Reaching back for an important lesson

As one illustration among many I can recall, let me tell you the story of the first investment made by a newly organized formal group of angel investors. Some of you can guess that name of the group. It was thrilling for these angels to find a young entrepreneur with an idea for a business that seemed so destined for greatness that the angels invested over $1 million on the condition that the group receive two board seats and one observer seat on the start-up’s board.  The young, eager entrepreneur immediately agreed, and the business was launched, well- funded and anticipating great profits.

Good intentions sometimes lead to…

As the business expanded into a second city and then planned expansion into a third, there was a rift that became evident between these angel board members, played out in front of the CEO.  The angels argued about whether the expansion was too quick, requiring additional money, or should be slower and bootstrapped with profits from the first city’s success.  Finally agreeing upon expansion at speed, the angels raised more money and encouraged the CEO to accelerate the expansion, which the CEO did with enthusiasm.  It did not take long for the company to again run out of money, and for the board to split over the next moves (since the first city continued to be profitable).

The consequences of not thinking ahead:

[Email readers, continue here…]    The angel investors could not raise the next, larger round to finance the shortfall and further expansion, putting the fragile young company at risk for following the advice of its board.  In the end, the company had to turn to a wealthy individual investor who took control of the corporation as his price for saving the company.  Look ahead only a short time, and the new major shareholder ran into trouble overleveraged with his real estate investments and defaulted on his funding promises.  But I digress.  Painfully.

What went wrong?

Had the angel board members been able to agree upon a financeable strategy for growth, the company might have been immensely successful.   To put an ending to this story, the entrepreneur followed the suggestions of the new investor just as he had followed the angels, and accelerated quickly into more cities, again running out of cash.  And now you know that the wealthy investor in the meantime, could not make good on his promise to further fund the company, which found itself unable to meet its obligations and ultimately was shut down, causing a complete loss for all.  Bad advice taken by an enthusiastic and compliant young CEO was the root of the cause, compounded by circumstance.

And the result for the entrepreneur for taking this advice?

By not putting up any argument and being completely compliant, the CEO ceded control of the company to outsiders who gave bad advice.

The lesson for any CEO or for any of us for that matter is to filter all advice through the strainer of good reason, taking that which seems reasonable and rejecting that which is wrong for ourselves or for the immediate time.  And, as I have learned from experience, if you perceive advice to be in error or against better judgement, form your arguments after a little thought and make your case with information to back it up if necessary.  Most of the time, the person on the other side of the table will see your side, feel your passion, and either agree or withdraw any objection.  Remember, passion and reason almost always win the day in these cases, even when facing a superior in the food chain.

Now you can tell your story…

Images for this block created using DALL-e, Microsoft Designer, with prompt: A group of diverse standing adults surrounding a single young businessman, all casually dressed, with all staking at once. Photo-realistic image with ragged edges and transparent background.

What’s the exposure?

Here are some examples: Entrepreneurs blaming their board for failures of a fragile, early-stage company.  Shareholders unhappy over the same loss, reaching out to sue every name available. Employees reaching out to anyone above to redress grievances.  In one case, an aggressive lawyer found all the members of an LLC, and sued every member found.  Whew!

So, what’s the chance this could happen?

Whenever there are outside shareholders or noteholders, or unhappy employees, and when there is a product in release, there is a chance, no matter how slight, of a lawsuit against members of the board as well as against the corporation itself.  Even if such a suit is completely without merit, the cost of defense and the risk of a negative outcome both hang over the company and the director.

What is D&O insurance?

[Email readers, continue here…]   Directors and Officers insurance (D&O) is meant to reduce that risk and provide for the legal defense of any such suit at the expense of the insurance company.  In that regard, even the lowest amount of D&O insurance available, $1 million, provides for legal defense costs to be covered.  The usual cost for such insurance is $4 to $6 thousand a year, with an extra $2 thousand for an additional million dollars of coverage.

Consider completing the package.

Recently, insurance companies have added employee practice liability insurance (EPLI) to the package to address specifically the risk of employees suing for redress.  Given the increasing number of suits for sexual, racial, gender and other discrimination, this now seems logical and necessary.  So, add another $3 to $4 thousand to the policy cost.  Ouch!

Is the required?

More important than the cost is the provision of investment documents from sophisticated investors like VC’s and sophisticated angels requiring D&O insurance for the company at the time of funding.

I am one of those.

Over the many years of board service, before insisting upon this insurance requirement before service, I had been sued as a director several times, in no case covered under the umbrella of a D&O policy.

Although I won all but one of these rather spurious suits (and settled that one outlier to keep my unaffiliated wife out of this swamp), the cost of defense in some of the cases was not reimbursed, and the time spent in helping the attorney prepare for the defense and in one case through to a several-day adjudication event, was not small.  As a result, I now insist upon D&O insurance for every board upon which I sit.  The backgrounds of these suits make for good stories – but for another time.

Images created using DALL-e, prompt: A realistic image of a man serving papers representing a lawsuit upon another younger man and his board of directors, all in business attire without neckties. Use clear background and ragged edges to picture.

Most all leaders new to their position underestimate this time requirement.  It is good for the company when you share concerns, threats and opportunities with your superiors or your board.  The rule of “no surprises” works well for your longevity.  But there are always surprises. The rule is: communicate with individuals or a committee of the whole as soon as possible when important issues or threats to the corporation arise.

Safety, protection, and transparency.

You might be late with a project, sense a possible safety issue, see something or someone breaking the law, or just uncomfortable with a condition or trend. Think of the whistleblowers at Boeing and other very visible corporations.  In the name of safety, they took the chance to step forward.

Involving the board or investors

And sometimes you or your CEO want to obtain concurrence from investors or the board for issues of urgency or importance.  It is not bad form to lobby individual members in the form of a briefing of the issue and give time for the investors or board to debate the issue, sometimes requesting an “executive session” of just the outside directors.

For your senior management or board, this could be time-consuming. 

[ Email readers, continue here…]   Gathering facts may take time but certainly be worth the effort to make the case and reinforce the sense of urgency. The CEO is also responsible for preparing information for investors and for the board, the board briefing package before regular board meetings.  It’s a time-consuming task if done correctly.

What happens to urgent issues when brought to the board?

Especially when there are urgent issues such as surprises to reveal and dissect, the board meeting package should contain the issues to be discussed with backup materials for the board to understand the issues.

Limiting the discussion to those important issues and decisions.

Operating statistics in detail and individual departmental issues that do not rise to the level of board discussion should be included only in an appendix for board and investor meetings for deeper reading, but not discussion.  The CEO should discuss the agenda and board package contents with the chairman (if the chair is a different person) since the chair is tasked with setting the agenda and controlling the meeting.

The time you take to prepare for these urgent discussions is well worth the effort.  But if there is a time bomb to reveal, such as a safety issue, then urgency trumps detailed preparation. You have a responsibility, and in many cases, the authority to step up and make issues noticed, sometimes public, and often easily resolved.

Images created with DALL-E AI using the following prompt: “Casually dressed executive informing group of serious issue at the company with five people listening, some with surprise, some with pensive thought. Realistic human images.”

Where did this statement come from?

I first heard this in a governance seminar for a non-profit higher educational board upon which I sit, over 25 years ago.  It made an impact and stuck with me through the years.  I have repeated it often to boards deliberating action and to individual board members seeking to get their hands dirty inside the corporation by giving advice and helping at levels beneath the CEO.  (And it is interesting to hear it returned from various unrelated sources, even quoted as “Noses in; hands out.”)

The problem cannot be overstated.

Once a board member reaches beyond the CEO into the corporation, especially without the approval of the CEO, incurable damage has been done to the CEO’s ability to govern.  Even if not the intent, there is an instant change in dynamic once this line has been crossed.

There is even a gray area that illustrates this effectively.

As chairman of a company in an industry where I have extensive experience, I elected to attend a regular meeting of the management team with its middle managers on a Monday morning, a practice I had not done in the past.  The meeting was tame to say the least. The CEO spoke, shared metrics, spoke of issues to be addressed during the coming week, and did a fine job of pointing the assembled troops in the right direction. I could not have been more pleased.

My lesson learned about this mantra:

[Email readers, continue here…]   After returning to my office, I received a call from the CEO. ‘Would I please (oh, don’t take this wrong, Dave) not attend these meetings anymore?’  What I took for unusual silence was a complete disruption of the normal give and take of the management group because of my presence.  The chairmanship carries unstated power even if not overtly demonstrated, since the CEO reports to and is accountable to the board, and of course its chair.  I learned from this that there are times when members of the board are appropriately brought into an operating group, and certainly times when the board should hear from vice presidents presenting their issues in a board meeting.  But the position of CEO is absolutely to be reinforced at all costs, never to be undermined by any member or by the board as an entity.

So, what is the proper behavior?

Therefore, it is appropriate to ask tough questions, request help in understanding issues, seek permission from the CEO to interview others.  But a board member or advisor should never react to statements heard by issuing directions or hints of action in return.  It is appropriate to state that the advisor or board member understands much more after the briefing and will be able to address the problem with the board and CEO.  It is not appropriate particularly for a board member to promise any action to anyone beneath the level of CEO.  Noses in; fingers OUT.

While the CEO and management offer the vision, strategies, and tactics as well as the proposed budget, it is the board that controls with its votes the execution of strategy, the expenditure of cash, the taking on of debt or new equity, the very direction of the company as well as its ultimate health. Surprised?

Then who is most important?

The most important person in a corporation usually is and should be the CEO. This person, often the founder in early-stage companies and beyond, is the originator and keeper of the vision, leading all others below and the board above as willing believers in the vision advanced.  But the board is responsible for providing resources to fulfill that vision, which may include new cash infusion or assumption of new debt.  

Does this ever happen?

Yes, but… In extreme situations, it is the board that must step up and replace the CEO, assuming the responsibility for finding and integrating a new leader quickly and efficiently.  Sometimes this means having a board member step in for a short time as CEO for continuity.

A true story…

[Email readers, continue here…]    One of the CEOs in a round-table who had been active and vibrant for years in both his company and the round-table, died suddenly of a heart attack.  His board met in emergency session and managed a smooth transition to a new leader within a month, during the most traumatic of times for all employees and the board itself.

Remember the most important duties of a board member?

For non-profit boards, the two most important duties under the duty of loyalty and care are the oversight and eventual replacement of the CEO, and maintenance of the entity over its infinitely long lifetime.  I have been a member and even chair of presidential search committees and can attest that board members (and other designated stakeholders) spend hundreds of hours in the recruiting process, all without pay.

It’s all about continuity of the organization.

It is because the continuity provided by the board is the one thing shareholders must count on above all else to protect investment, that the board rises in importance to at least equal stature as the executive cohort.

In my last insight, I described the CEO who stacked the board with two friends, making a majority for control purposes and relegating the investor representatives to insignificance.  There were no outside board members with industry experience, no members the CEO trusted with governance backgrounds, no scientists to evaluate the technology that is the core asset of the corporation.

A recipe for failure.

If the CEO does not fight for balance of the board, outside board members must fight for this to protect the corporation.  If for no other reason, this protects the members of the board from making decisions without rising to the standard of careful deliberation under the “reasonable care” test.

How about the size of the board?

[Email readers, continue here…]   Some board members find themselves debating whether there should be an expansion from five to seven, from seven to nine or more to allow for such a mixture of protective seats created by the investment documents and balance with outside board members.

What about multiple investor rounds?

Sometimes, as in one board where I sit today, there are so many classes of investors, each with one or more seats, that a seven-person board is not enough.

I am not for large boards.

There are social studies that reinforce the notion that a group of six or seven is far more likely to arrive at reasoned decisions effectively than larger groups.  Look at the example of most non-profit boards, where the number of members often exceeds thirty, requiring the creation of an executive committee to get the work done.

In fact, such a board would seem out of place in a one-person company.  As soon as any outside money is ingested into the corporation, others have a vested and legal interest in the behavior of officers entrusted with the best use of funds.  Money from friends and family usually is offered in a casual manner with much less restriction than professional investors, so that a formal board is a logical step but not often created upon this event.

Then along comes either money or contracts from strategic or financial investors or partners.

The operations of the corporation become more complex. Ownership is spread among

several classes of investors.  The number of employees grows.  Bank loans with restrictive covenants are taken on.  These events, one or all, usually are triggers for the founders to seek to create a board for oversight and guidance.

And then company grows…

Once the company hits high growth or larger size, it is logical to follow the standard practice in the creation of two standing committees composed of outside board members (not employees or executives) – the compensation committee and the audit committee.  Compensation’s charter is to approve stock option grants for any employee, no matter how small the grant, and all salary and benefits for at least the CEO if not the next level down, to avoid conflict of interest with the CEO.  All actions of the committee are in the form of recommendations to the full board for a vote and are not binding until that event.

[Email readers, continue here…]    Second, the audit committee is responsible for hiring an outside auditor as appropriate, reviewing the accounting practices of the corporation and making sure that laws are followed relating to recognition of revenues and expenses.  Good audit committees also review the corporation’s insurance portfolio, risk protection policies such as email and computer use, disaster response and recovery policies and any other area where the corporation’s very life could be at risk from inattention.

Yet another personal story…

Let me tell you the story of a company on whose board I sat for several years.  The CEO insisted that between husband and wife, over half the stock always be in their hands, refusing new offerings or any other form of dilution, and controlling the majority of board seats in the process.  After replacing two board members with two other friends who were a bit less independent, during that first meeting with all of us present including the two new board members, I suggested that the corporation then form the two committees – audit and compensation.

“Never!” was the single word as I recall the CEO’s immediate outburst.  I made a motion to bring it to a vote. The corporate attorney was present, recommending this as a relatively safe move for the CEO.  I called the question after a drifting discussion. You can guess that the three friends voted down the measure, perhaps as a sign of unison, since this was the first vote by the two new members.  It was the final nail for me.  I engineered the extraction of the outside investors, even at a near total loss.  At least the investors could then take the loss against ordinary income under rule 1244 of the IRS code, worth something to each, rather than being locked into what was a slowly failing lifestyle business with no effective oversight.

Even venture capitalists who sit on boards where they have significant investments often forget this point.  They write in their investment documents that they will occupy a seat on the board for as long as they are invested in the company, thinking of this as a protection for their investment and tool for them to influence growth.

Actually, there are two legal duties of board members. 

They are: the duty of care, and the duty of loyalty.  Everything else is a self-imposed duty or responsibility.  The duty of care is to care for the corporation’s asset itself, not the shareholders whom they represent.  Each corporation, when chartered becomes a live person in the eyes of the law, independent and subject to the care of its board of directors.  Shareholders such as investors are granted few rights by law. They can elect directors for their class of stock, approve mergers and acquisitions; approve increases or changes to the capital structure of the company and other more minor actions.

[Email readers, continue here…]  It is the board, made up of individual members, that is responsible for the care and maintenance of the corporate person.  Sometimes, there will be a conflict of interest between the people representing the various shareholder classes on a board.  This happens often when one class would be quite satisfied with the outcome of a sale of the corporation because it has lower expectations of exit value and a lower cost of shares, while another later investor class would see little relative gain in a sale and veto’s the proposed transaction.    The duty of care is the legal responsibility of each board member and cannot be shed because the member was elected to protect a particular class of shareholder.

Second is the duty of loyalty…

…Loyalty to the corporate person, not to the shareholders who elected the board member.  Once again, there is a need to educate board members that in conflict of interest cases, the corporation comes first.  Some investor board members are also member of boards for companies that may overlap in markets or even compete directly, although rare.  Either way, I have seen many instances over the years of my board service with VC’s on the board, which the VC’s have had information about other firms that would be classified as confidential – that they offered at least piecemeal in a board meeting of another company where they serve.  There are issues that stress the loyalty of board members such as placement of employees or recruiting of executives from firms where the VC or board member has inside knowledge.  These are rare, but each stresses the duty of loyalty to the corporation on whose board they sit.

Well, how far should a board member go?

Should board members therefore withdraw and not participate in corporate planning, coaching the CEO and other issues not related to the duty of care or duty of loyalty?  Of course they should not.  A board, in exercising its duty of care, must do everything it can as an entity and each member as an individual to become acquainted with the issues, problems, opportunities and threats that overhang the corporation.  In fact, there is a legal concept (not a duty) of “reasonable care” that board members must meet in order to be protected by the insurance carried by a company for directors and officers.

Reasonable care means that members deliberate issues in depth, attract expert advice when appropriate, attend meetings regularly, stay current on corporate issues and hold regular sessions of the outside directors without management present. None of these requirements are by law, but the sum of these add to a powerful statement of commitment by board members and therefore a protection under the law when a group of shareholders sue boards or members for irresponsible actions.  Most every court will side with the members of the board under the rule of reasonable care when these behaviors are in evidence.

At one time or another, most all businesses use consultants to fill the gaps in knowledge or to provide guidance for management.  Consultants are good in that you can sample their work with short projects, change to other consultants quickly, and stop using them when a project is completed.

A personal story of ignorance of good advice.

I have a partner in a consulting practice that specializes in the travel industry.  Several years ago, we were hired by one of the largest companies in the industry (yet another Fortune 50) to perform a top-to-bottom audit of their processes across 27 facilities, and recommend measures to increase efficiency, increase income, better the customer experience, and of course, decrease costs while also increasing the quality of service.  We were quite confident that our services would yield great, measurable results.  The work continued for about eight weeks between the two of us as we visited the 27 locations and worked with employees in departments across all disciplines within each location and at central offices that performed services for all locations.

The result of the consulting project…

Finally, at the end of the project, we had identified nineteen specific issues, each of which would, if implemented, accomplish one or more of the goals outlined at the start of the project. The sum of the savings and increases in revenue were worth multi-millions annually, well worth the implementation of most or all of the recommendations.

[Email readers, continue here…]   On the final day of our assignment, I was responsible for the “reporting out” to the assembled twenty or so executives in the large conference room of this major corporation.  I started my presentation, which had been carefully documented in handouts and PowerPoint, with this story…

A unique description of the “ignore” lesson.

“I want you to all imagine that it is tomorrow morning, looking back upon today’s reporting of these past months of work by your consultants.  Imagine that today I build for you a beautiful sandcastle exactly at the water line of the ocean nearby.  Tomorrow, we both will visit that beach and look at the water line, and find not a beautiful castle, but just smooth sand, just as it had been the day before building our beautiful sandcastle.  In other words, I would not be surprised if you accept our report today with enthusiasm, but then in the overwhelming rush of daily business, fail to implement few if any of these recommendations that you so enthusiastically received.”

The story is true, and the results were as I predicted.

A few of the recommendations were implemented over time, one with great effect and even a national advertising campaign behind it (that you surely saw on TV).  But most were just ignored.  I imagine that our report sits today on someone’s shelf, filed with others from past and from following months and years.

Unfortunately, it is human nature to enthusiastically ignore to act upon recommendations of third-party consultants. There are many, many exceptions, but far more instances of this in the business world.  Not all consultants give advice worth taking, of course. But when they do so, it is only as good as that which you implement.

Is it ethical to allocate income between periods to take advantage of tax breaks?  Can expenses be put off until the next period to increase income, or accelerated into this period by prepayment to decrease net income?  Where do you draw the line, assuming no intent to defraud?

Revisiting corporate vs. personal tax rules

First, corporations are usually on an accrual accounting basis, meaning that income and expenses are accounted for as earned, not when the cash is received.  (You, on the other hand, account for your individual income on a cash-accounting basis, counting the cash not the date of your earning or accrued expense.)  The difference:  If you earn pay due December 31^st and it is paid January second, you pay income tax on those earnings in the following year.  But the corporation that pays you accrues the expense and takes the deduction in the year in which the income was earned or expense actually incurred.)

Where do we draw the line here?

[Email readers, continue here…]   It is perfectly legal to hold delivery of goods until after the start of the next period and take the income next year rather than this.  It is a bit murky if you accelerate payment for incomplete services or even for products not yet received into this year to take the deduction from income early.  In either an IRS audit or an accounting review or audit, the accelerated costs and payments will show as an accrual – a balance sheet item – that does not change income, just cash and an asset.

In other words, for the usual accrual-based business, there are fewer ways to affect the outcome than for a cash-accounting individual.  There are lots of caveats here and certainly if the issue is critical to you, an accountant (rarely a bookkeeper) should guide you to the action that is both legal and strategic.