Wednesday, May 28, 2008

Building a Board for your Startup – Noses In, Fingers Out

There’s an old saying, “If you want to live long, choose your parents well.” This came from Dave Berkus of the Tech Coast Angels during the Angel Capital Association Summit in San Diego held earlier this month. Dave sits on ten for-profit boards. He went on to describe how entrepreneurs can prolong the life of their startup by choosing their board members well. As an angel investor you may be invited to sit on the board of a company. Dave provided sage advice on the subject.

The first question to the entrepreneur sitting up a board is why are you building the board?
1. Advice or governance?
2. Do you have outside investors?
3. Do you need legal expertise or expertise otherwise?
4. Source of appeals for management?
5. Do you know what you don’t know?

The entrepreneur faces risk on several fronts with the board because the board can
1. Hire/fire the CEO
2. Influence/control the strategy
3. Withhold approvals for funding, acquisitions, and more
4. Become misaligned with the management

Dave advises the entrepreneur to
1. Not stack the board with family and friends
2. Balance the board with financial, operational, and industry experience
3. Determine the frequency of the meetings. For a startup, a weekly meeting is not uncommon.

The board has a legal responsibility. The first is the duty of loyalty to the corporation and the second is the duty of care to the shareholders. Dave recommends setting up two committees—the audit, and compensation committee.

Dave summarized the board’s posture as “noses in, fingers out.” The board should know what’s going on but they should let the management team operate the company.

Compensation for the board is typically in the form of stock options usually amounting to 1% over 2 to 4 years. Cash is rarely used and stock grants create tax events. The stock options are usually non-qualifying and are priced at the last transaction price. Dave also noted that common stock is worth about 1/5 of preferred shares so that factor must be taken into account as well.

As a board member Dave looks for the “bottleneck.” “Who or where is holding us back?” He then focuses the group on that problem. Dave noted the “every $3M” crisis. The first $3M crisis comes when the company reaches about 20 employees. The first crisis is the financial crisis, thus the company seeks funding. Those who grow the business then reach the organizational crisis – how to organize the people into an effective team. Finally, the company reaches the product crisis usually related to quality issues.

For those who will sit on a board, D&O insurance is a must. A $2M policy will cost $6K to $7K. The value of the policy is in the legal representation it brings and not just the dollar value of coverage. Dave noted that he has been sued four times.

You can find out more about Dave Berkus and his philosophy in Extending the Runway. The book is priced rather high because the proceeds go to the Boy Scouts of America.

Best regards,
Hall T.