Unlocking Growth: Why Entrepreneurs and VCs Embrace Startup Boards with Jacqueline Pieters

During the ScaleUpNation’s Board program several speakers mentioned the importance of independent board members in start-ups. Kaplan and Strömberg found that in 61% of the 200 start-ups studied, independent directors were holding a tie breaking seat. I wanted to understand what VC’s and entrepreneurs are expecting from an independent director and why they are even willing to share control of their board with an outside party. In this paper I investigated the added value of an independent director from the perspective of VCs, entrepreneurs and the academic world.

The VC’s view

Most blocks and interviews on this subject were given by people that were or have been fulfilling the role of investor as well as entrepreneur. To distinguish these views I identified the more methodical assessments as the view of VC’s, the more personal and skill driven values as the entrepreneurial view.

Why are independent board members necessary for VCs: 

• To fulfil the need for an odd number of board members. 
• To keep a balance in the Founder-Investor ratio. In the book Startup Boards the rule of one is mentioned: that at every financing round, if you add a VC to your board, you should always add an outside director too.
• To keep the long term interest of the firm at top of mind. While everyone should have the company’s best interest in mind, short term interests may take a significant weight in decision making.
• To increase the chance of success for limited costs. Opportunistic view of VC’s on the added value that an independent director can provide towards the company and the entrepreneur (mentoring, advising etc.) in combination with the little or no cash payments as independent directors are mainly paid with non-qualified stock options.

The Entrepreneurs View

I divided the long list that an entrepreneur is looking for in an independent board member, in the Must-have and the Nice-to-have, depending on the skills gap on the current board.

The Must-have entrepreneurs are looking for:

• Neutrality, to be able to rebalance the entrepreneur and VC ratio. The independent director should act with the company’s best interest in mind, always. Having one on board avoids letting hidden agendas potentially rule decision making.
• Strategic advice: someone that understands the business well, and that could provide some operational experience relevant to the business, particularly in a complex regulated industry. 
• Trust and time: a person that has enough time to dedicate to the start-up, and that is available to build a long term relationship with the entrepreneur and the company’s executives. 

The Nice-to-have entrepreneurs are looking for:

• Network / operating experience: deep connection with the market and client. Think about sales, but also service providers like lawyers or accountants, or even key hires.
• Mentorship: an independent board member can be the person who asks different types of questions through more casual or less formal conversations. 
• Operating advice: think of someone who grew a company already, knows what it takes to go from Seed to Big Company, and can share process or management best practices
• Diversity: someone that provides professional diversity as well as social diversity. Beyond skills complementarity, you want to get to differences of opinion and open-mindedness. 

Academic world view

Several theories in legal, economic and business literature identify that independent directors are necessary as they can serve as monitors, advisors or mediators. Brian Broughman adds to this the role of arbiter and that holding a tie breaking seat is essential for this task. Broughman’s theory is based on the divergent financial interest between entrepreneurs and VC’s, as a result of the allocation of cash flow rights and control rights in VC financing contracts. VC-backed start-ups almost always issue two classes of stock: common (held by the entrepreneurs and employees) and convertible preferred (held by the VCs). The independent director can settle disputes that may arise between the entrepreneur and VC as result of this divergent financial interest. More importantly, the presence of an independent director may prevent conflicts from ever materializing. The independent director often does not need to “arbitrate” actual conflicts, but primarily serves as a commitment mechanism that forces the entrepreneur and VC to compromise. Provided the independent director is relatively unbiased, competition for the independent director’s support limits the threat of opportunism.

Conclusion

VCs, entrepreneurs and academics give a variety of added values and reasons to be willing to share control of their governance with a third party. Familiar with the controlling, advising and mentoring role of an independent director, I had not realized how important they regard the role of neutral party: rebalancing the entrepreneur and VC ratio. And I was intrigued by what Broughman added, the role of arbiter: someone who can settle disputes that may arise between the entrepreneur and VC and whose presence may prevent conflicts from ever materializing. In my opinion,1 an independent director can only act as a neutral party and arbiter when he/she has the trust of entrepreneurs as well as VC’s. This trust can be built over time by a combination of credibility, reliability and willingness to spend time and expertise. The trustworthy neutral arbiter role seems to me the main reason why VCs and entrepreneurs are even willing to share control with an outside party. As Scott Weiss of Andreessen Horowitz noted, “neither founders nor VCs should control any given board; always seek balance and give your company its best chance at survival”.