Since its inception in May 2006, the Working Group on Director Accountability and Board Effectiveness has grown to 33 people, all of whom have contributed to the recently expanded “Simple Guide to the Basic Responsibilities of VC-Backed Company Directors.”
VC directors of early stage companies often overlook basic internal controls requirements because they feel that these emerging companies remain small and therefore don’t require burdensome administrative structures. The expanded white paper dives more deeply into these issues to call out the fact that implementing best practices should not be a burden. Having strong processes in place should make directors work more smoothly together, whether they come from the ranks of management, independent directors or VC investor directors.
The legal fiduciary duties associated with board service are duties to all of the shareholders, not just to the shareholder class in which a VC director’s firm has made an investment. At a minimum, the board must agree to common goals and basic tenets of behavior. Although all boards are made up of individuals with differing interests and responsibilities outside the boardroom, they must serve common goals inside the boardroom.
A key feature of effective boards is that they deliberately align expectations:
- The board is economically and strategically aligned among itself.
- The board’s expectations of the CEO and the CEO’s expectations of the board are mutually well understood.
To ensure the board is aligned economically, there are four main areas surrounding investment strategy that should be considered:
1. Exit Plans. VCs should openly address their expectations regarding a liquidity event. Specific exit values (or ranges) should be discussed to ensure common expectations from the management team (which is most likely the final arbiter of any potential M&A activity). For example, different investors even within the same round may have different exit valuations in mind. One investor may be happy selling the company for $100 million while another may need $300 million to even consider a deal.
2. Exit Timing. The board should openly discuss the timeframes for exit options. Some investors may want to wait longer than others for an exit. This issue becomes even more important when investors join the board in different rounds, especially if one VC invests many years later than the earliest investors.
3. Investment Expectations. VCs should candidly discuss the amount of money their funds have allocated for follow-on reserves to the company. Depending on the stage of investment, some investors may have reserved 1x – 3x or more of their initial investment. It is important for the entire board to understand the level of each investor’s reserves and the conditions for follow-on investment.
VC directors of early stage companies often overlook basic internal controls requirements because they feel that these emerging companies remain small and therefore don’t require burdensome administrative structures.”
4. Syndication Expectations. The VC board should discuss its interest in syndication for follow-on rounds. Some VCs do deals based on a “fully funded syndicate” model, which expects all the early investors to continue backing the company through liquidity. Others depend on syndication across rounds, expecting new investors to join them in subsequent rounds. A transparent discussion is required for the VC-backed company (VCBC) to not pursue investment paths (such as recruiting new investors) if the current investors are not interested in outside capital.
Peer review and self evaluations may lead to greater director accountability, better education and the adoption of governance practices that are appropriate for private companies. At the same time, the Working Group recognizes that the only useful tools for a board are those that will actually be used in the field.
Someone on the board must take ownership of educating directors about their service responsibilities and implementing the process of director evaluations. Whether the “owner” of the implementation process is a VC, CEO or an independent director is secondary. The Working Group recommends that, at a minimum, the CEO initiate a board discussion to assign this responsibility.
Because VCBCs experience significant changes in board size and composition over their normal life cycles, not all of the processes described in this paper are applicable to every VCBC, especially at the earlier stages of their development. Below is a matrix that describes the typical range of board sizes and mix of directors associated with the different development stages of VCBCs, along with a guide to the types of corporate governance processes that should normally be considered for implementation during these development stages.
Applying sound standards of corporate governance to an emerging company does not end in the boardroom. The most critical board committee from a compliance standpoint is the audit committee, and the audit committee’s duty of oversight falls squarely into the area of assessing the adequacy of the company’s internal controls.
Even a small company that is not selling products or services is likely to have activities in the following areas: purchasing and disbursements, payroll, treasury management, fixed assets, equity and stock administration, and financial reporting. The risks associated with checks and balances around cash disbursements will in many cases depend on the volume of transactions and the type of transactions.
Having strong processes in place should make directors work more smoothly together, whether they come from the ranks of management, independent directors or VC investor directors.”
The board should establish thresholds for board approval, and approve management authorization levels. The board is normally pretty close to financial metrics, such as spending levels, which serve as effective monitoring controls. An awareness of fraud risks (smaller companies typically have segregation of duties issues) and an understanding of the company’s key financial processes, monitored appropriately, layered on top of the board’s review of financial metrics, should normally cover the typical risks.
The transition from product development to generating revenue is one of the most difficult for emerging companies because priorities are reset and new personnel are brought on board in senior positions. Typically these new senior team members have not lived through the “birthing” process of the development program, which can bring stress to the prior team.
As the operating business model is being established, this is the point where the company’s applicable accounting policies begin to take shape. At this time, it is appropriate to assess what accounting expertise is required, and what is already in place. The full board, or, at a minimum the audit committee, should be asking the following questions:
- What are the critical accounting policies (and what are the applicable pieces of technical literature)?
- What experience and expertise do we have in-house?
- Do we have enough depth in our finance team to have someone effectively review complex accounting judgments (or are we relying on the “preparer” to get it right)?
- If we don’t have the technical expertise we need, can we train existing personnel to be responsible for certain areas of accounting complexity?
- As we look at building the finance team (typically, headcount increases as a company moves from early commercialization to expansion), what specific accounting expertise and skill sets should our next hire possess?
- What processes do we have in place to identify new accounting issues and determine if they apply to the company?
- How much ongoing training do finance personnel receive, and is it sufficient to maintain competence levels?
- Do we need to engage outside parties in specific areas to supplement our existing skill sets?
As the growth rate of annual revenue begins to accelerate, it becomes appropriate for a company to adopt more formal risk assessment processes (relative to financial reporting risk). This risk assessment should enable discussion around questions such as:
- What are the significant accounting processes?
- What are the areas of accounting complexity?
- Where is my highest risk of material misstatement?
Some factors to consider as management prepares and the board reviews process and account level risks are:
- Materiality to the financial statements.
- Level of accounting and reporting complexity.
- Account characteristics (transactional and routine, estimate and non-routine).
- Fraud risk inherent in account or process.
- Volume of activity.
- And other reporting considerations inherent in account or process.
The risk assessment will guide more extensive monitoring activities, as appropriate. While designing appropriate monitoring activities, the audit committee and/or board should also consider items such as known weaknesses, especially any reported significant deficiencies or material weaknesses, and the maturity level of its financial reporting processes.
A free copy of the “Simple Guide to the Basic Responsibilities of VC-Backed Company Directors” can be downloaded at the following URL: http://www.levp.com/news/whitepapers.shtml
Pascal Levensohn is the founder and Managing Partner of Levensohn Venture Partners. You may read his blog at www.pascalsview.com.