Dr. Earl R. Smith II

Dr. Earl R. Smith II
Managing Partner, The Federal Circle
DrSmith@Dr-Smith.com
Dr-Smith.com

Quite often my engagements begin with an invitation from the Chief Executive Officer to ‘take a look at the company and suggest improvements’. One of the most common initial tasks is to evaluate the structure, operations and productivity of an existing Board of Directors. In most situations, the company has successfully exited the early stage and is now focusing on expanding its business base and improving its governance practices.

In early stage companies this Board is often made up almost completely of insiders. By the time the company has grown to four or five million dollars in run rate, the CEO may have begun to realize the need to bring in experienced talent to help with the issues of corporate governance. In many cases they also have begun to use the Board as a place to park individuals who can help with business development. As I will point out later, this decision can have potentially disastrous consequences.

The Board of Directors is part of the legal structure of a company and the rules governing its operations, prescribing its prerogatives and defining its obligations are part of well established corporate law. Properly run, it serves as an oversight of senior management and carries the primary responsibility of protection and expansion of shareholder value. The Board is the representative of the shareholders in direct contact with, and supervision of, senior management.

In early stage companies the group of shareholders and the senior management tends to be roughly the same. This leads to the illusion that the senior management is looking out for its interests as shareholders and doesn’t need an intermediary oversight. But nothing could be further from the truth. This strategy of avoiding oversight is the rough equivalent of parachuting without a parachute. It might be fulfilling for a while but the end will be ugly. A well structured and managed Board of Directors can supply not only effective guidance in corporate governance but also a critical longer view of the evolution of the company.

My experience has been that senior teams running early stage companies are so engaged in the day to day struggle to drive the run rate and improve margins that issues of corporate governance with an eye towards preserving and increasing shareholder value are poorly served or overlooked all together. Many times the results are poorly structured client bases, grossly inefficient operating procedures, completely inadequate financial controls and reporting systems, an inefficient financing strategy and an equity structure which looks bizarre in the clear light of day. In any case, shareholder value tends to suffer.

Properly structured, the Board of Directors should be dominated by a clear majority of truly independent outsiders. Those outsiders should bring skill sets that are important in oversight of key governance issues. Board Members should be in regular contact with the appropriate members of the senior team and have access to all aspects of the company’s operations, record keeping and strategic planning process.

In companies where the shareholders and senior management team are roughly coincident, special arrangements are often advisable which will allow the Board of Directors to operate effectively without an ever-present threat of dismissal in the event that they find serious problems with the way management is conducting the company’s business. When properly addressed, this approach can protect the company against the kinds of CEO arrogance that recent history has provided so many examples of or a team’s tendency to take their eyes off the ball and follow distractions which are not in the company’s best interests. In short, the Board of Directors needs to be both independent and secure in its position in order to operate effectively.

Board service should be based on a fair compensation plan which includes an adequate but modest annual retainer, a small honorarium for meeting attendance, a provision for reimbursement of expenses and an appropriate provision for long-term service resulting in some equity interest. The maxim here is that you get what you pay for assuming; that, of course, you choose prudently what you decide to pay for. Most individuals of substance will not assume the liabilities of Board service with a small company in exchange for a pittance for meeting attendance or an equity position of questionable value. The liabilities they incur, particularly without adequate D&O insurance, could be substantial multiples of the compensation received.

The quid pro quo for this compensation should be a clearly defined set of metrics by which Board performance, and individual Board member contributions, are to be measured. This requires a clearly stated operating procedure and a carefully negotiated understanding with each Board member. From my experience, neither of these typically receives adequate focus. For the most part, these understandings are best reached at the launch of the Board and with the help of an external source of experience in the organization, operation and management of Boards.

A final word seems appropriate on the issue of Board compensation. It is absolutely crucial that no part of the compensation scheme for a member of the Board of Directors puts them in a position where their own interests conflict with their fiduciary obligations to the shareholders. This rule is most frequently violated when individuals, whose principal contributions are in the area of business development and whose compensation depends on the volume of business brought in as a result of their efforts, are placed on a Board of Directors. This situation places the individual in a completely untenable position. Their compensation depends on a reduction of shareholder value to the extent that it is drawn directly from the revenue stream. A minority shareholder, owner of a single share, could bring a company down based upon this obvious conflict of interest. Both management and the individuals involved could find themselves in court with an essentially un-winnable position. The sad part of this story is that there are easy ways around this dilemma. But that is a subject of a future column.

© Dr. Earl R. Smith II

Related Articles:

• The Conflict that Keeps on Giving
• Good Governance – Talent and Compensation
• Board Governance – Searching for Leadership
• Characteristics of a Task Oriented Director
• New Board Member Selection

Dr. Smith is Managing Partner of The Federal Circle. The Federal Circle partners with teams and existing companies. We help them up their game and win big in the Federal space. We also arrange funding for acquisitions and expansion by acquisition. Our model is based on the belief that, if you select the very best and work with them in a highly professional and focused manner, the results will be truly amazing. He is the author of Amazing Pace: Turbo-charged Business Development – a book that shows how Advisory Boards can dramatically increase revenue. Dr. Smith is also the author of Dream Walk: Parables for the Living – a book of Raven Tales and exploration.

This entry was posted on Tuesday, August 12th, 2008 at 9:56 PM and is filed under Governance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.