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Ask an Angel : Berkus on Building a Board of Directors



Note :  Having heard Dave speak and had several discussions with him, I can confirm Dave is very knowledgeable about Angel investing and how companies need to organize themselves to move forward.   The following article provides great insights to Founders and Angels on how to engage, add value, improve decision making, and build a successful company.

If you have any questions on this topic or any of the associated considerations,  please let me know.   … Ron

Dave Berkus, chairman emeritus and member of Tech Coast Angels, has invested in 68 small technology companies since 1993, earning an IRR of 97 percent. He served on the boards of 40 of these companies and was chair of 12 of those boards. Currently, Berkus is a board member of 10 private companies, chair of six of those, and an active member of four non-profit boards. He is co-author of Better Than Money and Extending the Runway (available at www.berkus.com with author royalties donated to charity). ACEF’s Mary Jane Grinstead recently talked with Dave to get his advice on the best practices for boards of directors for early-stage companies.

ACEF: Let’s start with the bottom line. How can the angels participating on boards of their portfolio companies assist those companies in meeting milestones and overcoming obstacles ?

DB: The role of angels who are board members doesn’t stop with the investment—in fact that’s where their most important role begins. The responsibility for helping grow a company falls on the board members as well as on management. If investors insist on having board participation, as I think they should, then they should be trained to respond effectively as a part of the company team. Boards require time to nurture and grow. That time is well-spent with the crises hit; and crises will hit all early stage companies.

ACEF: You have a flair for helping entrepreneurs and seem to understand why they need an effective board of directors. Tell us about your approach.

DB: It all starts by recognizing the entrepreneur’s perspective and experience, or more likely lack of perspective and experience, with a “real” board. Early stage boards look and act differently from later stage boards. So it is helpful if both angels and entrepreneurs remember this.

Before a company has outside investors, the role of the board, which is usually made up of friends and family, is more advisory than one of governance. When angel investors come in, our documents dictate that we have investors’ rights which usually include providing for one or two members on the board at all times. We’re almost always the first “real” board that the entrepreneur has had to deal with.

In addition,  because early boards before external funding are stacked with friends-and-family investors, and the entrepreneur hasn’t yet bought into the process about needing people from outside.  To create awareness of this issue I try to get into the entrepreneur’s shoes and ask questions that will get them to buy into the need to get better organized for the future.

Some questions to ask the founder  –  Do you need a board ?   Is it advisors you seek or governance ?   Do you have outside investors ?   Do you need legal operational, industry, or financial expertise to help you grow the company ?   How about a “sounding board” for management or a source of appeal for managementissues ?

At least one of these points will resonate with almost every entrepreneur. No one CEO can do it all well, and CEOs are often isolated when they need help the most.

ACEF: Any tips on recruiting for the board ?

DB: Get references from investors and existing board members. If you have to pay a reasonable recruiting fee to find the right industry expert from the outside, consider doing that. Ensure that candidates are comfortable with company management and the rest of the board. Be sure that prospects have the time and willingness to attend meetings and be available between meetings for telephone access by the CEO.

ACEF: After you get the entrepreneur comfortable about the benefits of a board, do you talk about potential risks ?

DB: Yes. Many entrepreneurs don’t realize that the board can hire or fire the CEO or that even though the entrepreneur has and is keeper of the vision, the board can influence and control the strategy of deployment. There’s always the risk that the entrepreneur and the board can get sideways and that the board could withhold approvals for funding for acquisitions or other initiatives.

I advise the entrepreneur not to stack the board with friends or investors but to find a balance between finance, operational, and industry expertise. You want a board that helps the entrepreneur and the company to get things done. On a five-person board, giving two seats to the investors, one seat to management, and two seats to carefully selected independent members usually works well.

ACEF: What about having an attorney at board meetings ?

DB: If one board member is experienced in governance, I believe that you don’t need to have an attorney on the board. I also prefer not to have attorneys as observers in board meetings, which is a bit more controversial. Attorneys certainly add value when they have the answer to a question, but who on the board is going to raise their hand if the attorney oversteps? And it’s a poor board if the attorney is there to protect the CEO not the company, especially if it is not stated clearly in advance who the attorney represents.

ACEF: You have participated in dozens of boards. Is there typically a board member experienced in governance ?

DB: Yes, usually me. After running two public companies and two private ones, governance training has been part of my life going way back; so I become the governance officer by default. I also find myself on the audit committee of virtually every board where I serve.

Government is increasingly applying the rules that affect public corporations to smaller and smaller companies, and training in governance itself is something many angels lack.

Angels need to know that as a board member, their legal responsibility, or duty of loyalty, is to the corporation, not to the shareholders, the employees, or the vendors. There will be times when there are conflicts of interest because of this. For example, there is a legal transfer of loyalty at the moment of insolvency when the board’s duty of loyalty legally changes to protection of the assets for the creditors, which means that the board must protect assets for the payroll and vendors, and for all the entities that come in front of the investors.

Then there is the duty of care, a legal duty to care for that corporation asset—to protect and grow it and defend it against all forms of attack. Even if it is not in the best interest of the investors we board members represent that as board members we can’t vote for things that are against the best interests of the corporate entity itself.

ACEF: How do you suggest early stage boards organize ?

DB: Small boards should emulate big company boards in many ways, which includes establishing audit and compensation committees. If needed for governance or if requested by management, a company may have additional committees for finance, human resources, or technology. It is important to have ongoing focus on board development, at least as a subcommittee of the board; to assess continually whether the board is composed of the best possible members and balance of skills; whether there are non-performing members who should be replaced, and if so how that is going to be done. Consider having annual board evaluations; setting fixed but renewable terms, and even when to “fire yourself.”

Angels need to remember that when the company reaches the growth stage that calls for VC investment and the venture capitalists come in, the angels will lose a board seat. If we understand that there are stages of board development, then we won’t get upset when that event happens and one of us gets asked to leave. Often the departing board member will be granted observation rights.

ACEF: How can angels participating on boards appropriately help the companies they serve ?

DB: There are five easy-to-understand resource areas that define value added activities for a board: money, time, relationships, process, and context.

ACEF: Money—there’s an obvious one. How can a board help an entrepreneur and a fledging company not run out of it ?

DB: By guiding the company not to spend precious dollars until they begin to see the first evidence of demand. That saves the company from pushing products based on evangelizing a product into the marketplace that is not receptive to the message, which is how most small companies die. When the company does have a strategic partner that is willing to put resources behind the company, product, or distribution, you have the fist evidence of demand. Put the money behind that one and search for another strategic partner, and then another. I would label this “demand pull” as opposed to “cost push.”

Avoid the “tyranny of the new office.” Think how many companies are stuck with a lease for an overpriced office at the critical stage of capital preservation. Focus on extending the cash. At the high end of the curve, rapid growth actually demands more cash, not less. Boards should hold the company to a disciplined, constant, cash forecast.

Like money, start-up companies and entrepreneurs never have enough time. Deliberate over-commitment leads to “time bankruptcy,” which is just as serious as running out of cash. The board can guide the company to use its vision statement as a tool to filter time allocation.

Yet another “opportunity” for board members is to probe for and discover the greatest bottleneck in the company’s product or service delivery process, then work to provide resources to eliminate that bottleneck and restore smooth operations and efficient use of capital.

I’ve seen more boards of our tiny size hire the expensive “C” level officer; contract with the P/R company; pay for a large booth at one or more trade shows, and then the results don’t appear and the money quickly runs out. The message here is, don’t bet the farm unless the crops are on fire. Probe for demand and back up that demand with the resources saved for the real opportunity.

ACEF: Relationships and process management are part of the mantra of angel investing. It seems that a board can be invaluable to the entrepreneur when it comes to networking.

DB: Unquestionably. An effective board constantly encourages the entrepreneur to leverage the golden rolodexes of the people on the board, recognizing that there is always someone who can and will help to get a product to market faster or reduce the cost of development.

Process management means getting from start of the company to successful product launch and growth safely and faster. If the inventor/entrepreneur hasn’t built a company before, the board can help him or her figure out how to use fewer resources given the time to market and resulting burn of fixed costs.

And then there is the “every three million dollar crisis.”

ACEF: What’s that ?

DB: Companies hit critical points at about every three million dollars of incremental revenue—or of gross profit if there are outside vendor product costs. These stages are where the entrepreneurs and their boards are likely to have disagreements and conflicts. To some extent, a board that has a good working relationship with the company founder and management team can rehearse these stages in advance; however, some conflict is unavoidable.

At $3 million with about 20 employees, it is often time to replace the weaker people in the company—and that could include CEO’s friends or even the CEO. Reporting or organizational management usually needs to be realigned. At $6 million in revenue with about 40 employees, the company will hit another bump, this time usually a cash crisis, and raising growth capital consumes at least half the CEO’s time. If he or she was the bottleneck, all heck really breaks loose inside the company.

Assuming the company stays on track, another rough patch happens around $9 million. By now, the product is in second or third generation with new features. The high quality that the company thought was sacrosanct suffers from the rapid growth, and quality problems consume management. At the $12 million level, the problem often returns the operational, closing the ever-expanding circle of repeating crises.

ACEF: So if these bumps are likely, what can a board do to help a company manage through ?

DB: From the beginning, provide the leadership to ensure that the entrepreneur follows a constant planning exercise that helps the company stay in sync or context with the market. This perspective doesn’t come from investors or from the CEO, but from industry experts on the board who understand whether or not the company is flying with the prevailing winds of the marketplace or wasting money pushing product to an indifferent market.

The CEO is always going to have a gee-whiz idea that will take the market by storm. Independent board members with industry knowledge can supply an important balance, helping find that elusive receptive market for a new company or product. Think about Apple; only about a half-million iPods were sold in the first year because the product came out too early. If a product as big and successful as the iPod had market context issues, you can bet that most of the companies angels deal with are going to have these sorts of challenges, too.

The planning process should also include actively seeking great strategic partnerships, especially in the context of pre-thinking the company’s exit strategy. I like to run a white board exercise with the company’s board, asking them to name 10 companies that might be candidates to eventually buy the firm down the road.

Then we talk about how to create the most value for those candidates.  Is our value to those companies in our patents, products, or distribution?  If we discover that six of the 10 companies would want the same thing from our company if they knew that we could provide it better than anyone one, then that discovered value becomes a core competency that the company will want to develop. In this way, boards can create credibility for future fundraising and liquidity events.

ACEF: How does a company pay an early stage board ?

DB: Cash is nice, and typical in public companies, but very rare early on. Stock grants create taxable events and must be carefully managed. Options are the most typical form of board compensation because options align the board with management.

You typically see early stage funded companies offering one percent of the fully diluted value in common stock to each non-VC outside board member, vesting over two to four years. If there are both preferred and common classes of stock, there are pricing choices for the options. In any event, these board member non-qualified stock options (NSO) must be priced at the last transaction price or at a carefully derived share price after considerable research and discussion.

ACEF: How often should boards meet and what should an entrepreneur be expected to prepare ?

DB: Monthly meetings are appropriate early on or if the company is in a directional crisis. Bi-monthly works well if the company is progressing and cash flow isn’t a problem. The board package should include financials, projections, statements of progress, and a separate statement of concerns or problems authored by the CEO. At meetings, leave time and encourage the CEO to include other members of the management team to demonstrate depth of management and to give the board a better understanding of management issues.

ACEF: Any final observations.

DB: The education of Angels who want to add value and aspire to be good Board members is important. We want to understand what is going on with the company, to effectively advise management, and to open our rolodexes for help, but we must keep our “noses in and our fingers out.”

Once a board member steps across the line and deals directly with operating issues and interfering with management, it is almost impossible to cross back and repair the damage. Such moves, whether triggered by the CEO or by board members, although well-intentioned, create a stressful situation and significantly reduce Board effectiveness.  To avoid these situations is why it is very important for the venture to have a mature, experienced CEO with strong business and people skills as well as for Angels to be proactive in moving the company forward by being sophisticated investors..

We must constantly remember that we Board members are not managing the company, only providing governance, resources, and direction to help management.  The goal is for the team to work well together and make good things happen.

July 2008 :   From the Angel Capital Association Newsletter

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