Angels Add Value - Governance

One key value-add by Angel investors to their portfolio companies is appropriate governance. Governance is about ethics, culture, values, strategy, execution and, yes, compliance too. Compliance is the baseline and not overly challenging in a well-run business while all the rest of the requirements of good governance are very challenging.

Good and appropriate governance results from having the right skills mix in the Board room, a genuine commitment to the stewardship of the company and a compelling alignment of interests among all the stakeholders in the company.

Among founders and many inexperienced investors there is an enormous amount of misinformation about governance. It is worth noting that most private investors are NOT Angel investors.

Many people expect that governance means burdensome compliance with no benefit. To be sure, that can be the situation but, that is far from good or appropriate governance. There are quite a few issues to consider, including:

• “Shareholder value” primacy
• Nominee Directors act for their nominators
• ASX Model is the right benchmark
• Independent Non-executive Directors
• High profile ‘name’ directors
• Advisers as directors

The remarks here are made in regard to the circumstance of an early-stage company aspiring to rapid value growth and owned by a small number of private shareholders. This can be summed up as a closely-held, high-growth start-up. Further, these remarks are made within the context of the Australian regulatory environment while much of the misinformation that abounds is due to people assuming we operate within the American regulatory environment.

Director Accountabilities

A very common misconception in all sectors of the business community is that directors are responsible for driving an increase in shareholder value as their first priority. Actually, this is very much mistaken. The hierarchy of accountability for directors is first, to the company (a legal person); second, to the employees; third, to the creditors; fourth, to all of the shareholders; and, theoretically, if all of those are satisfied then a director could act, transparently, in the interests of a specific shareholder or group of shareholders. In practice, that last can never really happen as it is almost impossible to be in that position of satisfying the four higher priorities and then acting for special interest.

So, the point here is that shareholder value is certainly a desirable outcome but, is neither the primary, nor the most important metric against which directors must perform.

An example of this divergence is in the decision to pay dividends. The directors are bound to make a decision about paying dividends based on the best interests of the company itself. True, a dividend distribution can drive perception and sentiment that can support a higher share price. However, if that capital would be better used as reinvestment in the operations of the company then any temporary increase in shareholder value due to the perceptions of a dividend will be more than lost when the company suffers from undercapitalisation. Indeed, in such circumstances the most likely outcome is a new round of capital investment at a depressed valuation forcing excess dilution on the shareholders.

Nominee Directors

As described above, once a director joins a Board their accountability is to the company, its employees and all shareholders. If a director is appointed to the Board as the nominee of a particular shareholder or group of shareholders under rights granted to those shareholders by the shares they purchased then that director is often referred to as a nominee director. It is not uncommon for those shareholder rights to include the appointment, withdrawal and replacement of that director subject only to a reasonable review by the Board to avoid conflict of interest or breach of ethics.

Once in the Board room, that director must act with the interests of all shareholders in mind, even if it might seem that doing so may disadvantage the subset of shareholders who nominated that director to the Board. Further, that director is not able to exercise any of the rights attributable to the shares of the shareholders who appointed that director. Those are shareholder rights and must be exercised by the shareholders directly, typically in a general meeting of the shareholders.

This latter issue is one that really needs to be cleared up because far too many founders, inexperienced investors, inexperienced directors and, surprisingly, legal advisers take the view that a director can exercise shareholder rights in the Board room. One reason is that such behaviour is actually possible in the American system but, in Australia such behaviour leaves the director exposed to criminal sanctions and, if the Board allow the behaviour, then all directors are liable.

ASX Benchmark

How often have you heard people say that they will run the company as-if it were a listed company, implying that such behaviour is highly desirable?

It is not desirable at all, unless the company is a listed company already, or expects to be a listed company within 3 years (the period required to accumulate audited accounts to satisfy listing requirements). For the sort of company we are considering in this discussion many ASX Guidelines are far from appropriate. For a start, an ASX listed company must be a public company while a high-growth start-up is most likely to be a private company. If you get advice to become a public company without plans for an imminent listing be careful, check the advice. Public companies carry significantly increased burdens of compliance and reporting that deliver no meaningful value to most start-ups.

This is one of the flaws in the proposed equity crowd funding regime which will force every participating company to be a public company.

Another misunderstood and misapplied ASX practice is disclosure. Listed companies are mandated to provide continuous disclosure and non-discriminatory disclosure, i.e. every shareholder has to get all the information disclosed to any other shareholder. This is not the case for a closely-held, private company. High-growth start-ups frequently need to keep their business activities and strategic decisions as quiet as possible to enable them to establish new practices and penetrate markets before alerting competitors.

Often a start-up has a shareholder, or group of shareholders who can be of very particular help in advising the Board and management. Indeed, the commitment to proactive contribution of their intellectual capital is a hallmark of Angel investors that distinguishes them from many other private and institutional investors. However, to get the best advice from shareholders the company often must share sensitive information. There may well be other shareholders with less business acumen, or investment experience who, if that sensitive information was shared with them, might inadvertently mishandle that information. So it is normal, advisable and entirely permissible for the Board to selectively disclose information in such circumstances.

Note this is not the same as withholding reporting from shareholders. The company should make regular and complete reports on its performance and progress to all shareholders as agreed in the information rights section of the shareholders’ agreement.

Independent Directors

Over the last couple of decades much has been made of the issue of director independence, particularly on the Boards of listed companies. Initially this was to break the tradition of ‘old-boy’ networks using Boards as jobs-for-mates. The expectation was that by refocusing Boards on recruiting professional business people who could specifically add value to the company, the stewardship of the Board would be both more effective and more valuable.

Like many such trends this notion of independence swings like a pendulum. In the world of listed companies today there is much debate trending towards the need for all directors to be shareholders of the companies they govern, thus watering down the concept of independence. This is happening due to a perceived need to improve the alignment of interests.

For a private, closely-held company attempting to change the world by doing something radically new there is much evidence that the way to align the interests of the Board, the company, the staff and the shareholders is to have all members of the Board with strong vested interests in the success of the venture.

Start-ups need small, agile, active Boards with directors who are not afraid to roll up their sleeves and assist with execution. The directors need both the skills and wisdom to direct strategy and the experience and expertise to mentor and support management. They must commit substantial time to their role for minimal remuneration against the expectation of future reward.

It is common that a start-up first gets a formal Board when it takes on its first external round of investment, e.g. an Angel round. It sounds good to design the Board for balance, say one founder director (usually an executive director), one Angel director (usually a non-executive director) and a non-executive, independent chairman. However, high quality non-executive directors rarely work for free and even less so if they are to be the chairman. Start-up companies typically are not able to adequately compensate non-executive directors with cash and their shares (equity) are both of low value and entirely illiquid, i.e. essentially worth zero. So attracting independent directors of value to the Board of a start-up is very difficult. Further, since they are independent there is little to motivate them to join the Board, or to contribute the work required of them in that role and thus nothing to really align their interests with the rest of the stakeholders in the company.

‘Name’ Directors

There can be benefits to getting some high-profile individual to associate themselves with your company. The right profile can help the company when raising funds, approaching customers, engaging with government, accessing suppliers, or negotiating with channel partners.

However, you can realise all of those benefits without that person being on the Board. The important consideration here is whether that person will be an effective and value-adding director active in the stewardship of the business. If you really only want to exploit that person’s personal brand then appoint them to your Advisory Panel, make them a consultant, a patron, an ambassador, or any of a myriad of other arrangements that are not linked to the governance of your company. That way the company gets the benefits, the individual is not put into the circumstance of personal risk that is directorship and you can allocate your scarce resources to attracting and retaining a high-value director.

Many corporate advisers, legal advisers, family and friends will urge you to take advantage of your networks (or theirs) to appoint an ex-political leader, former corporate executive, recognised sports star, or entertainment celebrity to your Board. That can be a good move but, most often it is not. Make sure you understand the motivation of the advice you are receiving as all too often it is more about the benefit to the adviser or the nominee than to your company.

Advisers as Directors

There is a long-standing tradition of appointing your lawyer or accountant to your Board. In times gone by there were valid reasons for that practice but, these days it is very poor form. For a start, a professional service provider is instantly conflicted if she takes a directorship for a client. As a director she is beholden to give her very best advice in the Board room drawing on all of her knowledge and expertise, anything less is a serious breach of her fiduciary duty as a director. However, as a professional service provider she and her firm want to be paid for the services (advice) that she gives her client, that’s how they pay the rent and make a living. The result is an inescapable conflict of interest due to a fundamental misalignment of interests.

This circumstance is as true for lawyers and accountants as it is for corporate advisers, bankers, landlords and anyone else who has a direct and pecuniary self-interest in the disbursement of the company’s funds.

Directorship matters! To the company and all its stakeholders the importance of a good Board is critical to the future of the venture. To individuals directorship represents one of the riskiest roles in business as each individual’s entire personal wealth and assets are at risk. Angel investors, particularly those in Angel groups, have considered these issues deeply and developed sound practices designed to optimise the performance of the companies in which they invest. Always ask your investors to explain why and how their recommended practices will align interests and drive for success that rewards everyone in the company.