BERKONOMICS

Let me tell you the story of the first investment made by a newly organized formal group of angel investors.  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 agreed immediately and the business was launched, well funded and anticipating great profits.

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).

[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.  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 the angels, and accelerated quickly into more cities, again running out of cash.  The wealthy investor in the meantime, unknown to the CEO or the board, ran into personal trouble with real estate investments, and 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.

The lesson is for any CEO to filter all advice through the strainer of good reason, taking that which seems reasonable and rejecting that which is wrong for the company or the times.  By not putting up any argument and being completely compliant, the CEO ceded control of the company to outsiders who gave bad advice.

Whenever there are outside shareholders, 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.  Directors and Officers insurance 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 of coverage.

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

Over the many years of board service, I have been sued as a director several times, in no case covered under the umbrella of a D&O policy.  Although I won each of these rather spurious suits, 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, which you might ply from me at a later telling.

Expect a board member to give a meeting a month, emails and phone calls between.  Urgent issues require more of all.

Board members are usually busy people, often running other companies or serving on multiple boards.  Early stage boards usually meet once a month for two to four hours, enough to ruin the rest of a day for those who travel even short distances.  In addition, most all board members freely receive phone calls and emails from the CEO during the month, all considered part of service.

There are times when board members are called upon to give extra-ordinary time to the corporation, such as interviewing candidates, strategic planning, recovery from a cash flow crisis or other urgent  issues.  Most often these are freely given by board members.

The line is crossed when a CEO asks a member of the board to consult to the company, spending considerable time with other employees regarding issues that might be handled by others than from a board.  Depending upon the board member, it is appropriate to offer a consulting fee for this time spent above the call of board duty.  Any such informal contracting of service should always be preceded with an agreement between the CEO and board member as to the amount to charge and estimate of time to be spent before further agreement is necessary.

Give one percent equity to each outside board member vesting over four years of service.

Many early stage CEOs and board members have asked for some guidance regarding pay and time commitments for board members.  Here is my best advice, based upon many boards and many years.  Pay early stage board members of companies that are not lifestyle businesses one percent of the fully diluted equity in the form of an option that vests over four years of service.  The option price should be set by appraisal under IRS rule 409a, and certainly should be low enough to recognize that common stock options are not worth as much as preferred stock, given the many preferences of the latter.  Further, the option should contain a special clause that accelerates vesting to 100% upon a change of control in the corporation, which aligns the board member with the best interests of the corporation itself. Otherwise, you might picture an event in which the sale of a company to be consummated a few months before full vesting could cause a board member to find ways to vote for delays or even against a sale of the company, awaiting full vesting of his or her options.

[Email readers continue here…] For lifestyle companies or later stage companies, board members should be paid on a per-meeting basis in cash. Typically this payment amounts to $1,000 per meeting of the board, adjusted upward for public corporations to $3,000 per meeting on average, with special pay for committee chairs and special meetings.  These payments recognize that board members are not working for equity but for the equivalent of consulting fees plus the attendant risks of board membership.

Venture investors with investments from their funds are not typically ever offered pay for board service, which is expected as part of the investment.  Inside board members, CEO and any other paid employees are not paid for board service in either stock options or cash.

Expenses for travel are often reimbursed by the corporation.  VC board members sometimes request this, other times do not. It should not be offered to the VC members unless requested.

The next insight will cover what should be expected of a board member in the way of time allocated to the company.

Plan 10% of your time for board relations.

Most all leaders new to the CEO position underestimate this time requirement.  It is good for the company when the CEO shares concerns, threats and opportunities with the board.  The rule of “no surprises” works well for the longevity of a CEO.  But there are always surprises. CEO’s should communicate with members of the board if not a committee of the whole as soon as possible when threats to the corporation arise.

Sometimes the CEO wants to obtain concurrence from his board for issues of particular importance to him.  It is not bad form to lobby individual board members in the form of a briefing of the issue as the CEO sees it, as long as the board is allowed the time to debate the issue, sometimes requesting an “executive session” of just the outside directors.

All of this board management is time consuming.  The CEO is also responsible for preparing the board briefing package before regular board meetings, a time-consuming task if done correctly.  The package should contain the issues to be discussed with backup materials for the board to understand the issues.  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 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.

Does this not appear to add to at least 10% of a CEO’s time now that you’ve seen some of the elements of the task?

I first heard this in a governance seminar for a non-profit higher educational board upon which I sit, 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.

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.

[Email readers continue here…] 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.  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.

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

Perhaps this is the natural conclusion from the several insights previously explored.  While the CEO and management offers 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.

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.

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.

Recently, one of the CEOs in a roundtable who had been active and vibrant for years in both his company and the roundtable, 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.   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 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 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.

No board member should be grandfathered, guaranteed a board seat forever.

Practically speaking, this is an impossible goal.  We have investigated the restrictions imposed by investment documents and the obvious need to keep continuity on the board with the retention of the CEO position at the very least.  But it would be the best of form to require in the bylaws of a corporation that all seats are re-elected annually.

For non-profits, this allows for the creation of a board development committee to find and recruit outstanding new board members and find ways to unseat those who are no longer contributing or even attending board meetings.  Such a policy further reinforces the duty of care for the corporation by its board.  Unseated board members with longevity and a history of participation can be invited to become “emeriti” members of the board with observation rights but no vote.

Although not required by all corporate bylaws, all companies should hold and document an annual shareholder meeting in which the shareholders are notified at least 20 days in advance and given the right to submit a proxy vote for their choice of officers and for any other issues that will come to a vote, including expansion of the stock option plan to include more available shares.

The bottom line is that good corporate governance calls for a skill set within the board that is not often present, but for protection of the members and the corporation itself, necessary.