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Secrets of Sand Hill Road by Scott Kupor

Secrets of Sand Hill Road by Scott Kupor

by Parker · 222 things on Twos

Venture Capital and How to Get it
Introduction
There is often a misconception that venture capitalists are like other investment fund managers in that they find promising investments and write checks. But writing the check is simply the beginning of our engagement; the hard work begins when we engage with startups to help entrepreneurs turn their ideas into successful companies.
While all VCs hope that each of our companies succeeds against huge risks and grows into a successful business, the reality is that the majority fail.
42 percent of all US company IPOs since 1974 were venture backed.
Chapter 1: Born in the Bubble
“Live to fight another day” is another great startup mantra to always keep front and center in your mind.
Cash is undoubtedly king in the startup world—and in the business world more generally.
Angels are traditionally individuals who invest in very-early-stage startups (generally known as “seed-stage companies”).
Tech startups represent an amalgamation of engineers who identify some innovative way to solve an existing problem or create a new market by introducing a product or service that consumers didn’t even know could exist.
No doubt that effective sales and marketing, capital deployment, and team building, among others, are also crucial ingredients to success, but fundamentally tech startups need to “fit” a market problem to a compelling market solution to have a shot at success.
To increase the odds of ultimately building a widely successful and valuable company, Marc and Ben had a thesis that founders should ultimately be product/engineering types and that there should be a tight coupling between the product visionary and the individual responsible for driving the company’s strategy and resource allocation decisions. Those latter responsibilities are typically the province of the CEO. Therefore, Marc and Ben had a predilection for backing CEOs who were also the source of the company’s product vision.
While technical founding CEOs might be great at product development, they might often lack the rest of the skills and relationships required to be all-around great CEOs—technical recruiting, executive recruiting, PR and marketing, sales and business development, corporate development, and regulatory affairs, among others.
We consistently tell our team to “make new mistakes,” which we hope translates into taking informed risks, iterating on product and service offerings, and learning from previous mistakes to avoid treading down the same dead-end path.
Startups thrive (or die) based on the availability of capital from VCs, particularly at the formative stages of their lives when the business itself is in growth mode and can’t support itself through operating cash flow.
Chapter 2: So Really, What Is Venture Capital?
VC is a source of funding for companies (whether technology based or not) that are not otherwise good candidates to get funding from other, more traditional financial institutions.
Loans are best suited for businesses that are likely going to be generating near-term positive cash flow sufficient to pay interest and, ultimately, the principal amount of the loan.
A company that is generating excess cash flow may wish to return capital to its equity holders in the form of a dividend or a buyback of shares, but there’s no requirement to do this (at least not in the vast majority of VC equity financings).
If you think you are going to need to invest all your cash into the expenses of the business and don’t see a near-term ability to generate cash flow (or don’t want to be constrained by the fact that you have nonpermanent capital in your business), equity financing may be the better bet.
VC is equity financing that the investors are willing to hold on to for a long time, but only on the assumption that they will ultimately get paid for the risk they are taking in the form of significant appreciation of the equity value.
There are basically three types of people involved in VC. There’s an investor (institutional, “limited partners”) who invests in a venture firm’s fund. Then the venture capitalist, usually a general partner at the firm, takes that money to invest in (hopefully) upward-bound startups. And the entrepreneur uses that money to grow her company.
Institutional investors (i.e., professionals who manage large pools of capital) often have a defined asset allocation policy by which they invest. They might for example choose to invest 20 percent of their assets in bonds, 40 percent in publicly traded equities, 25 percent in hedge funds, 10 percent in buyout funds, and 5 percent in VC funds.
Missing the next Facebook or Google is no doubt painful, and depending on the rest of your portfolio, can be career ending for a VC.
False positives are way less costly than a false negative and missing out because of the positive signaling that comes along with being apart of a winner.
VC investing is undemocratic not only in the sense that the winners seem generally to just get richer, but also because a limited number of players are allowed to ultimately compete.
If you don’t have the brand to create the positive signaling that attracts the best entrepreneurs, it’s hard to generate the returns.
50 percent of the investments are “impaired,” which is a very polite way of saying they lose some or all of their investment.
20–30 percent of the investments are—to continue with the baseball analogy—“singles” or “doubles.” You didn’t lose all the money (congratulations on that), but instead you made a return of a few times your investment.
Luckily, we still have 10–20 percent of our investments left—and these are our home runs. These are the investments where the VC is expecting to return ten to one hundred times her money.
In VC, all we really care about is the at bats per home run.
Chapter 3: How Do Early-Stage VCs Decide Where to Invest?
People and team
If an idea turns out to be a good one, assume there will be many other founders and companies that are created to pursue this idea.
A decision to invest means that the VC cannot invest in a different team that may come along and ultimately be better equipped to pursue the opportunity.
Among the cardinal sins of venture capital is getting the category right (meaning that you correctly anticipated that a big company could be built in a particular space) but getting the company wrong (meaning that you picked the wrong horse to back).
First, what is the unique skill set, background, or experience that led this founding team to pursue this idea?
In the product-first company, the founder identified or experienced some particular problem that led her to develop a product to solve that problem, which ultimately compelled her to build a company as the vehicle by which to bring that product to the market. A company-first company is one in which the founder first decides that she wants to start a company and then brainstorms products that might be interesting around which to build one.
A real-world problem experienced by the founder becomes the inspiration to build a product (and ultimately a company); this organic pull is often very attractive to VCs.
Product-market fit speaks to a product being so attractive to customers in the marketplace that they recognize the problem it was intended to solve and feel compelled to purchase the product. Consumer “delight” and repeat purchasing are the classic hallmarks of product-market fit. It is an organic pull on customers, resulting from the breakthrough nature of the product and its fitness to the market problem at which it is directed.
As a corollary to the product-first company, founder-market fit speaks to the unique characteristics of this founding team to pursue the instant opportunity.
This has historically been less typical in the venture world, but, increasingly, as entrepreneurs take on more established industries—particularly those that are regulated—bringing a view of the market that is unconstrained by previous professional experiences may in fact be a plus.
The scars from previous mistakes run too deep and can make it harder for one to develop creative ways to address the business problem at hand.
Whatever the evidence, the fundamental question VCs are trying to answer is: Why back this founder against this problem set versus waiting to see who else may come along with a better organic understanding of the problem? Can I conceive of a team better equipped to address the market needs that might walk through our doors tomorrow? If the answer is no, then this is the team to back.
VCs are trying to determine whether this founder will be able to create a compelling story around the company mission in order to attract great engineers, executives, sales and marketing people, etc. In the same vein, the founder has to be able to attract customers to buy the product, partners to help distribute the product, and, eventually, other VCs to fund the business beyond the initial round of financing. Will the founder be able to explain her vision in a way that causes others to want to join her on this mission? And will she walk through walls when the going gets tough—which it inevitably will in nearly all startups—and simply refuse to even consider quitting?
To make the decision to be a founder (a job fraught with likely failure), an individual needed to be so confident in her abilities to succeed that she would border on being so self-absorbed as to be truly egomaniacal.
You have to be partly delusional to start a company given the prospects of success and the need to keep pushing forward in the wake of the constant stream of doubters.
Most ideas are not proprietary, nor likely to determine success or failure in startup companies. Execution ultimately matters, and execution derives from a team’s members being able to work in concert with one another toward a clearly articulated vision.
Product
Will this product solve a fundamental need in the market (whether or not that need is known currently to customers) such that customers will pay real money to purchase it?
Only through iterative testing with real customers will the company get the feedback needed to build a truly breakthrough product.
You’ll often hear VCs say that they like founders who have strong opinions but ones that are weakly held, that is, the ability to incorporate compelling market data and allow it to evolve your product thinking. Have conviction and a well-vetted process, but allow yourself to “pivot” (to invoke one of the great euphemisms in venture capital speak) based on real-world feedback.
New products won’t succeed if they are marginal improvements against the existing state of the art. They need to be ten times better or ten times cheaper than current best in class to compel companies and consumers to adopt.
Market Size
If VCs are wrong more often than they are right, and if success (or failure) as a VC is wholly a function of whether you get 10–20 percent of your investments to fall into the home-run category, then size of the winners is all that matters.
Getting the company right but the market wrong, that is, investing in a company that turns out to be a nice, profitable business, with a great team and a great product, but in a market that just isn’t that big. No matter how well the team executes, the business will never get to more than $50–$100 million in revenue, and thus the equity value of the business is capped.
Sins of omission are worse than sins of commission. It’s okay for a VC to invest in a company that ultimately fails—as we’ve discussed, that’s par for the course in this business. What’s not okay is to fail to invest in a company that becomes the next Facebook. Remember, you can’t risk-averse your way to success in this business.
VCs often think of market size as the “so what?” question in evaluating a startup’s potential success. It’s all well and good that the team is great and the product is great, but so what, if the market size isn’t sufficient to sustain a large business.
Andy Rachleff, a founder of Benchmark Capital, has said that companies can succeed in great markets even with mediocre teams but that great teams will always lose to a bad market.
Chapter 4: What Are LPs and Why Should You Care?
Growth assets: public equities, private equities, hedge funds
Inflation hedges: real estate, commodities, natural resources
Deflationary hedges: bonds, cash
As a potential entrepreneur and a consumer of VC dollars, you need to be aware of the time constraints ultimately imposed on you. At some point in your company’s life cycle, the VCs will push for an exit to generate this type of liquidity.
If they are later in the fund cycle and haven’t generated sufficient liquidity from other investments, the pressure for a more near-term exit could be more intense.
VCs tend not only to invest capital in startups earlier in the life of a fund, they also generally set aside “reserves,” expected monies that they anticipate they might invest in a startup over the course of its next several financing rounds. Thus, the later in a fund cycle your investment occurs, the greater the likelihood that the VC may also not have sufficient reserves to set aside for subsequent financing rounds.
Most entrepreneurs tend to raise money at least once or twice after the initial funding round, because if they are doing well, they’ll want to accelerate the growth and fuel that with additional capital, and if they are not doing well, they will need the capital to get to the next set of milestones. Thus, at least in the early years of a company’s life, access to capital is critically important.
Chapter 5: The “Limited” Edition: How LPs Team Up with VCs
LPs have no say over the investments that the fund chooses to make.
As an entrepreneur, when you investigate whether a particular GP is appropriate for your business, you’ll want to understand whether you fit into their investment domain. There’s no sense in your wasting your time pitching your life sciences company to a firm that simply can’t (by virtue of its LPA) or won’t invest in you, regardless of how exciting your company may be.
Chapter 6: Forming Your Startup
C corps are best for building long-term equity value in the business versus distributing profits directly to shareholders.
The cost of course of being a C corp is that, when profits do get distributed from the C corp, we have to deal with the double taxation problem: profits are taxed first at the corporate level and then a second time at the individual owner’s level when paid out.
A C corp does not have any limits on the number of shareholders that can be part of the organization; thus, as a startup hopefully grows, later employees can also benefit from potential equity ownership.
VCs like to invest in what is called “preferred stock,” whereas most founders and employees hold “common stock.
Make sure board seats are conditioned upon continued service to the company as an employee, not simply granted to someone as a function of having been a cofounder.
A blanket transfer restriction means that shareholders cannot sell without some form of a company consent—often the board's consent is required to do so.
The ROFR right-of-first-refusal agreement means that if someone (in this case, a cofounder) is trying to sell her stock, the company has a right to match any offers received and effect the purchase. This is a good right to have, but it is often insufficient because this alone does not prevent cofounders from selling stock. Rather, it gives the company an option to buy the shares itself, but doing so requires that the company utilize its existing cash to do so. In most startups, this is not the highest and best use of cash, and as a result, most companies waive this right and permit the third-party sale to go through.
In the acquisition scenario, founders will often have single-trigger or double-trigger acceleration provisions. In a single-trigger provision, the founder’s stock is accelerated upon the closing of an M&A event; in a double trigger, both the closing of the deal and the acquirer’s decision not to retain the founder in the new entity are required for acceleration.
The founders put in place an employee option pool equal to 15 percent of the company. (I somewhat arbitrarily picked 15 percent, but this does tend to be the standard size of an initial employee option pool in a startup.) As a result, the ownership of the company has changed: the two cofounders are splitting 85 percent of the equity, and the employee option pool comprises the final 15 percent.
“Stock options are a contract that gives the option holder the right, but not the obligation, to purchase the stock at a future date, at a specified price. That price is called the “exercise price.” So, if a startup gives you an option to purchase one hundred shares of stock at an exercise price of one dollar per share and that option is valid for ten years, that means that any time over the next ten years, you can pay the company one dollar per share of stock (or one hundred dollars for the full option exercise) and therefore own the stock.
The act of buying the stock at the exercise price is called “exercising” the option. If, however, the stock is worth only fifty cents per share, you would never pay one dollar to buy the stock and then lose money by selling it at fifty cents per share. Thus the “option” gives you the choice to not buy the shares as well.
Chapter 7: Raising Money from a VC
The right time to raise capital is when the capital is available.
You should be able to generate a profitable, high-growth, several-hundred-million-dollar-revenue business over a seven-to-ten-year-period.
Raise as much money as you can that enables you to safely achieve the key milestones you will need for the next fundraising.
What will you need to demonstrate to the next round investor that shows how you have sufficiently de-risked the business, such that the investor is willing to put new money into the company at a price that appropriately reflects the progress you have made since your last round of financing?
Most entrepreneurs raise new capital every twelve to twenty-four months.
They want to see $3-5 million before raising a series B.
A successful enterprise software company that makes it to an IPO is probably going to raise at least $100 million.
Scarcity is the mother of invention.
A big mistake is raising too small an amount of money at an aggressive valuation.
Employees often judge the success of the business at least in part on the external measure of valuation in a financing round.
Never underestimate the value of always maintaining momentum in the business.
Chapter 8: The Art of the Pitch
Angels, seed investors, and lawyers are motivated to introduce you to VCs.
If you can't find a creative way to get to a VC, then, for example, how are you going to find a way to get to the senior executive at a potential customer prospect of yours?
Pitch essential #1: market sizing
You need to paint the picture for them that enables them to answer the “so what?” question. That is, if I invest in this company, and the CEO and her team do everything they say they are going to do and build a nice business, can that business be big enough to really drive an outsize return to my fund?
Lyft argued that the taxi market was too limiting because people made assumptions about the availability of taxis, the security of taxis, and the convenience of hailing taxis in choosing whether to in fact order a taxi. If you closed your eyes for a moment and imagined a world in which everyone was walking around with a fully networked supercomputer in their pockets with GPS tracking, which is exactly what a smartphone is, then the market size for on-demand car sharing could be much larger.
Sometimes as an entrepreneur you have the hard job of positing the creation of a market that develops as a result of a new technology.
So the market-size challenge in this case was to build your argument on two assumptions: (1) this iPhone thing would really become a dominant global computing platform, and (2) photo-sharing would be a killer app for the platform.
It was not a crazy hypothesis that if you can amass billions of photos that are being shared among millions of people, there ought to be some way to make money from that.
Andreessen Horowitz took the leap on market size and invested in Burbn. Two years after they invested, Facebook acquired the company—now named Instagram—for $1 billion.
Pitch Essential #2: Team
What matters to the VC is team.
The real question for a VC now becomes “Why you?” That is, “Why do I want to back this set of entrepreneurs versus waiting for the next set that might walk into my office tomorrow tackling the same idea?” After all, ideas are a dime a dozen; execution is what sets the winners apart from the pretenders.
You need to spend a significant amount of time in your pitch talking about you as the CEO and the rest of your team.
What makes you as a person uniquely qualified to win the market?
You should relate your prior accomplishments or experiences to the current business you are pitching—what do they say about your likelihood of success in the current venture? Don’t be shy to talk about your failures—after all, experience is what you get when you don’t accomplish what you set out to do—and relate what you learned. VCs love infinite learners.
You do need a convincing story as to why you are the best fit to start a company in a competitive market.
Once you’ve successfully convinced the VCs of your fitness to the market opportunity, you still need to help them understand how you are going to build the right team around you. No matter how great a product genius any founder may be, she can’t build a large business without employees and other business partners.
So what makes you a natural-born leader, or a learned leader, that will cause people to quit their jobs and come work for you; cause customers to be willing to buy your products or services when there are many safer, established choices available to them; cause business development partners to want to help you sell your wares and penetrate new markets; and, of course, cause funding partners to want to provide you the capital to do all of the above?
Pitch essential #3: Product
No VC expects you to be clairvoyant about the precise needs of the market, but they are evaluating the process by which you came to your initial product plan. VCs are fascinated to learn how your brain works. We want to see the idea maze. What data have you incorporated from the market; how is it more aspirin than vitamin; how is this product ten times better or cheaper than existing alternatives?
Walk them through your thought process and demonstrate that you have strong beliefs, weakly held; that is, that you will adapt to the changing needs of the market but remain informed by your depth of product development experience.
Pitch essential #4: Go-to-Market
How will you acquire customers, and does the business model support customer acquisition profitably?
Are you planning to build a direct, outside sales force, and can the average selling price of your product support this go-to-market? Or are you planning to acquire customers through brand marketing or other online forms of acquisition? If so, how do you think about the costs of such activities relative to the lifetime value of a customer?
You ought to have a framework that gives a VC enough fodder to understand your thinking around customer acquisition.
You are not expected as an entrepreneur to have all the correct answers figured out, but you do need to have theories grounded in reasonable assumptions against which you can then apply real-world experience. Again, strong opinions, weakly held.
A thoughtful, engaged discussion on how you came to the conclusions that you did and a willingness to listen to the feedback and incorporate it into your thinking, as appropriate, would be a far better response than pivoting on the fly.
Pitch essential #5: Planning for the next round of fund-raising
For the final part of your pitch to VCs, you should clearly articulate the milestones you intend to accomplish with the money you are raising at this round.
In general you want to aim toward a valuation that is roughly double your prior round. That momentum will be well received by both your current investors and your employees.
How do I convince a VC that my business has a chance to be one of those outsize winners that can make her look like a hero in front of her LPs?
Chapter 9: The Alphabet Soup of Term Sheets: Part One (Economics)
The economics bucket, includes the sections that talk about the size of the investment, valuation, antidilution treatment, liquidation preference, the size of the employee option pool, and vesting of options and founder shares.
The whole reason for creating a new class of stock is to give it “preferred” economic and governance rights relative to those enjoyed by the common shareholders.
Aggregate proceeds: By forcing all the notes to convert into equity in this round, the VC ensures that everyone is in the same position with respect to the distribution of proceeds in the event of an exit.
Recall that convertible debt means that the instrument starts out as debt but can be converted into equity based on the occurrence of certain events. In most cases, the debt will convert into equity in connection with an equity financing round, typically in a Series A financing.
There are several flavors of convertible debt. In its most basic form, the debt converts into equity at the same price at which the Series A investors purchase equity. This is referred to as an “uncapped” note, meaning that the valuation at which the note converts is not restricted and will be determined based upon the Series A equity price.
Capped” notes establish a ceiling on the maximum price at which the debt will convert into equity. For example, a convertible note with a $5 million valuation cap means that in no case will the debt convert into equity at a price higher than $5 million. If the Series A round valuation comes in below the cap—say $4 million—then the debt holder gets the benefit of that lower valuation. And if the Series A valuation exceeds the cap—say $10 million—then the debt holder converts at the $5 million cap, in this case a full 50 percent discount to the Series A investor.
One very common mistake that we see entrepreneurs make is to raise too much convertible debt in the early days of the company such that they end up giving away too much of the company to outside investors.
If the entrepreneur owns too little of the company at such an early stage of the company’s life, the likelihood is that either she will become demotivated over the coming years or the VCs will need to grant her more equity down the road to maintain her economic interest.
Post-money” means exactly what is sounds like: the valuation of the company once the VC has invested her $10 million. You’ll often hear VCs use the term “pre-money” as well; this is the valuation of the company before the VC makes her investment. So, mathematically, pre-money + amount of investment = post-money (in our example, since VCF1 is investing $10 million and has said that the post-money valuation is $50 million, the pre-money must be $40 million).
This is why the VC wrote the term sheet to hard-code the post-money valuation at $50 million. She wanted to be clear that whatever the existing capital structure of the company and however big an employee option pool the founders wanted to create, the VC would not be diluted by those.
Whatever annual cash a company can generate in the future, if we discount that cash to present-day values, an investor should be willing to pay no more than the current value of that stream of future cash.
A “winner” means a return of ten times it's investment.
Liquidation preference is a fancy way of saying who gets their money back under certain circumstances.
1x is the predominant form of liquidation preference for early-stage venture financings.
Nonparticipating” means that the VC doesn’t get to double dip. Rather, she gets a choice: take her liquidation preference off the top or convert her preferred shares into common shares and take the equity value of her percentage ownership of the company. “Participating” is the opposite flavor—not only does the VC get her liquidation preference first (her original investment back), but then she also gets to convert her shares into common and participate in any leftover proceeds as with any other shareholder. Double-dipping is pretty unusual in the standard venture capital financing.
Redemption means they can take their money back. Most state don't allow it if doing so would put the company in a dire financial situation.
In a full ratchet, using our five-dollars-per-share/two-dollars-per-share example from above, our VC would essentially ignore its original five-dollar price and reset its stock holdings based upon the two-dollar price. Mathematically, this means the number of shares that the VC will now hold based on its original investment in the company increases by roughly two and a half times (5/2). As you can see, the full ratchet therefore protects the VC from getting diluted by this down round of financing.
Chapter 10: The Alphabet Soup of Term Sheets: Part Two (Governance)
Probably the most foundational thing that a board does is to hire (or fire) the CEO.
The first seat is mostly for the lead investor. The second seat is for the CEO, not necessarily for the founder. The third seat is reserved for an independent, someone not otherwise affiliated with the company by virtue of being an investor or officer.
Things they vote on:
Authorization of new classes of stock
Corporate actions: It permits the Preferred to vote on an acquisition of the company and a sale of its intellectual property.
Liquidation or recapitalization
Increases in the option plan
Pro rata gives VCF1 the right, but not the obligation, to purchase its pro rata amount of future rounds of financing to avoid dilution.
You’ll also note that the right applies only to “major investors,” which was defined in the information rights section to be anyone who invests at least $2 million in the company. This is really just a matter of convenience. If you have a lot of small investors, sometimes it is just a pain to track them down and then wait for them to tell you whether they are going to invest their pro rata amount in the new round of financing. So the major investor definition reserves this right for those who are putting some material amount of money into the company.
The drag-along provision is intended to prevent minority investors from holding out on a deal to try to get a better deal for themselves. So what it says is that if each member of the board of directors, the majority of common stock, and the majority of Preferred stock all vote in favor of an acquisition, then any of the other 2 percent shareholders (recall this was our major investor definition) gets dragged along in favor of the deal.
To provide some protection to these 2 percent holders, note that there are three separate votes required: (1) the board needs to approve; (2) the common voting as a separate class need to approve; and (3) the capital “P” Preferred voting as a separate class need to approve.
The VCF1 GP who sits on the board of XYZ Company thus has several lines of defense: XYZ’s D&O policy first and then VCF1’s policy as a backup. And just as the venture firm indemnifies its GPs, XYZ Company will also indemnify its board members and officers. This enables them to be the beneficiaries of the D&O insurance policies.
It often takes from two weeks to as much as a month to get from term sheet to closing, which occurs once the parties sign all the agreements and the VC wires its money to the company.
No-shop tie-up is in the form of preventing XYZ from being able to disclose the term sheet to other parties or pursue a deal with somebody else. After all, the last thing VCF1 wants is to have XYZ Company shop this term sheet to other VC firms to see if someone else wants to provide a better deal.
In general, simplicity is better.
Chapter 11: The Deal Dilemma: Which Deal Is Better?
The difference between weighted average dilution versus a full ratchet is very meaningful.
It’s simpler to have a capital “P” Preferred vote as the baseline precedent at an early stage versus setting up a series-specific vote this early in the company’s life cycle.
There is no rule that says that all subsequent investors get the benefit of the same terms as did earlier investors, but in my experience this is often the starting point of the discussion: if it was good enough for those investors, why isn’t it good enough for me as the new investor? No doubt the best retort to this argument is: “This time things are different.”
Chapter 12: Board Members and the Good Housekeeping Seal of Approval
What boards do:
Hire/Fire the CEO
The CEO has all her executives in the company reporting to her (and thus she has the ability to hire or fire any of them), and the CEO herself ultimately reports to the board.
When VCs find themselves getting too entangled with the day-to-day operations of the business, you as the CEO should engage with your VC board member to understand why. It’s possible that your VC may simply not be aware she is doing this, or there may be a deeper concern she has with your abilities as a CEO that is causing her to increase her level of engagement. Uncovering if either or both of these are present is a good thing for you to do as CEO.
If the common shareholders control the board by having more board seats, that effectively neuters the VCs’ ability to remove the founder CEO from her role. And the opposite of course is true: if the VCs control the board, the founder CEO might have concerns about whether the VCs will be trigger-happy and remove her from the business prematurely.
Guidance on long-term strategic direction for the business
The board does have a role in at least providing guidance and review of that strategy.
To execute the CEO’s strategy might require a certain budget (or the need to raise additional capital): these are areas where the board’s input is both expected and desirable.
Good CEOs bring these discussions to their board for input well before they are asking for a formal vote.
Approving various corporate actions
In order to issue stock options to an employee, the board must first determine the appropriate fair market value of the stock.
Good boards should also review CEO and broader executive compensation every one or two years.
Maintaining compliance and good corporate governance
VC-specific roles
Many times a VC board member is an informal coach to the CEO.
Another informal role of the VC board member is to open her network to the benefit of the CEO. Sometimes this may be to introduce potential executive candidates or external advisors for the company. Other times it may be to introduce potential corporate customers or partners.
The board's non-roles
The role of the board is not to run the company or dictate the strategy, in particular the product strategy; that is the job of the CEO.
If you see this kind of overreach from the board, you should address it directly with your respective board members.
First, set the right expectations up front about what you want from your board members. Many CEOs like to do regular one-on-one meetings with board members to ensure that they have time outside of the board meeting to share information and receive feedback. In addition, do you expect them to help you identify future members of the executive team, interview candidates for executive roles, open their Rolodexes to identify sales prospects, etc.?
You should also set expectations about how you intend to run the board meetings—e.g., do you expect people to have read the deck beforehand and plan to use the meeting largely as a discussion of open questions?
Second, get agreement among your board members as to how they will provide you feedback. Some boards ask a single member to consolidate feedback from all the others and deliver it one-on-one to the CEO. Others may have an executive session with just the board and the CEO at the end of each meeting to provide group feedback.
Third, make sure that you and your board agree on engagement outside of a board meeting with members of your executive team. Good board members will make sure that you know if a member of the exec team has reached out to them to meet, and provide appropriate feedback to you as the CEO if critical questions are being raised.
Finally, you need to orchestrate the board meeting itself and the agenda. This doesn’t mean not sharing bad news or being selective in your disclosure of important information to the board, but it does mean figuring out what topics are worthy of board discussion and not spending time on topics that are appropriately delegated to you as the day-to-day manager of the organization. Sitting down with your board members at the outset to solicit their feedback on what they would like to see as part of the board agenda is a great way to avoid missing the mark during the board meeting.
Chapter 13: In Trados We Trust
The duty of care says that you need to be informed about what’s going on in the company to perform your basic role of maximizing value for the common shareholders.
The duty of loyalty requires that a director not self-deal or enrich herself.
If you are on the board of a company, you need to keep confidential any information that you learn in the course of your tenure.
The decision to invest in a company likely means that you are conflicted out of other companies that are directly competitive. To be clear, there is no prohibition against this, but the convention of the business makes this hard to do—as a VC you are lending your name and your firm’s brand to your investments, so it’s hard to invest in direct competitors without creating challenges for both companies in the marketplace.
The duty of candor requires that board members disclose to shareholders all the requisite information they need to be informed on important corporate actions.
Board members do not owe fiduciary duties to the preferred stock. Instead, the courts have long said that preferred rights are purely contractual in nature; that is, they are negotiated by the parties to the financing agreement at the time of the funding. And—probably most important—they are negotiated by sophisticated parties who can take care of themselves.
Directors are generally entitled to a pretty lax standard of review known as the business judgment rule. In simple terms, the BJR says that the courts are loath to second-guess a board decision as long as, at the time the decision was made, the board acted on an informed basis, in good faith, and with the honest belief that the action taken was in the best interest of the corporation and its common shareholders.
The courts will look to evaluate the process of the decision-making to ensure that it complies with the duty of care: Did the directors inform themselves of the facts, did they read the board materials, did they take the time at a board meeting to discuss the issue? Essentially, was there a clear record of an informed, deliberative process? That’s it; if you did that, then you can get the outcome wrong and still be protected from legal liability.
It is up to the plaintiff (the person who is challenging the board’s decision) to prove other-wise; she has the burden of proof to convince the court that the process was bad and thus led to a bad decision.
Keep good minutes of the meetings to reflect the frequency and level of deliberations. That doesn’t mean you have to capture every word that is said in the meeting—and good lawyers know how to do this well—but it does mean that you want enough in the record so that if you ever have to defend yourself against a fiduciary duty claim, the record will support your good process.