Jul 17 2004

Boards That Are Not Bored

I wrote the following article for The Kauffman Foundation’s Entreworld web site some time in the late 1990’s. Someone reminded me of it the other day and I looked it up. It’s especially relevant today after all the major public company scandals of the past few years, the passage of Sarbanes-Oxley, and the renewed attempts at activism by boards of directors. A few of the comments – such as the one on D&O insurance – are dated (D&O insurance for private companies is economical, although not often that useful). I’ve sat on plenty of boards and when I reflect on them am sad to say that they are spread equally between the first two categories I list below (I’ve been on lame duck boards, but have resigned quickly after realizing that’s what they were). I wish I could say they have all been (and are all) working boards, but I can’t. I guess it’s up to me to continue to be vigilant about changing that in the future.

Every large public company has a board of directors. The news is filled with stories about prominent people joining boards, about boards kicking out presidents and founders, and about personal liability of members of the boards. In a large public company, the board plays an incredibly important, and often controversial role in the governance and development of a company.

Given this, should a startup or small entrepreneurial company have a board of directors? I say, emphatically, YES!

By definition, every corporation has a board of directors. The minimum legal size of the board varies by state. In some states, the minimum size is three people (typically a president, secretary, and treasurer–also referred to as the officers of the company). In other states, the minimum size is linked to the number of shareholders–if there is only one equity holder in the corporation, there only needs to be one board member. Of course, there are several different types of companies, such as partnerships or sole proprietorships that do not require a formal board.

For many companies, the board of directors ends up being the founders of the company. However, I believe there is huge value in expanding the board to include “outside” directors–those that do not work for the company, but offer their time and advice to help shape and guide the company. These outside directors serve a similar function to those of a public company, but often with a much different approach.

It is important not to get a board of directors confused with a board of advisors or a strategic advisory board. These other boards are incredibly valuable tools for a company, but they serve a dramatically different purpose which I will discuss in a separate article.

I have been a member of many boards of directors and I have come to classify each board as one of three different types:

  • Working Boards: These are boards that role up their sleeves and help the founders and management team of the company get the job done. They meet frequently, have animated, engaged discussions, and offer significant ongoing support and help to the key owners and managers of the company.
  • Reporting Boards: These are boards that meet four to six times a year for a status report on the company. If everything is going well, they tend not to have much to say. If there are problems or issues, they are often critical of the CEO and the management team. If things continue to go poorly, they often take action of some sort.
  • Lame Duck Boards: These are boards that have no influence on the company. In many cases, they are simply rubber stamp exercises for the CEO or founders.

The only type of board that I believe is useful for a small, entrepreneurial company is a working board. The pressures in an entrepreneurial company are great enough that the founders and the management team need everyone involved doing everything they can to make the company successful. This does not mean that everyone agrees on everything, or the members of the board are not critical of the management team. But, it does mean that there is an active, open commitment to work with the founders and management team to make the company succeed wildly.

Board members come in many shapes and sizes. In my experience, a good size of a board is five to seven people, including the insiders. If there are only one or two insiders on the board, a total board size of five is plenty. If there are more than two insiders on the board, seven board members is more appropriate. I recommend that several of the outside board members be highly experienced entrepreneurs in the market that the company is going after. The rest of the board members should be experienced entrepreneurs in other business segments, but with a particular interest in something about the company.

The chairman of the board is often one of the insiders, such as the president or CEO. However, in many cases, you may want the chairman to be one of the outsiders, especially in a situation where one of the outsiders helped start the company by putting up some of the initial seed capital. The role of the chairman varies dramatically, but it often raises the level of commitment of the individual board member that is the chairman and the overall board in general.

Significant outside investors, especially venture capitalists, will want board seats. I recommend you limit the number of outside investors on your board, unless they fit the criteria listed above. A venture investor only needs one board seat – if you have a syndicate of venture investors (several different venture capitalists that invested together in the round), consider offering one board seat and extending observer rights (e.g. the right to attend any board meeting) to the other investors. These rights should be negotiated as part of the investment.

In addition to functioning as a regular sounding board for the management team, board members can contribute substantially to the business, both as a group and individually. Board members can be incredibly useful during financings, merger and acquisition activity, general corporate strategy, and executive recruiting. Do not overlook the experiences and skills of each of the individual board members–they can often play high value, short term consulting roles as needed.

Board members should be compensated for their efforts. At the minimum, their travel expenses should be paid. Most entrepreneurial companies should set up an option package for the board members – depending on the level of effort requested of the board, this could be as little as 0.25 percent of the company or as much as 2 percent of the company vesting over four years. In addition, many board members are interested and willing to invest in the company. I always believe that it is in the best interest of a company to have the board members have a meaningful equity stake in the company.

In some cases, the directors that you recruit will have a substantial personal net worth. In these cases, they might ask if the company has “Director and Officers Insurance” (D&O Insurance). This is insurance that protects the director from having personal liability in case the company gets sued. Small companies cannot afford D&O insurance (in fact, most private companies cannot afford this), while most public companies must have this as a requirement of the underwriters in an initial public offering. So, when confronted with the question, the best solution is to make sure that the articles of incorporation of the company provide the directors with the highest limitation on liability afforded by the state the company is incorporated in. Don’t waste your time investigating D&O pricing – it won’t be economical.

Finally, take good care of your board members. These are busy folks that are making a substantial time and energy commitment to you. They share in the rewards if you are successful, but their time and energy is at risk since their primary form of compensation is equity in your company. Feed them. Make them comfortable. Have fun together! You’ll be pleasantly surprised how much faster the relationships evolve and how much more valuable they become when everyone is working hard, but having a good time together. Don’t ever let your board get bored.

This article can be found on the Kauffman Foundation’s Entreworld web site at the following link.