important at this early stage that the company view the investor as a partner with whom information should be shared and with whom problems should be discussed and worked out together.

The Implementation Process
The next step is to identify areas in which more specific communications or segregated director oversight may be useful and to put in place structures to facilitate these goals. In early-stage companies with two or three board members, adjusting the frequency and agendas of meetings may be sufficient to address these concerns. It can also be useful, however, to assign the oversight of a particular issue, such as management's progress on negotiating a corporate teaming opportunity, to an individual director to monitor between board meetings.

It can also be particularly valuable to afford the directors, or a subset of them, the opportunity to separately meet with the company's principal financial officer on a quarterly or semi-annual basis. While this could be threatening to a chief executive, it should be stressed in the education process that it will, in fact, be beneficial, since it will help avoid any later perception that directors are not fully informed, help spread accountability among the other executives and underscore the self-confidence of the chief executive.

In later-stage companies or companies with larger boards, establishing board committees with defined tasks is often critical for effective board participation and monitoring. The appropriate number of committees and the division of responsibility among committees is the board's decision. The most common committees are the audit committee (now a requirement for all Nasdaq companies), compensation committee and nominating committee.

It is also advisable, although not yet commonplace even in publicly traded companies, to form or charge one committee with the direct responsibility of monitoring the quality and satisfaction of both the board and management with respect to flow of information, the level of participation of directors in board and committee meetings and other governance issues. This would be particularly beneficial to venture-backed companies approaching the initial public-offering stage. It would assist in making sure that the company's internal house is in order and sending that message to underwriters and prospective purchasers of the company's stock.

The board should also consider adopting formal corporate governance guidelines. Helpful guidelines for growth-stage companies could include a board "mission statement" emphasizing the importance of an active and responsible board; criteria and selection procedures for directors and officers; the importance of regular attendance at board meetings and timely distribution of board materials; board member access to senior executives; and the process for evaluating performance of the company's chief executive, chief financial officer and the board itself. If nothing else, adopting guidelines will again cause management and the board to discuss their working relationship and emphasize matters deemed important.

The Evaluation Process
The final step is to establish mechanisms to evaluate the efforts expended toward improving communications and the working relationship between the board and management. This might most effectively be accomplished by a board committee or, in the case of smaller boards, a designated director. The subject should also be a periodically scheduled topic for all or part of one board meeting on a periodic basis. In addition, evaluating the effectiveness of communications and response with respect to a significant event, such as the resignation of a chief executive or the occurrence of a negative operations event, may be helpful. Evaluation methods should involve interviewing both management and individual directors and seeking constructive suggestions for improvement. Evaluation questionnaires could also be used.

Taking steps to facilitate the performance of management and the board will help position a company to go public, when formal structures relating to accountability and performance will be expected, if not demanded. Even if a public offering is not the ultimate goal, these steps can help put a company in the best position to maximize returns for all parties.