Entrepreneurs should consider the role of board observers

As an entrepreneur, you know that venture capitalists will get seats on the board of directors when they invest.  What you may not know, however, is that the VCs will often also have board observers from their firm.  What is the difference between a director and an observer?  What are the benefits and drawbacks of observers?

Board Member Vs. Board Observer

Directors have two primary fiduciary obligations to the company: the duty of care, and the duty of loyalty.  Moreover, directors vote on matters that require their approval (e.g., approving business strategy).

Sometimes, there are more parties with an ownership stake in the startup than there are board seats.  The general guideline is that early stage companies should have five to seven people on the board.  When there are many investors, not all investors will get represented.  In this case, VCs will ask for and often receive observer rights.

Observer rights are covered in either the investor rights agreement or a separate side observer rights agreement.  These rights usually include:

1. Attend and participate in board meetings
2. Receive the same information as directors

However, observers are not allowed to:

1. Vote on matters
2. Receive attorney-client privileged communications

Advantages of Board Observers to Startups

Observers can contribute to the governance of emerging companies.  First, they can mollify investors who want to participate in board meetings.  Sometimes the observer is the second representative -- an associate rather than a partner -- from a venture capital firm.  The associate gets trained through the experience.

Second, more experienced observers can add to the discussion.  These observers may be investors who have come in on a later round when the board is already at its optimal size.

Disadvantages of Board Observers to Startups

Yet, observers can also potentially cause problems for early stage ventures.  Unlike directors, observers do not have fiduciary duties to the company.  As a result, except in unusual circumstances, observers are not liable for their participation.  However, directors can be held liable for breaches of their fiduciary duty.  Only directors risk personal liability, high legal costs, and damage to their reputation for alleged breaches of fiduciary duty.

This difference in liability suggests that observers may have different incentives in how they view their service.  Since startup boards typically try to reach a consensus on important issues, board observers may exert disproportionately large influence on decisions.  Although not entitled to vote, they can greatly influence the decision making process in situations where a vote actually does occur.  This is why venture capitalist Mark Suster dislikes board observers, except for where the person is the associate of a VC partner.

Balancing The Pros And Cons

In general, I have some concerns about allowing board observers to participate without limitation meetings.  Not every investor can be on the board. Observers can attend if they are significant investors.  Their participation should be limited in some fashion though.  They certainly should not be allowed to receive attorney-client communications or certain sensitive information.  Investors who do not have a board seat may have information rights, so they do receive important information regarding their investment.  Is that enough information for them?  If they are not actively participating, and merely observing, then what are they contributing to the meeting?

Of course, allowing these non-voting individuals to attend the meeting is often an exchange for their financial support.  Observer rights are usually given to investors who might get a board seat but for the limited size of startup boards.  But that does not mean that adding the investor enhances the board's work on critical corporate governance issues.  Yet, perhaps there is not much harm done either.

The question then arises:  Should the standard for board attendance and/or participation be do no harm, or do good for the company?

In rare cases, an overzealous observer can cause problems.  The individual may disrupt the proceedings or fail to prepare properly.  If this happens, first try to negotiate the situation with the observer and his or her superior.  Then refer to the investor rights agreement or observer rights agreement to see what you can do.

Of course, now that you know that problems might occur you should negotiate the scope of the observer's rights.

What kind of experience have you had with a board observer?  Do you think an observer contributes to the conversation?

Douglas Y. Park
Twitter: @DougYPark

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Angels Invest in Earlier Stage Companies

In 2009, VCs continued to invest less in very early stage companies.  This means less venture capital investment in seed rounds.  While venture capital investment in early stage companies and seed rounds has traditionally accounted for between 50 and 70 percent of all VC investment, that figure plummeted to 35 percent in 2009.

By contrast, angels increased their investment in seed rounds or Series A rounds.  BC Insights reports that the number of angel investments increased by 33 percent in the first quarter of 2010 over the same period 2009.

Angels Invest Smaller Amounts

In 2008, VCs on average invested $7.4 million in 2008 per funding round.

By comparison, whether investing individually or in a syndicate (such as Harvard Angels or Keiretsu Forum), angel investors typically invest small amounts in a startup.  Investment amounts for a round generally range from $10,000 to $500,000, and sometimes more.  Indeed, the average investment by an individual angel is $77,000, while the median is much lower at $10,000.  Angel syndicates on average invest less than $250,000 per round of funding.

However, angels have recently invested larger amounts.  Some angels report that entrepreneurs now ask for and get $750,000 or more, while in late 2008 angel rounds did not exceed $500,000.

The reason angels invest less than venture capitalists is that angels invest their own money, while VCs invest someone else's money.

Conclusion

This discussion raises several questions:

Since even fewer startups can obtain venture capital in this environment, will the role of angels in helping companies grow change?  Will they need to play a greater role in operations and governance? Are they up to it?

At the same time, how will the rise of super angels affect the role of venture capitalists?  How will super angels affect the way entrepreneurs think about VC funding?  As angel rounds get bigger, and as entrepreneurs become better at doing more with less (e.g., in web businesses), will they feel less of a need to secure VC funding?

Douglas Y. Park

Twitter: @DougYPark

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The venture capital industry is downsizing toward smaller and fewer funds.  What should the remaining VCs do?  What should new VCs do? The answers will have a large influence on entrepreneurs, innovation, and wealth creation.

Venture Capitalists Who Raise Money Now Will Win Later

In the current environment, raising money is tough, not just for entrepreneurs but also for venture funds. Limited partners are cautious about opening their wallets. But this is the best time to raise money. Just like startups who can get money from VCs, VCs who can convince limited partners to fork over money will set themselves apart from the pack going forward. This is because few venture funds are raising large sums of money these days. When things get better, VCs who can amass cash now will be well positioned to invest later.

This raises the question of what strategies VCs should follow to raise their returns and drive innovation.

Less Risk, Lower Returns?

One school of thought argues that VCs should put their money into lower risk ventures. This means companies that have revenues, or at least something that is clearly monetizable. For internet, Web 2.0 and social media plays, mere eyeballs probably aren't going to do it any longer.

More and more VCs are moving toward later stage companies and avoiding the seed rounds. This means that entrepreneurs are increasingly turning to angels and bootstrapping by necessity to launch their startups.

A variation of the lower risk, lower returns strategy is to grow early stage companies and sell them to "secondary" investors. In this scenario, the VC passes the baton to an investor better equipped to nurture more mature companies that might not be ripe for acquisition or an IPO. This approach mitigates the associated with trying to take a company public. Instead, the VC takes its gains and gets out before the difficulties of scaling the company  hit full force. The tradeoff is lower, but more certain, returns to the VC and the limited partners.

Smaller Bets, Higher Returns?

One new VC fund, Andresseen Horowitz, has pegged its strategy on putting smaller bets -- as small as $50,000 -- on startups. Andresseen Horowitz operates on the premise that small funds placing small bets on will enjoy higher returns. I guess a $300 million fund is small these days.

The firm pitches itself as a "super angel." However, unlike most angels who closely control and manage their investments, Andreessen Horowitz plans to invest in a large number of companies (70 to 80 at a time), take a hands-off approach and increase its investment in the winning companies.

The Ecosystem Approach: Investing In Related Companies

What do you do if you're a cleantech startup that requires large amounts of capital? You might look for a VC with a portfolio of related cleantech companies. Some VCs are building a portfolio of related companies and encouraging cooperating among the companies, instead of betting on one or two dominant winners in a given market. The strategy is to grow an interdependent ecosystem of companies whose innovations benefit and complement other companies. Under this approach, a VC becomes a deep specialist of sorts.

Go International

A growing number of VCs are investing in companies outside of the United States. At an SDForum panel that I recently attended, a venture fund attorney noted that in most of the funding deals he has worked on recently, the money came from U.S. VCs, while the team and the markets were in other countries. In one case, the management team was in Taiwan and the R&D operations were in Israel.

The biggest challenges facing venture firms with offices and investments in multiple countries are:

• having sufficient local knowledge to make smart investments
• coordinating and communicating across borders
• physical and technical infrastructure issues
• navigating differences in exit opportunities, and
• keeping the general partners in the geographically dispersed offices economically happy, while maintaining the firm's brand.

I will discuss these issues in future posts.

Getting Back To The Basics

In the end, VCs may not need to develop radical new investment strategies. While the industry has fallen on hard times, the key is for VCs to focus on fostering technological innovation and building companies with solid business models. That's where the best VCs shine.

Douglas Y. Park
Twitter: @DougYPark

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What Downsizing Means for VCs

For venture capitalists, the rubber will hit the road.

1. Those who can add value through operational and managerial skill will survive. Those who overmanage or fail to manage will have a hard time generating returns sufficient to please investors. VCs will need to strike the right balance between merely montoring and being hands on.

2. Further, these changes will test the ability to VCs to find high potential ventures can be grown into successful companies. There will be fewer bets to place, and each bet will matter more. Those who place bets on subpar, marginal startups will be exposed even further than the economic downturn has already done.

3. With the IPO market looking dry for the foreseeable future, VCs will have to build sustainable businesses that are attractive to potential acquirers.

4. VCs will still face stiff competition for funds and for promising companies, since the venture industry becomes increasingly global.  But it is important to remember that the way VC operates worldwide differs from VC in the US. Exit vehicles, including IPO markets, work differently and investors have different expectations from and relationships with VCs. Moreover, many US based funds are hesistant to invest in foreign startups.

5. The smartest money will win.

What Downsizing Means For Entrepreneurs And Startups

1. From my vantage point, the number of startups in Silicon Valley is booming because engineers and others cannot find jobs with companies. These entrepreneurs are chasing a shrinking pie.

2. As the number and size of VCs shrinks, Startup founders will face a higher bar for funding as VCs become more selective.  There will be fewer VCs to invest in subpar, marginal startups. Entrepreneurs will have fewer opportunities to pitch.

3. Startups with high capital requirements, for example, cleantech ventures, will have more difficulty raising sufficient funds or will have to do more with less.

4. Entrepreneurs will need to look to alternative funding strategies, such as bootstrapping and angel investors.

What Downsizing Means For Investors

1. Fewer and smaller venture funds means investors will have to find other vehicles to park their money. Even now, investors are shifting their money to private equity funds. At the same time, this one of the forces behind the downsizing of the venture capital industry. Andreesen Horowitz, which just raised $300 million, is an exception to the downsizing trend. As the ecpm blog notes, Andreesen Horowitz does not solve of the problem of too much money in the industry.

2. As the shakeout continues, investors can have greater confidence that their money is in capable hands. The smartest money will win.

Douglas Y. Park
Twitter: @DougYPark