Governance: Never too small to start
The reality of entrepreneurship is often a long way from the glamorous world of popular imagination. Founders put in long and frequently lonely hours in low-rent facilities trying to establish a business model to make that essential first sale, and establish a revenue stream that will make the business sustainable.
In parallel with this work, there is an ongoing need to sell the business and its prospects to investors. Initial start-up funds often come from personal savings, as well as family and friends, but if all goes well outside finance is likely to be needed. This will involve pitching the company to VCs and angel investors and repeatedly painting a compelling and relentlessly upbeat picture.
Most investors in early stage businesses invest in the founder to a greater or lesser extent, and pitching the business at events where no finance is forthcoming can feel like a personal failure.
After a year or two of this gruelling life, coupled with constrained personal finances, self-belief can waver and perspective is easily lost. The inevitable round of small successes and failures starts to feel very personal and emotionally wearing, and mood swings become amplified. Founders can become very sensitive and interpret constructive feedback as unhelpful criticism, while falling into the trap of categorising individuals as heroes or idiots (when most of us are somewhere in between).
Control is also an emotive issue, with successive rounds of investment often diluting founders down below the majority they may have enjoyed initially: some founders may even actively try to block additional (sorely needed) funding because of the effect of dilution. Other tech founders, including Mark Zuckerberg, use special classes of equity to retain control from a minority holding, although this is contrary to much contemporary thinking on governance and for a smaller stock is likely to be resisted by other investors. In fact, Facebook’s recent missteps are starting to demonstrate the dangers of a CEO with enormous influence versus the Board; Tesla and Uber have also presented governance challenges.
A well-chosen Board can provide support and guidance for the founder, as well as perspective and checks and balances on the ups and downs. Regular informal meetings with Non-Executive Directors can provide invaluable context, inspiration and useful contacts.
Managing Technical Risk
When a start-up is the first commercial application of a new technology, there is typically a substantial amount of development work to do. Entrepreneurs frequently overestimate the commercial readiness of their idea, and thus underestimate the amount of development work needed. While the Theranos story of a compelling vision entirely unsupported by technical reality is extreme, all start-ups tend to stretch the truth when talking about the performance and maturity of their technology. I have encountered pitches when the founder is frank about the technical challenges, but others where the key difficulty is either not acknowledged or breezily glossed over – spotting these is an important skill for angels, and arguably all investors.
It is thus essential that a start-up Board contain at least one individual with a well-founded understanding of the technology, and of the key development tasks. Technical project management is notoriously hard, especially when there is a high level of uncertainty about what a viable solution looks like, but the Board needs to take responsibility for establishing key milestones and monitoring progress towards these.
Maintaining Strategic Flexibility
It is quite rare for a startup’s business model to turn out exactly as originally intended. Many start out with a vision of making a breakthrough product incorporating new technology and rapidly discover that hardware development is extremely intensive as well as voracious of time and money. Few spend enough time studying their chosen market, analysing customers and establishing who is best placed to spend money on their product. Barriers to market entry can be difficult to overcome, and are often regulatory in nature, while government bureaucracies such as health services or schools can be extremely slow to buy anything at all.
As a consequence it is vitally important to change and adapt the company’s offering as the commercial reality develops, and the role of the Board in pushing this is one of its most important functions. It is not unusual for founders to develop an excessive attachment to one particular business model, and the Board can counter this, for example by promoting a move to a licensing model rather than developing bespoke hardware. It’s also important not to lose sight of the preferred exit route, which may change over time.
The Skills for the Job
Most entrepreneurs start out very convinced of their own abilities and like to think they can turn their hands to any task. This tendency is supported by the resource constraints that many start-ups labour under, and the lack of money to pay for dedicated functional staff. Yet the wiser founders soon realise their limitations and that the best way forward is to do more of what they are good at, and less of the other stuff.
Here again, the Board can be an important resource but needs managing with care. The essential difficulty is getting the skills the business needs at a price it can afford – there is no shortage of experienced individuals keen to sit on the Board and bill their time at a six-figure annual rate but this is seldom a good idea, particularly in the early stages.
Any money spent on outside help needs to be directly linked to the achievement of specific deliverables within a tight timeframe: otherwise a business runs the risk of increasing its cash burn rate without actually achieving anything.
One solution to this problem is to recruit Directors with relevant skills to serve upaid or for a moderate sum as well as options. It can help if investors sit on the Board, while their skills may not closely match those needed by the business, the investor perspective is a good governance discipline.
Transparency and Information for Investors
Investors in start-ups come in all shapes and sizes and can vary significantly in their information needs as well as in their desired influence over the business. The stereotypical angel investor is a relatively wealthy older person motivated primarily by the desire to give something back to the business community, as well as (in the UK) benefitting from the tax reliefs offered by the SEIS and EIS schemes. Often they will have skills and experience to offer, and they are prime targets for Board recruitment: like all investors they want to see a return on their money, and get quite excited at the prospect of an exit, but in general they are quite patient.
The profile of Venture Capital funds is rather different: as professional investors often acting on behalf of government schemes (such as the EU Horizon 2020 or the UK’s Midlands Engine) they are more focused on the numbers, may have a specific exit date in mind, and may impose quite onerous conditions as a condition of their investment. For example, I have experienced VC funds which insist on rights to appoint Directors as well as a special class of equity with preferential rights on liquidation or sale which effectively give them management control, as well as a higher price for their shares than that received by other shareholders. A category of fund currently enjoying some success in the UK consists of vehicles designed to take advantage of EIS tax relief (“EIS fund”) and typically these will behave more like VC’s than angels, though some are angel investor led.
Fair Play
The role of the Board is to ensure that all classes of investor are treated fairly and get the information and support they need. This starts with the administrative basics in terms of efficient company secretarial services, and for new investors, the clear communication of the terms of their investment and any pre-existing rights enjoyed by other shareholders. This may sound pretty obvious, but it’s surprising how many start-ups do poorly in this area.
It’s then incumbent on the Board to communicate regularly with shareholders regarding progress in the business, and at a minimum this should consist of quarterly updates with financials, as well as an annual meeting with an in-depth review and the opportunity to quiz the Board and management. It can also be helpful to nominate an investor director to act as a point of contact for individual investors.
The Board also takes a leading role in fundraising: it’s a rare start-up that doesn’t need multiple funding rounds, and anyone planning to get involved in angel investing needs to bear in mind that they will be asked to “follow on”; the people most likely to invest in later rounds are usually the existing shareholders. It’s also near-obligatory for those serving on a start-up Board to do so, as this sends a powerful message of belief in the company’s prospects.
Stephen Cheetham
Fidelio Conclusion
At Fidelio we believe that good governance cannot start too early. If start-ups seek capital they need to be aware of the associated obligations to shareholders, and what will give investors comfort that interests are aligned. For those start-ups lucky enough to succeed and grow to the IPO stage, there are frequently painful adjustments to be made. Governance can become a significant expense, increasingly so for large listed companies, as investors hold management and the Board to a higher level of account.
But good governance does not need to be onerous. Simple systems, clear communication and an understanding of roles form the basis of good governance and this is as relevant for the first round of funding as it is for a major share transaction for a global corporate.
However small or large the company, Board Members need to be clear about accountability and about respecting the interests of shareholders and stakeholders.
As we build Boards fit for the future through Evaluation, Development and Search, Fidelio argues strongly that good governance starts young and companies make growth much easier if basic governance precepts are followed from the outset.
To learn more about how Fidelio supports Boards to increase their effectiveness, contact awright@fideliopartner.com.