Independent board directors 101

Happy new year and welcome to our new subscribers! The next few editions of Above Board will be focused on independent board directors. We’re grateful to have Mike Baker join us to discuss this important topic. Mike is a successful technology business builder who has sat at every seat around the table, including as a 3x successful founder/CEO, C-level executive through IPO, venture capitalist, General Counsel, Chairman of the Board, and independent investor. 

AB: Welcome, Mike. Thanks so much for joining us. Let’s dive in. Can you please share a bit about your background and why you feel strongly that boards need independent directors?

MB: I love the topic of why companies need independent directors because I believe strongly that they do. I'm an investor in over 65 companies currently. As for my history, I started out as a General Counsel of a public company, including being the Board Secretary and sitting in on board meetings and seeing what really went down between the CEO and the board.

From there, I went into venture capital for a couple of years. And then I became a three-time founder and leader of tech growth companies, all of which were successfully exited to large cap strategics. Since then, I’ve had two Chairman of the Board roles and many board seats, both for my own investments and also independently where I'm not invested.

So, this is the lens through which I look and so the context for my insights is the world of high growth technology startups. These companies typically are funded by venture capital, growth or private equity funds; institutional capital is typically required to build up the technology and see the company through a period of initial losses. The CEO / founders usually are not professional managers. So, having an independent board director with prior operating experience is important to help coach the CEO.

I see a lot of CEO’s who are less experienced and fail to prioritize the composition of the board they're working with. My experience has taught me that thoughtful composition of a board is actually one of the key duties of a successful CEO.

AB: What is an independent director?

MB: An independent director, in my book, is one who's not affiliated either with the management team or with the institutional investors (ie: venture capitalists) that are backing the company. Institutional investors are fiduciaries for their funds, but they also have a fiduciary role relative to the companies they invest in. Therein lies the rub, and it’s a big part of why an independent director is so important for an entrepreneur.

AB: When should a board make sure they have an independent board member appointed?

MB: Often you won't see an independent board member involved until a Series A or larger amount of capital has been raised and the company has gotten through some of the basic product market fit.

AB: How does an independent board director help a company?

MB: I see two kinds of companies: one is a company largely owned by management and without institutional capital / board directors appointed by institutional capital. These are the homegrown companies and they're few and far between. But I happen to be involved with one right now and I’ve seen that an independent director in that situation can really help professionalize the company's management and governance, and serve as a reality check to prevent, for lack of a better term, excessive shortcut taking.

As an example, the CEO may say, we don’t really need an annual financial audit by a major audit firm. Or they may ask why do we need to formally close our books on, say, a monthly or quarterly basis? The answer is because you may get an acquisition offer down the road, but it will be subject to historical audits. Then it takes that company six months or more to get its books in order, which creates real risks to the deal. Similarly, the company might have a very idiosyncratic compensation system that will come under pressure and cause operational disruption when the company later scales. An experienced independent director can help ensure that key issues have been spotted and the right foundation is being laid.

All that said, the much more common scenario is with institutional investors in the company where an independent director helps the CEO better manage and collaborate with the investors, especially those who also hold board seats.

My assumption here is that the independent director has operating and investing experience, which I think is key. A lot of tech company CEO’s are first timers and while they may have been at it for a while they don't have the context of other businesses and investments. And so they struggle with how to best work with their financial investors: how to appease them, how to collaborate with them, how to pick the right battles, and so on. There are four ways an independent board director can help in this situation:

1. Serving as an intermediary between the management team and institutional investors is a great role for an independent director, especially one who's sat in the CEO seat before and also ideally the investor seat.

2. The second thing is that financial investors are not operators. It’s rare that investors at venture funds have really run or built their own companies. Of course, a number have, but many have just done really well in school and are analytically rigorous, exceptionally diligent, well connected or what have you.

And so, I think a lot of entrepreneurs would agree that too often some of the institutional capital perspective is sort of disjointed from the reality of the business they're running. For example, the institutional investors may be focusing on financial metrics that are inconsistent with customer satisfaction or what actually grows the business. In that case, an independent director can coach the CEO and help bridge the gap between the investor mindset and the operating mindset.

3. The open secret in the tech start up world is how spread thin VC’s are. For most of the past decade, we’ve been in this prolonged era of low interest rates which resulted in many investment firms raising mountains of capital and disbursing it with less diligence and more haste. Nowadays, it's not unusual for a venture capitalist to be on 12 or more boards. That’s crazy.

As an entrepreneur, an interesting question to ask a potential investor board member is how many boards they are on. After all, time is really the only hard constraint they have in a low interest rate environment. This is why some funds will just write checks without taking a board seat. So upfront diligence becomes more cursory and post investment governance is a distant afterthought. It takes too much time.

I was a former VC and can say there's a lot of great VC’s out there but I think there's a lot of bad practices as well. An independent director can help do the in-the-weeds work that a VC simply doesn’t have time for due to their other commitments.

4. Lastly, financial investor board directors have a built-in conflict of interest. I don't want to overstate this, but investors are money managers, employees or general partners of an investment fund that is managing money for their LP’s. So that's one duty they have. They are typically investing in preferred stock in the company, which is a different class of stock than the common stock that founders or management team or even the independent board directors have (editor’s note: for a full detail on preferred vs. common stock, see this prior edition of Above Board).

To illustrate the point: 2023 was a tough year for startup financing and a lot of companies ran out of money and had to do so-called “internal rounds” where they're raising from one of the existing investors who holds a board seat. What are fair terms for the investment?

Internal rounds are oftentimes punitive because the company has failed to raise capital from outside investors. The internal investors serve as last recourse for new capital. I'm sympathetic and think that's a very legitimate function. But, on the other hand, how do you write a term sheet if you're both on the board and you're the beneficiary of the new financial instrument being created. How big is that liquidation preference? (editor’s note: we covered liquidation preferences in this post of Above Board). What kind of pull through is there on other investors or management? When the preference stack builds, there's a potential and indeed real conflict of interest around questions like these.

Often a board will form a special committee of one person to ensure the fairness of this kind of interested party transaction. For example, the independent committee member may evaluate a deal and declare that even though the investor terms are aggressive, they are reasonable because the company conducted a bona fide process to raise capital and weren't able to. And so, given the circumstances, this is a reasonable transaction that's in the best interest of all the shareholders. I share that example because it shows how an independent director can benefit management, the company and the investors.

Moreover having an independent director with financial savvy who knows the capital markets will tend to curb any potential bad behavior of institutional investors when it comes to these sort of interested party transactions, which happen routinely with tech growth companies.

Thanks for reading. In our next edition we’ll be back with Mike to dive deeper into the topic of independent board directors. If you found this helpful, please consider sharing the newsletter with your colleagues/classmates/founder friends/portco’s/etc. And if you have feedback, please hit reply and send it over- would love to hear from you.