Dr. Earl R. Smith II

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

One the real joys for a writer is to find that people have found what you write useful and thought-provoking. This is one of those times to celebrate. Thanks to all for their responses.

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I want to thank each of you who took the time to reply to the two challenges that I outlined in a prior column. It wasn’t just the number of responses … it was the extended nature of most of them that was so rewarding. I feel honored to have readers who are willing to engage in such a way. My humble thanks.

The first challenge dealt with a situation that sometimes occurs in medium-sized, rapidly growing companies. A member of the Board of Directors has come up with a piece of business and has requested compensation for bringing it in. As CEO, how would you handle this?

A lot of you tried to have it both ways. Don wrote, “I do not feel that the deal between the corporation and the facilitator of income should be with such facilitator in his capacity as a director but should be in a separate contract with such person as a consultant.”

Others thought that ‘disclosure’ was the key. Dave suggested that, “First, a standard compensation policy be established for ‘bluebirds’, i.e., deals that come in via referrals other than from employees. Second, have no distinction in that compensation package between Board members and anyone else.”

Still others sought to have the arrangement approved by some part of the corporate structure. David wrote, “If a director is assisting in biz development, sharing to the extent it is consistent with what employees are receiving, i.e., sales personnel, is appropriate so long as it is blessed by the board, and is also available to other board members. Board compensation only works when broadly vetted with the board and done in a formal, egalitarian manner.”

There were comments that related to the stage that the company was in at the time. Charlie suggested that, “If it is a small, start-up company, I would probably allow it as revenue generation … . To mitigate risk, I would have counsel help draft strict guidelines to help ensure ‘intent’ is clear and ‘reasonable’ accommodations are made when ‘gray’ areas (inevitably) come up. For more established successful firms, I would probably not allow it.”

Carol focused on some of the practical risks when she wrote, “In the first situation, a Board member cannot know what deals are in the pipeline and may be putting the company in the position of taking a less desirable deal. They also should not be negotiating on the company’s behalf but may have set up expectations that cannot be undone. Their own interests in pursuing the deal may not coincide with the company’s interests. Suddenly, they are no longer looking out for the larger picture of how the company should best grow, but narrowly, how their deal can best be accomplished.”

Finally, there were some of you who saw great danger in the arrangement: Pete wrote: “There is one thing I can say right up front however, and this comes from both my experience and from my Dutch Calvinist set of principles, and has served me well through a lifetime filled with many military commands and major staff leadership positions, CEO of huge government entities, and CEO in business positions, as well as service on major boards and on those of not-for-profit foundations. And the bottom line is this: WHERE PRINCIPLE IS INVOLVED, BE TOTALLY DEAF TO EXPEDIENCY. This rule makes decision-making easy. You take the high road. I used to literally pound this rule into the heads of my subordinates, my commanders, and in my management classes. In reading your situations and searching around for an ‘acceptable’ position, it appears to me very much like searching for an expediency, and that path is wrong from the get-go, and is a fatal trap. It is akin to telling a little white lie which, as we know, never goes away but only grows with time. It is what has trapped so many companies in the past. ENRON is a perfect example.”

All of these suggestions have merit. It is a matter of how you assess risk and how you deal with your assessment. There is no right answer … mostly just right directions.

For some reason this challenge reminded me of a Hagar the Horrible cartoon. In the first box Hagar and the guy with the funnel on his head are sitting in a bar. There is a mug of beer on the table between them. The funnel guy says, “you know, some philosophers would say this glass is half full while others would say it is half empty”. In the next box, Hagar drains the mug and, in putting it down, asks “Why argue?”

A fiduciary relationship is a well defined and, these days, a carefully scrutinized obligation of Board members. I don’t accept the proposition that Directors are ‘like everybody else’ when it comes to such issues as incentivized compensation. Nor do I think that actions by any part of the company, including its legal counsel or the Board of Directors, are sufficient to give cover for such an arrangement. I certainly would not want to be present when a judge asks a defendant pointedly, “now are you answering as a member of the Board of Directors or as a paid consultant?”

In situations such as this, my conservative tendencies go into overdrive. I hate adopting risks that I don’t have to. My solution would be to move the Director in question to an Advisory Board focused on driving business development and compensate him as an Advisor rather than a Director.

I would crisply eliminate the possibility of exposure based on conflicts between the Director’s fiduciary obligations to the shareholders and their interest in getting paid fairly for contributions made by eliminating the fiduciary relationship. I would also, by this approach, establish the core of an Advisory Board focused on driving the company’s run rate. With the new Advisor’s help, I would build a Board around him … perhaps even giving him the title of Chairman … focused on the task of driving the run rate.

On the second challenge I heard from a number of venture capitalists and private equity fund managers. Several CEOs and consultants also weighed in on the subject. The issues were: ‘A fund is insisting that one of their partners sit on your Board of Directors. They are also insisting that, since their representative will not be paid for Board service, no one on the Board shall be compensated in any way for their service. As CEO what would you do?’

The VC/PEF set of replies were consistent. First they either ignored the first part of the challenge altogether or dismissed it by suggesting that their agendas were coincident with the shareholders. In the latter case, they tended to suggest that the shareholders were focused on a liquidity event just like they were and a short to medium term agenda was driving both groups. Jack’s comments were typical. “I also disagree that the VC is in it for the short term. 5-10 years is not short term at Merck, let alone a dynamic early stage company. It is forever for all practical purposes. So I believe your premises don’t jibe (with) the reality I live and work in.”

David weighed in based on obvious experience when he wrote, “After the money is accepted, all directors have the same responsibilities to all shareholders as well as creditors. Delaware case law is clear … the courts are not fond of self-interested investor directors who have disregard for minority shareholder rights. Trust me – I’ve been sued and so have enough of my VC colleagues to bend over backwards to be fair and just to all shareholders … even if we have contractual benefits that gives us hugely disproportionate returns.”

Michael saw the issue in terms of creating two classes of equity interests. His perspective was that Directors should represent the interests of the common shareholders and that investors, particularly since they might own no common shares, represent a class of owners distinct from the common shareholders. He wrote, “My view is that if a ‘common’ director becomes a patsy to the interests of the ‘preferreds’, he or she is potentially liable for breach of fiduciary duty to the ‘commons’.

More than one of you echoed George who mused: ‘Since the shareholders are supposed to elect Directors, I wonder how many emerging companies actually have a shareholder vote approving the acceptance of the term sheet and election of the ‘outside’ director’.’

Venture Capitalists and Private Equity fund managers also weighed in on the second part. Bill wrote, “ … I’ve never heard of a VC demanding that outsiders not be compensated.” Jack was unequivocal in his response. “I have never been involved in a deal where the VC’s didn’t unanimously support compensating true value added (by) independent directors, so they are not real VC’s you are talking about.” Here we are all on the same page. Management which recommends such a restriction to shareholders is incurring major exposure. They are planting a time bomb which can go off at most inconvenient times.

The management side of this response tended to reflect firmness and/or resignation. Ed summed up that perspective well when he wrote, “Turning to Board compensation for outside directors, that one is easy. I would never take any capital from a funding source that prohibits paying ‘independent’ directors for their Board service. This is flawed thinking on their part and foretells even more troubles to come. If that is a condition to funding, go elsewhere!! Of course outside funders will always require, and should get, one or more (uncompensated!) Board seats.

Jon wrote, “In the event of the venture capital company dictating terms of how the Board will operate, I personally dislike and distrust outsiders who are looking out primarily for their own interests being involved in any venture of mine.” Andy also reflected this perspective, “The reality is that the VCs simply do not have the shareholder’s interests in mind. Or rather, they have the shareholder’s interest in mind, but it’s the shareholders in their fund (the limited partners and in a big way the managing partners) not the shareholders in the start-up.”

One set of responses, which I can only describe as paranoia based on experience, is reflected in Rick’s comments, “On the second issue, which I shall assume is an indirect attempt to control the board, the company should take the position that in the world of Sarbanes-Oxley, board governance and protection of shareholder rights is a very serious obligation with which the company will comply, even as a private entity. In most transactions, the number of board seats going to a new investor is negotiated up front before closing, and the company retains the right to appoint its own ‘independent’ directors who protect its rights from any abuses by the investor and management.”

Rick quoted Andy Grove of Intel; I suggest that the principal obligation of the Board of Directors was to “ensure the success of a company is longer lasting than any CEO’s reign, than any market opportunity, than any product cycle.” I would add ‘longer than any investor’s participation’ to that list. Ed summed it up well, “But even then, the independence required and expected of an adviser, is greatly compromised when that adviser is called upon to act as a Board member. The two roles are in inherent conflict and it is impossible to overcome that conflict.”

My own solution to these challenges begins and ends with the issue of shareholder value. I would not recommend for shareholder approval a term sheet with a restriction of compensation for outside directors … period, paragraph. On the second issue, I would suggest to the investor that we find a truly independent director candidate that 1) is acceptable to both of us, 2) is not a member of their fund management team and 3) will bring substantial benefits to both the Board and the shareholders.

In the latter case, my suggestions reflect what is rapidly becoming, in this post Sarbanes Oxley world, a standard practice. An increasing number of fund managers are beginning to realize that their positions on Boards do involve inherent conflicts and bring significant risks. Some have discovered that there is another way to protect the interests of their stakeholders while contributing to the future of the company they are investing in. Risk mitigation is driving their actions as it should be driving the actions of management.

© Dr. Earl R. Smith II

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• Sea Change Brings Change
• Lack of Accountability – The Core of Failure
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• Four Mistakes Entrepreneurs Make When Buying a Business
• Why Most Start-ups Fail – Part One
• Why Start-Ups Fail – Part Two

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Dr. Smith is Managing Partner of The Federal Circle. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

This entry was posted on Tuesday, August 12th, 2008 at 9:54 PM and is filed under Advisory, Questions. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.