On June 20th, Scott Lenet (the founder and president of Touchdown Ventures) published a story on Forbes titled “Venture Capital Needs Desperately More Governance.” The gist of the article is that VC and Silicon Valley still operates in a sort of Wild West “where rule-breaking is a foundational principle.” Specifically, he calls for more training and education for directors of venture-backed companies, since “board service [in venture-backed companies] is yet another arena where there is no formal training” noting that “in any industry where individuals serve as professional fiduciaries, there are typically degree programs, mandated training, certification, continuing education, and oversight.”
I couldn’t agree more with this observation. In fact, during my tenure as the Executive Director of the Stanford Rock Center, we launched a program called Directors’ College for Venture Backed Company Directors (VCDC) in 2014 based precisely on this premise. It was modeled after Directors’ College, the leading executive education program for directors of publicly-traded companies, pioneered 25 years ago by Professor Joe Grundfest, a former Commissioner of the SEC. However, we realized that nothing of this sort existed for private venture-backed companies. How could it be that at the heart of Silicon Valley no institution provided this type of training for directors, who operate in such a different organizational structure than public companies?
So we decided to roll up our sleeves to tackle this problem. We partnered with Scott Kupor from Andreessen Horowitz (who has just published a brilliant book on venture capital, which includes a few excellent chapters on governance) plus a group of VC experts to develop a very specific agenda focused only on governance for venture-backed company directors. A couple of years later we partnered with the National Venture Capital Association, broadening the focus of the program beyond only governance. I recommend any director of a venture-backed company to attend the rebranded Stanford/NVCA Venture Capital Symposium to learn more about this topic.
- What is the Problem with Governance at Venture-Backed Companies?
Let me start with a classic scenario: one or more founders create a new company, initially bootstrapping via personal savings, family and friends or other angel investments, until raising the first “institutional” round of venture financing. The VC that leads the first round of financing (typically called the Series A round) will get a board seat. Then, every 12–24 months the founders will raise new rounds of VC financings at (hopefully) higher valuations than the A round, adding more directors to the board. Mark Suster, the managing partner at Upfront Ventures, has written a very good series of articles on VC boards, and created the following graphic of the venture-backed board’s evolution:
Now let’s say that in year 5 or 6 of this company things are not going so smoothly anymore. Maybe the executive team has not hit all their milestones or maybe external factors have slowed the growth of the company. This is when good governance (and board leadership) really matters and where typically conflicts of interest come into play. Why conflicts? Because the interests of venture capital investors (who hold preferred shares) may diverge from the interests of founders and employees (who hold common shares). In such contexts, VCs are referred to as “dual fiduciaries”: they owe fiduciary duties both to the fund (to maximize return on investment) and to the stockholders of the company on whose board they serve (to maximize the long-term value of the stock held by the common stockholders). These issues turn into relevant questions of duties of loyalty.
So when do these conflicts matter the most? Typically in down-round financings (if the company raises funds at a lower valuation than the previous round), recapitalizations (raising at a lower valuation including reductions in liquidation preferences and/or reverse splits of the stock to reduce the equity ownership of existing investors) or at the sale of the company. This is when directors should pay close attention to their fiduciary duties and where, unfortunately, many directors fail to act appropriately and/or don’t undestand to whom they owe their duties [disclosure: I have been involved in VC litigation and have witnessed depositions of board members whose understanding of governance is low to inexistent].
Relevant guidance on this topic has been provided by Delaware courts, since most startups are incorporated in Delaware and are therefore governed under Delaware corporate laws and principles. In one of the seminal cases on duties of directors in venture-backed companies, In Re Trados (which should be required reading for all directors), Vice-Chancellor Laster wrote a lengthy decision explaining the duties of directors in these situations. Let me give you a short take-away: fiduciary duties of directors in venture-backed companies are owed to the common stockholders, not to the preferred stockholders (who are instead contractually protected). I’m not going to get into the details of this case, but if interested in a deeper dive I suggest you read “The Venture Capital Board Member’s Survival Guide: Handling Conflicts Effectively While Wearing Two Hats” by Steven E. Bochner and Amy L. Simmerman.
Moreover, in our very first VCDC program at Stanford, we invited Vice-Chancellor Laster to keynote the program and participate in a panel about the Trados case, which was a bit reminiscent of the Marshall McLuhan scene in Annie Hall. I recommend you watch Laster’s keynote speech, where he explains that under Delaware corporate law, fiduciary duties are owed to the corporation “for the benefit of the undifferentiated stockholders” — ie. the common stockholders (if you don’t want to watch it all, just go to minute 11).
The latest in this series of venture capital director malfeasance cases is the Basho case from July 2018, where Vice-Chancellor Laster ordered a VC and his fund to pay $20.3 million in damages after finding that defendants breached their fiduciary duties in connection with the collapse of the company. The Court found that this particular VC used contractual consent rights granted to it as a preferred shareholder together with “hardball” negotiating tactics and “egregious” conduct to force the company to the brink of insolvency and leave it with no choice but to accept “oppressive” financing terms from the VC. Take note, Silicon Valley directors.
- The Increasing Importance of Governance at Venture-Backed Companies.
As I’ve explained in a prior post, governance matters for your startup. Furthermore, as companies have elected to stay private for longer (as of this writing there are 362 “unicorns” valued cumulatively at ~$1,127 billion) and with venture capital reaching historic records (in 2018 LPs committed $54 billion to venture funds; startups raised more than $130 billion in funding; and venture-backed exits surpassed a combined value of $122 billion), the rather obscure corner of governance in these companies will require more sunlight and better understanding.
There have also been other types of well documented governance failures in some of the most prominent private venture-backed companies, such as with Uber, Theranos, Zenefits and SoFi, where founders engaged in illegal and/or bad behavior that led to serious failures of culture, ethics and compliance. But these are only the most well known cases involving high profile companies. There is a lot more malfeasance going on behind the curtains.
Moreover, governance disputes at startups involve more than just conflicts between common and preferred stockholders, as Elizabeth Pollman explains in her excellent article Startup Governance. There are other complicated governance dynamics that can involve vertical issues (shareholders vs. board, board vs. founders or executives, and shareholders vs. founders or executives) and horizontal issues (preferred vs. common, preferred vs. preferred and common vs. common).
The days of “Wild West” governance practices hopefully will diminish but I believe that there is still a large number of directors out there who have little to no understanding of their fiduciary duties and of governance, generally. There is also a subset of directors who are accustomed to serving on public boards who may be invited to join as independent directors in private venture-backed boards and may think of it as a “fun” or “prestigious” position. However, if and when conflicts arise, and if they lack proper understanding of the nuances of venture capital, they may be exposed to liability in breaches of duty of loyalty. It should be emphasized that most venture boards are conflicted, so their decisions may not benefit from the business judgement rule protections usually afforded to independent boards in public markets. Instead, these cases go into entire fairness reviews, a much higher threshold where the Court will get into the details of the fairness of the process and price of the transaction at issue. In these scenarios, independent directors may be exposed beyond the coverage of the D&O insurance provided by the company. Not a good place to be.
As a result of director shenanigans there will be a lot more damage inflicted to founders, employees, investors and/or other stakeholders in the ecosystem. Expect a rise in litigation in this space, and if you’re a director in one of these companies, the best you can do is to educate yourself in these matters with your in-house or outside counsel, or at corporate governance programs provided by institutions such as Stanford, Berkeley, NVCA, NACD, Kauffman Fellows, Nasdaq and/or any other programs of your choice. I also recommend Scott Kupor’s new book, Brad Feld’s book Startup Boards and Keith Rabois’ summary of how to run a board meeting and prepare a board deck, all of which will help you think about your role and duty as a director in a venture-backed company.
Author: Evan M. Epstein
Founder & Managing Partner
Pacifica Global Corporate Governance
Pacifica Global was founded in San Francisco to serve as a leading corporate governance advisory firm. The mission of Pacifica Global is to help public and private companies solve some of their most complex corporate governance conflicts and challenges.