After the Term Sheet –

Corporate governance is front-page news, with most of the attention being paid to practices at publicly traded companies and large institutions. But good corporate governance is a crucial and timely issue for venture capital-backed startups, although the issues are different.

I recently co-authored a white paper on corporate governance practices at venture-backed startups with Professor Dennis T. Jaffe, who is a well-known expert on organizational change management. To research this paper, which is entitled “After the Term Sheet: How Venture Boards Influence the Success or Failure of Technology Companies,” we relied on the experience of Levensohn Venture Partners and also interviewed venture capitalists, corporate attorneys, and company CEOs, all of whom shared their experiences working with technology startup companies or companies in turn-around situations. (The white paper is available for download at www.levp.com).

Ten Common Pitfalls Of Venture Boards

Through this interview approach, we identified 10 common pitfalls that can afflict startup companies and their venture boards, as well as several steps venture boards can take to correct these problems. This was not an academic exercise these problems must be addressed if venture-backed companies are to grow into profitable, competitive and more valuable enterprises, and by extension, validate the entire premise of early-stage venture capital investing.

As readers peruse the list, it can be a useful self-check exercise for board members and managements to ask themselves questions in the context of their own board experience. These questions are boldfaced.

Members of a board can confidentially assess the degree to which each of these factors is present in their board, and tally the results. Each item has some questions that can open dialogue. The process of candid self-assessment is key for a board that is open to learning. If a board cannot look at itself, then it will likely never ask the CEO and management team to look at themselves. Following are some of the common pitfalls:

1. Complacency: Larger boards may have misaligned investors who take a stance of excessive complacency and self-satisfaction. This leads to an inability to act and the avoidance of digging for the real issues. Complacent boards are comfortable and don’t go after or act on tough issues. They enjoy the power and perquisites of their role, without delving below the surface or challenging the company. This attitude has been deadly to some public companies (such as Tyco, HealthSouth, and Adelphia). What are the top three toughest issues facing your company? Is the board actively monitoring and focusing on those issues?

2. Inability to confront difficult issues: This can be common with long-serving board members who are tied to initial or previous perspectives and who make it hard for new members to make observations. Any group can benefit from new perspectives. Is your board willing to take a step back and challenge old assumptions about chronic difficulties? Do you face up to issues, or avoid dealing with issues where there may be disagreement?:

3. Distraction, over-commitment: VCs may serve on too many boards to be productive, or they may have written down their investment in the company and lost interest. The CEO faces a dilemma if that board member has priorities ahead of this company. The CEO is best served if he can ask the VC to consider appointing a colleague who is less burdened to the role, or freeing up more time for the effort. Is each member of your board prepared, available and helpful in the issues the board is facing?

4. Lack of alignment of board members and investors: This has evolved into a major problem in Silicon Valley as a result of the technology capital market downturn. For example, many VCs and others, including passive angel investors, have invested in seed and A rounds and expected to see their investments appreciate. Instead, since mid-2000 these early-round investors have experienced significant dilution of their ownership stakes due to subsequent financings completed at lower valuations. At the same time, these early investors have no assurance of near-term liquidity. The early and later investors have different financial concerns that often do not align. They must resolve difficult competing agendas or else remain deadlocked and severely compromise the future of the enterprise. This is why some CEOs find it hard to trust their VC board members. Are board members open about their agendas, and willing to work together to forge a position on key issues of valuation?

5. Divided boards: The best CEOs leads both the company and the board. The CEO brings the right information, and helps get all of the entire board on his side rather than just counting on a majority of allies. Does the CEO of your company work with all board members? Does the board strive for consensus on issues, or rely on the votes of a majority for decisions?

6. Paralysis over liability issues: Sometimes boards become so cautious that they cannot act at all. In the world of venture capital, where the competitive environment is so dynamic, inactivity is as powerful as any activity that’s apt to generate a negative outcome. Another issue is logrolling between VCs. They tend to invest with friendly firms, in cliques or packs, because risk diversification is essential and they need co-investors. There is more of this “co-opetition” than “dynamic competition.” For example, liability concerns have become so strong for some directors that in one startup, a director feared liability issues and litigation from other shareholder groups if he agreed to sell the company at a substantial loss, even though this was the most likely way to ensure the company’s solvency. Instead, he advocated the liquidation of the assets through a third party in order to avoid the liability risk even though liquidation would result in an even worse financial outcome with no chance for future gains. Is your board succumbing to irrational worries about liability? Should your corporate counsel give a realistic picture of reasonable versus low probability concerns? Does your board balance risk prudently but take action when it is warranted?

7. Board member role confusion: Board members with operating experience in the company’s domain may become over. Such a person becomes over-involved and advances his personal ideas without support from the rest of the board and without trying to generate consensus. This approach often leads to interpersonal conflict and accentuates board divisiveness. It is crucial in these situations that the board leader step forward in conjunction with the CEO and address the board member’s over-stepping. Are your board members maintaining an appropriate boundary between board and operating roles?

8. Leadership vacuum: A company may need to restructure its balance sheet, the composition of the senior management team, or both, but the board may lack a leader who will rise to the challenge. Existing investors on the board may be concerned that there will be no return on the additional effort and that the company will never be profitable, so they will resign themselves to failure before even attempting the program.Before giving up, the board must draw on its experience in companies where new management was able to bring positive and restorative change and look beyond the short-term pain to the possible pay-off. The answer may be that the effort is truly not warranted, but the board must consider its duty to shareholders to weigh every option. Does the board have a leader who attends to board business, and draws out the best advice the board can offer?

9. Loss of trust within the CEO: There are myriad ways a CEO and board can lose faith in one another, such as through miscommunication, board meddling and high-handed behavior by the CEO. If the board loses trust in the CEO, the CEO may respond by becoming even less responsive. Board members may get on the wrong side of the CEO and vice versa, resulting in loss of trust. This loss may diminish the CEO’s responsiveness, provoking further problems. This sets up a cycle of phone calls, secret conferences and plotting. What are the trust issues playing out on your board? Given that active distrust is untenable, how can you move to put issues on the table for resolution?

10. Resolution to fail: Sometimes, directors don’t see a clear way to proceed, so they lose interest in new thinking and begin plotting an exit strategy to the exclusion of forging a viable path for the company. Board members may subconsciously resolve to see only negative consequences in any turnaround plan, in hopes of clearing the company off their list of concerns. Is your company actively weighing its options, or is the board deciding in advance that nothing will work?

Recommendations

All of these challenges are solvable. Below are some steps companies and Boards can take to resolve issues:

* Develop a self-assessment and performance process: Boards must assess not only the company, but also how well they are performing as a collaborative team. The Board should look at itself both as a whole and in terms of the performance of each individual. Some boards ask a consultant, maybe the same consultant who works with management, to interview each board member and assess their performance.

* Create an open information-sharing system: The CEO and the management team must trust and feel comfortable with the VCs and Board Members, so they can share not their questions and concerns.

* Face emotional dynamics as they arise: Tensions will naturally arise between the Board and the CEO or management team, or within the Board. The path to resolution is through direct confrontation of the issues.

* Hold a Board retreat: Successful retreats allow the Board and top management to reach important strategic decisions or create new strategic plans.

Pascal Levensohn is founder and managing director of Levensohn Venture Partners in San Francisco. He invests in the enterprise software, semiconductor and communications sectors and help companies with broad management issues.