Governance of High-Tech Startups

Corporate Governance Corporate governance is the set of processes that provides an assurance of a fair return to outside investors. Resolve the conflict of interest between controlling (majority) and non-controlling (minority) shareholders. Resolve the conflict of interest between CEO and outside shareholders.

Examples of conflict of interest between CEO and outside shareholders Insufficient time and effort on building shareholder value Excessive time and effort on pet project that does not create shareholder value Inflated compensation or excessive perquisites Manipulating financial results to increase bonus or stock price Excessive risk taking to increase short-term results and bonus Failure to groom successors so management is “indispensible”

Corporate governance is important for privately-held companies because The IPO valuation will depend on how the market perceives the internal governance and the credibility of the financials. The price an acquirer (either privately-held or publicly-held) will offer for a privately-held target will also depend on the internal governance and the credibility of the financials. Succession planning: Builds confidence among employers, customers, and suppliers that even after the (sudden) departure of the current CEO, their implicit and explicit contracts with the company will be honored.

Number of Owners in Privately Held Companies and Frequency of Observing a Board Number of Owners 1 2 3 4 5 6+ Frequency of Board 11% 26% 49% 57% 60% 62%

Board Structure at the time of IPO Venture-Backed Non-Venture-Backed Average Board Size 6.2 6.0 % of Insiders on Board 32.0% 50.9% % of Outsiders on Board 65.1% 42.9% % of Boards with Fully Independent Audit Committee 77.0% 37.1% Compensation Committee 69.7% 26.6% % of Companies where Chairman and CEO are same 46.5% 72.7%

Board Structure and Life Cycle of the Private Company   Less Than 3 Years 3-6 Years 7-14 Years More Than 14 Years Governing Board 54% 74% 73% 80% Advisory Board 4% 9% 16% Both Boards 41% 22% 18% Number of Outside Directors 2.4 2.1 2.9 4.1 Formal Board Evaluation 0% 14% New Director Orientation 10% 28% Strategy to Change Board Composition 42% 45% 36% Percent of director compensation that is cash 39% 26% 60% 70%

Corporate Board Responsibilities The board of directors has a dual mandate: Advisory: counsel management regarding strategic and operational direction of the company. Oversight: monitor management and company performance. Effective boards satisfy both functions. The responsibilities of the board are separate and distinct from those of management. The board does not manage the company.

Corporate Board Responsibilities Selected advisory and oversight responsibilities: Approve the corporate strategy Test business model and identify key performance measures Identify risk areas and oversee risk management Plan for and select new executives Design executive compensation packages Ensure the integrity of published financial statements Represent the interest of shareholders

Board Independence Boards are expected to be independent: Act solely in the interest of the firm. Free from conflicts that compromise judgment. Able to take positions in opposition to management. “Independence” is defined according to regulatory standards. However, independence standards may not be correlated with true independence. Requires a careful evaluation of board member’s biography, experience, previous behavior, and relation to management.

Corporate Board Mechanics Presided over by chairman: sets agenda, schedules meetings, coordinates actions of committees. Decisions made by majority rule. To inform decisions, board relies on materials prepared by management. Periodically, independent directors meet outside presence of management (“executive sessions”).

Corporate Board Committees Not all matters are deliberated by the full board. Some are delegated to subcommittees. Committees may be standing or ad hoc, depending on the issue at hand. All boards are required to have audit, compensation, nominating and governing committees. On important matters, the recommendations of the committee are brought before the full board for a vote.

Audit Committee Responsibilities of the audit committee include: Oversight of financial reporting and disclosure Monitor the choice of accounting policies Oversight of external auditor Oversight of regulatory compliance Monitor internal control processes Oversight of performance of internal audit function Discuss risk management policies

Compensation Committee Responsibilities of the compensation committee include: Set the compensation for the CEO Advise the CEO on compensation for other executive officers Set performance-related goals for the CEO Monitor the performance of the CEO relative to targets

Nominating and Governance Committee Responsibilities of the nominating/governance committee include: Identification of qualified individuals to serve on the board Selection of nominees to be voted on by shareholders Hiring consultants as necessary Determine governance standards for the company Manage the board evaluation process Manage the CEO evaluation process

Director Term Annual election: Directors are elected to one-year terms. Staggered board: Directors are elected to three- year terms, with one-third of board standing for election each year.

Director Elections In most companies, directors are elected on a one-share, one-vote basis. Shareholders may withhold votes but not vote against. Four main voting regimes: Plurality: directors who receives most votes is elected, even if a majority is not obtained. Majority: director must achieve majority to be elected, otherwise must tender resignation. Cumulative: shareholders can pool votes, and apply to selected candidates (rather than one vote each). Dual class: different classes of shares carry different voting rights (disproportionate to economic interest). Typically, only one slate of directors is put forth for election; in a contested election, a dissident slate is also put forth.

Director’s Legal Obligations The “duty of care” requires that directors make decisions with due deliberation. The “duty of loyalty” requires that directors act “in the interest of the shareholders. The “duty of candor” requires that the board inform shareholders of all information that is important to their evaluation of the company.