Emerging Companies: How To Build And Work With Boards

Wednesday, March 28, 2012 - 09:51

The Editor interviews Richard M. Lucash, Special Counsel, and Benjamin M. Hron, Special Counsel, McCarter & English, LLP.

Editor: We understand you moderated an event sponsored by McCarter & English entitled “Boards and Advisors: How to Build and Work with Boards.” Please tell us about the key takeaways from this panel discussion.

Lucash: The first takeaway reflects how the role of the board of directors (“board”) evolves. For emerging companies, the board initially will be composed of the founders. Since the founders are already working together every day, board meetings as such are not a critical issue.

Outside board members will be added at various points, the first usually when the company takes on outside investors. While angel investors with smaller investments may seek only “observer” status, professional investors are generally looking for seats on the board. The most typical evolution of the board from the founders to the investors happens when venture capitalists (VCs) enter the picture, leading to a balanced group that may include two founders, two investor representatives and one independent director.

The independent director position leads us to the next takeaway: in assigning this position, the founders shouldn’t necessarily accept the VCs’ first suggestion.

As to whether the board should include members with specialized expertise, such as science or marketing, the general consensus of the panelists was that while those are good skills to have, it is better to have these people be part of the more informal group of advisors.

The panel noted that boards should meet monthly and offered suggestions as to effective preparation for and conduct of meetings, which should always include reviewing financial statements. The discussion about compensation noted that directors of early-stage companies are universally compensated with equity, whether options or stock, whereas consultants/advisors might also receive hourly or daily compensation. The panel noted that neither the founders nor investors should be compensated for board participation.

Editor: Please talk about the typical working relationship among management, shareholders and the board. What should be the major governance objectives for an early-stage business?

Hron: At the earliest stages, the shareholders, directors and management are typically the same group of people, so the major challenge becomes determining the proper division of power, including the equity split among the founders, the officer roles (CEO, CFO, etc.) for each founder and which founders will be on the board.

Determining the equity split can be particularly challenging. A simple “split-the-pie-equally” approach to equity distribution is easier at the front-end but creates many potential problems as the business develops, particularly if no one has the authority to resolve a deadlock. But the alternative requires trying to put a relative value on the contributions of each founder, both at the outset and in the future, which is very subjective. We try to resolve those sensitive issues by helping the players think through the entire process, i.e., understand in practical terms how things will work going forward. While there is no single perfect solution, we can help with negotiations that yield creative solutions, such as an unequal equity split that vests differently for each founder based on their respective contributions to the enterprise (financial and otherwise), thereby ensuring that everyone is properly rewarded over time.

Later on, a company’s biggest challenge usually involves investor relations and a variety of dynamics that stem from the fact that investors and founders have different incentives. Everyone wants the company to prosper, but investors may have a shorter time-horizon, so they may be looking for exit opportunities before the founders are ready. Investors may also decide that a founder is not helpful to the business and should be pushed out, which raises the issue of whom the other founders will support. If not managed properly, these challenges can lead to an outright conflict between the investors and founders over who is going to control the company, and in that situation the investors usually win.

Editor: Overall, do you find that emerging companies tend to strike a healthy balance between investors and founders?

Lucash: It’s hard to generalize. Investors might be fine with founders acting as the board of directors, but when, for instance, investors bring half a million dollars into the company, they also have the power to demand seats on the board for themselves and for an independent director.

Then there are important questions about whether founders do a good job of managing the board and of extracting the best value from outside members who may or may not be a good fit for the company. Perhaps the single most important contribution of a board that includes outside directors is the ability to show “tough love” to the CEO. This might involve not only a constructive, mentoring approach, but also the courage to make necessary changes.

Editor: When a company is in its infancy, what are the critical issues you focus on as a legal advisor? Do these companies usually have inside counsel as well?

Hron: In my experience, startups never have inside counsel until after their A-round of financing or reaching some level of predictable recurring revenue. Most young companies don’t have enough legal work to justify a lawyer’s salary. Critical early-stage legal matters are largely confined to discreet tasks, such as determining the corporate structure and the division of equity among the founders, and protecting IP.

Other key legal issues often arise from employment matters, such as ensuring proper classification of employers versus contractors, and commercial relationship. In many cases, the companies that startups partner with have most of the leverage in the relationship, so we try to help them negotiate contract terms that protect them as much as possible.

Editor: At what point should an emerging business decide to form a board with outside members?

Lucash: That decision tends to be event-based, rather than based on time elapsed or hitting a pre-defined revenue target. At the beginning, all corporations are required by law to have a board, but if the company needs outside advisors with specific expertise, those people generally are not interested in assuming the legal liability attached to directorship. Also, early stage companies frequently do not have the money for directors and officers’ liability insurance.  Accordingly, at the outset, the legally required board is made up of the founders, and the company may also have an informal board of advisors whose members received either direct or equity compensation.

The most common point of change is when outside investors get involved. As mentioned, these investors often require seats for themselves and for an independent director, both as the theoretical tie-breaker and as a good option for bringing in specialized expertise. Short of reaching a milestone that requires action, founders likely are in no big rush to create an independent board because doing so brings in outside people with a fiduciary responsibility and  voting power, and more reporting responsibilities.

Editor: What are the special characteristics of early-stage business financing, and what constitutes the optimal management team to manage this process?

Hron: At the early stages, market size and team are key.  A good team can improve a so-so product in response to feedback, but a bad team will kill a great product. Creating the optimal team requires assembling people with complimentary skill sets, and part of the vetting process for investors is figuring out if the right team is in place.

Editor: If a company opts for independent board members right from the start, what critical advantages/disadvantages may ensue?

Lucash: A critical advantage is that the right board member brings a lot to the table: everything including holding the CEO to goals, providing mentorship and opening up her Rolodex and providing contacts for financing, for customers and for strategic partners. The right board members can make a huge difference in whether the company succeeds or fails.

One disadvantage is that the management team must spend considerable time working with the outside board members to maximize their contributions. This involves preparation for meetings and, between meetings, maintaining one-on-one contact with the board members to elicit their advice and network. Furthermore, dealing with board members that are wrong for the company can absorb considerable management time. We hear as many positive stories about companies that evolved all the way to a very successful exit or public offering – and give much credit to their board members.

Editor: Is technology the key industry sector for emerging businesses?

Hron: While technology is the key area in our practice, it certainly is not the only sector for emerging businesses. There’s a great monthly program called Mass Innovation Nights (http://massinnovationnights.com/) that showcases up-and-coming businesses in a whole range of areas. Some are technology driven but many are not.

Within the technology sector, I’ve seen a lot of recent interest in mobile applications, clean tech, healthcare technologies, particularly medical records, and big data, which analyzes large quantities of data created by anything from Twitter to the stock markets. There is also a lot of focus on using technology to enable smaller businesses to more effectively engage with consumers. Groupon led the way, but many others are following suit.

Editor: Is an education and background in technology key to a legal practice in advising technology start-ups?

Lucash: Like Ben, I’ve spent my entire career working with emerging technology companies. I have a technical undergraduate degree in electrical engineering and physics, which has been helpful in a number of ways. First, it creates a certain bond with the entrepreneurs who are generally technically oriented and second, it enables me to speak intelligently and to understand the important issues.

Hron: My background is in biology. I started my career doing more biotechnology than IT, and I still do some of that. While this background is not essential, it does help me understand some of the science. With high-tech and biotech companies, I collaborate closely with my colleagues in McCarter's intellectual property group who have the relevant technical expertise. Being a general corporate lawyer, it’s important for me to be engaged in the emerging tech company world so I understand the challenges my clients face and can identify the legal issues that are likely to arise, which allows me to help my clients avoid them.

Editor: Tell us about McCarter’s ongoing series at Cambridge Innovation Center (CIC).

Hron: We started the CIC series last June, both to give something back and to become more visibly engaged in the entrepreneurial community. We deliver a regular series of programs on subjects that are of interest to entrepreneurs, and so far it’s been wildly successful. We’re now drawing 40 to 50 people per event, and the feedback has been very positive. We have a lot of great programs coming up.

Lucash: McCarter has a branch office at the CIC which is primarily staffed by Ben and me, so the programs are a great way to provide value to the entrepreneurial community.

Please email the interviewees at rlucash@mccarter.com or bhron@mccarter.com with questions about this interview.