Saturday, September 09, 2006

Board Control: VCs vs. Entrepreneurs

On Wednesday, I wrote about the Rapt co-founders suing their CEO and investors and brought up the topic of entrepreneur/VC tension over startup ownership, control and rewards. Matt McCall of DFJ Portage Venture Partners initially wrote a good post titled "A Dark Side Tale" on this tension and lessons learned from Rapt. Mr. McCall then followed this up yesterday with another good post on "Where does Power Lie," about startup board control. David Cowan of Bessemer Venture Partners also wrote a great post on the subject earlier this year titled "Control Roulette: A Bet on Red or Black." Both posts explain how control really depends on what the company needs more, the founders' knowledge and momentum or the investors' capital. Mr. McCall's article also explains that having to use financial/legal levers of control is really a last resort because "it poisons the relationship going forward." Its often said that the entrepreneur/investor relationship is like a marriage and as such its tough to work closely with board members when irresolvable differences must be decided through use of force.

However, I do believe there are two circumstances where board control is very important, the capital vs. management equation is less relevant and the need to work together in the future has less impact on outcomes :
  1. When evaluating prospective liquidity events
  2. When evaluating options if no investors (or at least no current investors) will invest additional capital under any circumstances
In both of these cases VCs and entrepreneurs can sit on very opposite sides of the fence. When evaluating prospective liquidity events entrepreneurs and VCs can have different risk tolerances because entrepreneurs (especially first-timers) have all of their eggs in one basket, while VCs can spread risk across their entire portfolios. In this case, management does have more influence that investors because their ability to quit can easily derail a successful company. Nonetheless, VCs tend to shoot for the moon because a singular 100X return investment is often what makes or breaks a fund. Thus, VCs may want to turn down a guaranteed $40M liquidity event in favor a 10% chance at a $400M outcome because they have multiple investments and can handle many failures as long as a couple are successful. On the other hand any outcome that nets a couple million bucks to an entrepreneur is often a successful personal outcome but it may have little or no impact on a VC's fund. The right decision is an objective assessment of what is best for the company. However, neither the entrepreneur faced with the potentially life-changing opportunity to secure a couple million bucks nor the VC faced with the need to make the top quartile of funds can truly be objective.

Entrepreneurs' and VCs' interests may also differ when a company has run out of cash and the investors do not want invest any additional capital. (I have a friend going through this right now. It is a gut wrenching experience that I hope he will write about when it is over.) The entrepreneurs may have a plan to pursue the company as a life style business and/or find new investors. However, VCs typically want to sweep the failed company under the rug as quickly and quietly as possible. In fact, some investors want to kill off companies when there is still some remote prospect of success because they don't want to be seen as having walked away from a good thing even when offered a percentage of common stock to resign from the board.

The goal in both of these situation is to protect the best interest of the company rather than favoring either the entrepreneurs or VCs. Thus, I believe that David Cowan nails it when he describes the ideal company board as having 5 directors with no more than 2 VCs, the CEO and 2 outside experts. The only thing I would add to Mr. Cowan's description below (which I believe he is implying anyway) is that the 2 VC board members represent different firms.
"I find that the ideal board of directors has 5 members--a nice, small odd number that allows for multiple skill sets without losing anyone's attention or complicating communications. The CEO is the only employee on the board, so that open, apolitical conversation can ensue regarding the team. VC's occupy no more than two of the seats--more than that yields rapidly diminshing returns (and fuels the conspiracy nuts who blame all setbacks on evil VC control). The remaining seats are held by outside experts recruited opportunistically--the board should regularly consider skill sets and credentials that would add value to the board (contacts, reputation, domain knowledge, customer perspective, CEO coaching experience...) and keep all eyes open for the right individuals who inevitably pop up."
With the intensity of a startup its easy to forget that the goal is to build a great company not to protect the interests of any one party over another.

Here are a couple of other interesting perspectives:
Please comment with links if you know of any other good posts to add to the list.


At September 11, 2006 9:48 AM, Anonymous Max Bleyleben said...

Hello Andrew - I do agree that 5 members is close to ideal for a venture-backed board.

Here is a European view on the topic from my own blog:


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