How To Do it..

By Kaleil Isaza Tuzman 

Over the past 15 years, a set of broadly accepted principles for good corporate governance have emerged. Although these principles are most often referred to in the context of the governance of publicly traded companies, they are equally-if not more-important for the boards of directors of privately held companies, where information is usually more opaque and conflicts of interest more prevalent...

"We should have seen it coming."

-Former GE Chairman & CEO Jack Welch, on the spate of recent large company corporate governance lapses

Over the past 15 years, a set of broadly accepted principles for good corporate governance have emerged. Although these principles are most often referred to in the context of the governance of publicly traded companies, they are equally-if not more-important for the boards of directors of privately held companies, where information is usually more opaque and conflicts of interest more prevalent.

Broadly speaking, the rules for good corporate governance are as follows:

1) Board composition: The board of directors should be comprised of both executive directors as well as  non-executive, independent directors.

2) CEO selection/oversight: The board of directors selects and oversees a competent, knowledgeable and ethical chief executive officer (CEO), and approves the selection of certain senior management personnel. This includes senior management compensation-setting, as well as planning for CEO succession.

3) Financial fiduciary: The board of directors' primary responsibility is to protect and produce value for shareholders; except in the event of insolvency, when a board member's fiduciary duty is to a company's creditors.

4) Reporting: The board of directors, through the appointment of independent auditors and oversight of management, is responsible for ensuring complete, honest and timely information about the company's financial performance to its shareholders and, where appropriate, other stakeholders (creditors, employees, regulatory agencies, government).

5) Conflicts of interest: The board and management must put the interests of the corporation above their own, and should disclose any potential conflicts of interest.

6) Duty to be informed: The board of directors must remain fully informed of material operational and financial developments within the company. Members of the board must dedicate the time and energy to fully review material presented by management, ask questions where information is lacking, and attend board meetings with few or no absences.

7) Business practices: The board of directors should ensure that the company deals with all stakeholders in an ethical and equitable manner.

While there are a few additions that could be made to the above list (such as the mandatory formation of audit or compensation committees on the board, separation of the chairman and CEO roles, or the extent to which a board should get involved in strategic planning and budgeting), these are the widely accepted tenets of good corporate governance, and it would be tough to find a self-respecting venture capitalist who would challenge any of these basic guidelines. Why, then, do venture-backed companies have such poor corporate governance?

Actually, it's not tough to see why. Consider the following situations:

Example #1: The fox guarding the coop. A software company takes in its first round of venture capital, after having been backed previously by friends and family investors. The venture firm gets a new series of preferred stock, with a 3x liquidation preference, weighted average anti-dilution protection, and 3 of the 5 board seats. A couple of years later, there's an offer from a competitor to buy the company-and the price offered is 2.5x the venture capital firm's original entry valuation.

The venture firm happily takes the deal, cuts in the founders a little to get their support, and leaves the other shareholders (who are behind the venture capital firm's 3x liquidation preference) in the dust. Good business? Perhaps. Proper corporate governance? Probably not. Did the venture firm's board representatives properly consider the other shareholders' interests? Did they disclose their conflict of interest and excuse themselves from voting whether to approve the deal? Did the 5-member board include any truly independent directors at all?

Example #2: Debt by any other name… A later stage venture capital firm likes to invest through collateralized convertible debt with warrants. This protects their downside somewhat in the event of a flop, while allowing them to exercise the warrants (and perhaps convert into equity) when things go well. A heavy equipment manufacturer was looking for a traditional senior debt facility, but liked the lower interest rate available through the convertible, and felt it could avoid equity conversion through early payback of the loan.

The venture capital firm joins the board of the company-an action a straightforward lender would never think of taking for the obvious conflicts of interest created. But the venture firm sees itself as an equity investor rather than as a creditor, and the company doesn't object. Later, as the company falters in meeting its numbers (and debt covenants), the board has to consider whether to try to swap out the debt facility or allow it to convert to equity.