Three Corporate Governance Issues At Venture Capital Backed Startups

Board of Directors of Venture Capital Backed Startups

When you think about what startups and their venture capitalists should focus on, does corporate governance quickly come to mind? Probably not. But it should. As with public company boards of directors, boards of venture backed companies should emphasize strategy execution and risk oversight. Startups, though, face special challenges. Accordingly, the boards of directors of startups need to spend their time on these challenges. Three corporate governance issues central to a startup's success are (1) executive and employee compensation, (2) implementation of the business model and strategy, and (3) preparing for exit.

1. Executive and employee compensation

Every startup with venture capital funding has a stock option plan. Founders, executives, and employees receive a portion of their compensation as shares in the company. The purpose is to provide the incentive to work hard now to build a successful company that will be worth much more in the future. Founders and employees want certainty that they can cash out their stock as as reward for their hard work. That is the essence of sweat equity.

Questions that the board should address in connection with executive and employee compensation include:

  • What are the criteria for granting stock options?
  • How much compensation should be in stock relative to cash compensation?
  • What types of restrictions should be placed on stock transfers, within the applicable securities laws (e.g., 500 shareholder rule)?

Further questions concern the relationship of equity compensation to secondary market transactions and liquidity or illiquidity or private company stock.

In addition, what is the role of the compensation committee at venture backed startups? Startup boards usually have less detailed committee structures than public companies. Given the importance of executive compensation issues, however, directors should ensure that the compensation committee addresses the issues described above.

2. Implement the business model and strategy

Good corporate governance should advance the execution of strategy and the business model. Scaling for growth and strategy execution are critical to a startup's success. The recent NYSE Commission Report on Corporate Governance Principles points out that good governance must be integrated with business strategy. This principle applies with equal force to emerging companies. Emerging companies have little room to fail in executing their strategy and business model. They need all the help they can to turn the odds in their favor.

More so than in public companies, directors at venture backed startups should be knowledgeable about specific operational, organizational, and financial details. Of course, venture capitalists sit on the boards of their portfolio companies. The board of directors, with its experience across many companies, plays a crucial role in helping entrepreneurs to set and achieve performance metrics and benchmarks. Consistent with this idea, entrepreneurs prefer venture capitalists who can spend time to help the company succeed.

3. Prepare for exit, whether through a merger or acquisition or an IPO

Venture capitalists are well represented on venture backed company boards, and they naturally have exit as a goal. An initial public offering (IPO), and more recently a merger or acquisition, is how VCs exit their investment and provide a large, positive return on investment to the limited partners.  For now, the IPO market remains uncertain, and the return from an acquisition is much lower than that of an IPO. Since corporate governance is the biggest concern of companies preparing for an IPO, directors should prepare early for the governance challenges that public companies face.

Before exit can become a realistic scenario, the infrastructure for the next round of investment must be laid. That involves growing the company and executing the business model and strategy. The progress needed to move through rounds of funding highlights the board's role in implementing the business model and strategy.

Conclusion

In contrast to public companies, venture backed startups face fewer compliance-related corporate governance issues. For instance, private companies do not have to file disclosures with the SEC on a periodic (Form 8-K), quarterly (Form 10-Q), or annual (Form 10-K) basis. Nor are they subject to Sarbanes-Oxley.  Instead, the board must guide the company so that is well positioned for the next round of financing and, eventually, for an IPO and acquisition. Further, because venture backed boards do not have deal with pressure from external shareholders or intense public scrutiny, they have fewer stakeholders on their radar screen.

Public companies also face the first two governance challenges -- compensation and strategy execution. However, the specifics of the challenges are different for two reasons. First, the companies are at different stages in their life cycle. Thus, the issues are necessarily different. At public companies, compensation discussions focus primarily at the CEO level. At startups, execution issues center more on establishing product/market fit, scaling the product and organization, and developing organizational culture. Second, private companies have fewer compliance concerns than public companies.

What is your startup board doing to deal with these corporate governance issues?

Douglas Y. Park

Twitter: @DougYPark

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