Musings on Governance in the context of Corporate Development

In my career I have had, as a board member and an executive deal with quite a few challenging situations. Some have related to dealing with unhappy shareholders, others with difficult c-suite personnel and still others with clients, disgruntled by poor delivery, suspect quality or both.

In the majority of cases, I have managed to navigate to a solution though of course, it has inevitably led to different stakeholders experienced quite different results, in other words, a happy path for some and a dissatisfactory path for others. ?This reflects the nature of compromises which often require one person to enforce a view that is most likely to preserve and extend value, even if it means some disgruntlement.

For anyone with experience in being a NED, or a significantly invested c-suite executive none of this will come as any surprise; but I thought it was worth sharing, especially for entrepreneurs some of the key learning lessons I myself have taken away and share with the company teams I work with.

Before I do so, it is worth commenting that the tech boom & bust from a valuation perspective between q2 2021 and the early q1 2022 has created a lot of “wishful thinking” and “hangover” among investors and entrepreneurs alike adding some explosive tinder to both fund raising and exiting discussions alike.?While market adjustments in both the private and public sector may underscore a very large and broad valuation mark-down, many are still trying to argue they are somehow a special case, or that the underlying “dry powder” and rising asset allocation to private markets (at all stages) will bring valuations back in no time.?In other words, the current environment represents one of the trickiest in relation to valuation for almost any type of deal and is particularly tough on majority and full acquisition scenarios where financial and strategic buyers (the later now in the ascendancy) are pitted against each other.

I won’t choose at this point to share an opinion on the merits of this perspective, but instead would like to return to the question I initially raised around governance, especially as it relates to spending, funding, and the exit process.?

In my experience, while entrepreneurs generally do need to be trusted when it comes to domain and product knowledge, and most of the key aspects of product/market fit, they often have some weaknesses, especially in the earliest stages of growth and scale-up, in relation to commercialization, and the entirety of the governance processes that help to build resilient companies. This often mans that 1) the state of commercial business, esp. within firms that are strongly R&D and innovation business is often in a messy, non-standardized and contractually ambiguous place, and 2) the discipline of managing cash flow burn vs. investment is often tilted toward over optimistic outcomes, combined with too much overspending on people based on concerns about recruiting and retaining quality personnel. One often finds that these challenges are also associated with weak management covenants in shareholder agreements, and thus can end up making certain types of decisions, particularly those related to funding and exit much more difficult to execute later.

The outcomes that arise from this might seem like they will generally work in favour of incoming investors, especially when companies might find themselves in a tight position, but this isn’t necessarily true.?For example, in situations where founders continue to retain majority ownership, even when they might have departed the company other investors might find that their ability to act, esp. in a distressed situation is highly compromised. ?As a result, they might be unhappily coerced into accepting sub-optimal outcomes to avoid participating in fiduciary and legal issues that they did not create but find themselves nevertheless an exposed party. ?This is a particular danger in mainland Europe and Australia for example where social security and pension protections are taken very seriously by the authorities.

On the other hand, entrepreneurs can also find themselves in unfamiliar territory too when on occasion institutional shareholders are of a mindset that is different.?Most of the time the investors are eager to realize attractive, above market IRRs to return cash and solidify their track record as prudent risk takers, but sometimes when the stakes are too low, or some element of the underlying market thesis, too attractive (but yet unrealized), investor consent can be hard to come by without much arm twisting and external advisory spending.

When I consider the risks in both of these quite different pathways, the conclusions that I have to reach are as follows:

1)????Shareholder agreements need to be flexible enough to re-align voting rights on key decision areas so that founders who have, for one reason or another, found lacking, cannot continue, if due process has been followed, to retain control over key decisions like funding and realization, especially when they have invited institutional shareholders into the cap table.?I am someone who almost always is a defender of the entrepreneur and can tolerate a lot of commercial hiccups for the right sort of execution and leadership, but once a breakpoint has been reached, certain rights need to be returned to the company.

2)????Entrepreneurs need to be very careful in turning production clients and turning them into advocates and shareholders. It is fine to have new minority investors into the tent who may have commercial partnership ambitions and capabilities, but it is another thing to muddy the waters between commercial, intellectual property and share ownership. ?I have seen as much harm as good come from corporate venture arms being on the cap table due to investments by other parts of the organization, and generally think that unless there is a true venture capital investment vehicle, corporate money should be avoided.

3)????Entrepreneurs should try to set with their investors some parameters around investment consent hurdles if they can so as to minimize the risk of value disparity. ?There will certainly be challenges in arriving at this in a highly scientific way, but there are known quartile return benchmarks for all types of institutional investor mandates and thus these should serve as a relevant guideline in such a discussion. ??Entrepreneurs should also be prepared to challenge investor consent as a principle if the size of the capital contribution or the relevant value that is being attained is in question.

At the end of the day of course, companies that get themselves through poor decisions, combined with misinterpretation of market feedback, will of course almost always find themselves challenged, while those in the opposite place, not so, but nevertheless considerations of the governance framework, the rights extended to minority-majority investors in the shareholder agreement, and the specific courses of action that relate to different types of transactional event should be a shared priority of entrepreneurs and investors alike. ?If this done properly and evolves to continue to do so, clients, employees, and partners will all be equally well served and companies will find themselves much more likely to create sustainable and attractive enterprise valuations.