Most angel investors, when funding a start-up, ignore the structure and operation of the board of directors. Most early-stage companies that I work with have only a casually structured board that seems to exist to satisfy legal requirements. Accumulated experience has shown me that this is a very risky approach. A board has defined obligations that are important to the future of any company. Boards unable to fulfill these obligations severely limit possibilities. Here are some of the guidelines that I offer when working with these start-ups: 

Composition: A well functioning board is independent of the management team. Friends and family do not meet that test. A board, which is simply a rubber stamp or doormat, creates an imbalance within the organizations culture – key functions are untended or receive short shrift. A functioning board should have a majority of independent members. In my view, the term independent excludes both members of the senior team and investors.

Balance: All the rhetoric aside, the tendencies of management are inherently tactical and self-serving. The CEO is – or should be – focused on implementing the strategic and tactical plans. All implementation is inherently tactical. The team’s compensation – if it is correctly structured – should depend heavily on meeting those metrics and delivering on the plans. Even the most experienced CEO work this way. That implies an unbalanced emphasis on the tactical. An independent board acts as a counterbalance to this tendency.

Professional Members: Board members need to have the accumulated experience and refined judgment that will allow them to help formulate an effective strategic plan. Their vision needs to be long-term. They fulfill their fiduciary responsibility to the shareholders by balancing short-term tactical issues with longer-term ones. One of the changes that I have seen in recent years is a tendency among angel investors to seek out professional board members to take the seats that their investment entitles them to. Angel investors can draw on two pools of talent. The first is successful serial entrepreneurs and the second is professionally trained directors. Both bring important knowledge and experience to the board – both add significantly to the corporate culture.

The Business of Business: As I have written elsewhere, most start-ups fail (one in ten makes it to their fifth anniversary) because the team fails at the business of business. Most start-up teams have a good grasp of the business of the business. A well-functioning board will help make sure that the ‘non-technology’ aspects of the start-up are not the ones that bring it down. One of the most important of these is oversight – both strategic and tactical. Professional board members have the experience to tell when a management team is blowing smoke or missing the point. They also have the ‘stiffness’ to confront the CEO and force the necessary changes.

Standards and Metrics: One of the biggest dangers in a start-up is constantly moving goalposts. The double diversions of constantly evolving Power Point slide stacks and constantly reworked Excel spreadsheets can eliminate the possibility of holding the management team to any metrics at all. A functioning board will insist that performance meet projections and aggressively oppose the proposition that projections should be adjusted to match performance. The later is one of the most serious diseases that can infect any start-up. A management team that constantly lowers expectations to match failure is an amateurish gaggle.

Holding to Account: In most simple terms, if you cannot say what you are going to do and then do it, what is your word really worth? If you say you are a CEO, make statements about what your team is going to accomplish which induce investors to risk wealth based on those statements and them fail to deliver on those statements, you are not a CEO – you are a highwayman. A well functioning board will detect these bandits and take steps to replace them with people that are more professional and productive.

There is a tendency to overlook the impact of governance on the fortunes of start-up companies. My view is that this is a mistake. A well-structured and focused board significantly improves the prospects of any start-up. The cost of such a board is incidental when compared to the risks that it helps control and overcome. ‘Adult supervision’ alone is worth the investment. However, the other benefits – such as a wider range of contacts, introductions to important decision-makers, support in implementing effective control systems, professional evaluation of performance and more, make a well functioning board one of the most valuable assets any start-up can have.

© Dr. Earl R. Smith II

~~~~~~~~~~

Dr. Smith is a proven senior executive, successful entrepreneur, published author and public speaker. He serves on boards of directors and advisory boards or as a strategic adviser to CEOs. Dr. Smith specializes in turnaround management, strategic planning, leadership development and executive coaching. He also works as an executive and/or life coach in the areas of personal growth and spirituality. 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.

Of course, the fact that it is not has led investors to structure their deals to take advantage of the difference.

And, flavour of the month is convertible debt. But more of that in a minute…

Firstly, why debt rather than equity? Well, because the interest payments that a business makes on debt are tax deductible for the company. Similar returns going to equity investors (in the form of dividends) are not!

Therefore, companies make bigger profits if they leverage up with debt rather than seek equity investment.

And, in this current environment where banks have either withdrawn funding or increased the cost, more start up businesses need to depend on Business Angels for a greater part of the initial investment.

This gives the Business Angels greater power to negotiate convertible debt. That is, a cash sum which earns a particular level of interest each year (and the company can off-set this interest cost against profits) with the magic ability to convert into equity at a pre-defined ratio, should the investor so desire.

However,  it isn’t just for tax reasons that convertable debt is popular. It is also because business plans are less clear and timing of exits are less certain that a debt investment structure means that the investor still gets a return on his money whilst waiting for the market to pick up and the company to be sold for a profit.

Hence, it is tax efficient for the company and great for the investors. Now that the business owners have fewer options, it seems that business angels are able to negotiate and agree these structures more easily.