Board of Directors: Cultural Evolution

Page 1 Page 2

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

As a board evolves from in-house through insurgent to collaborative status its culture also evolves.¹ This process is driven by the new realities which the board must come to terms with.

During the in-house phase, board membership is largely ceremonial. Members are expected to do a great deal of listening and make modest contributions. Such a board is limited in its prerogatives – and often restricted to issues which management decides to ‘delegate’ to it.²

For the most part, in-house boards are expected to provide ‘rubber stamps’ for decisions which management has already made. Information supplied during this phase tends to be highly fragmented and focused on supporting management’s recommendations. Because the internal culture of the board is largely unformed, board members seldom have an alternative to complete acceptance of management’s recommendations. As members of an in-house aboard, most often, service is at the sufferance of the senior management team. This means that a board member may only have two options – go along or leave the board.³

Although board members can incur significant liabilities during this phase, the issue of personal exposure tends to be lightly considered. The board is often only a response to legal requirements. In some cases it might be formed to provide cover for management in the event that some significant problem arises.⁴ As a result, and this is particularly true for a venture backed company, directors may receive a nasty shock as unhappy creditors or investors include them as defendants in lawsuits over issues that they had little or not involvement with.⁵

Very often insurgent members will be fairly new to the board; often appointed as the very first outside directors. As a result they will not share, and sometimes will not accept, the dynamics which evolved during the early stages of corporate growth. The very presence of the first outside director almost guarantees that management will be challenged on one or more issues. Although insurgent board members are often urged to speak out – indeed, management may introduce such members with an expressed expectation that they will do precisely that – ‘stir things up a little’. But most of the time insurgent board members quickly realize that, although management has perceived that need for a more fully functioning board, they’re not really ready to accept the implications of that decision. As a result, the relationship between insurgent boards and management can to be rocky and focused on management’s response to board members, concerns. At this stage, management might still expect the board to operate as a ‘rubber stamp’ for its suggested strategies and tactics.⁶

Once a board becomes insurgent, the situation is much more complex. Board members – particularly outside directors – struggle to meet their responsibilities – to deliver on their fiduciary obligations to the shareholders. Their job is made more difficult by the emergence of a growing class of minority shareholders.⁷

In the first stages of insurgency, boards tend to be reactive to specific issues; principally issues which are closely related to their fiduciary obligations. Because new members do not buy into the status quo, they tend to focus on, and can aggressively question, the wisdom (and indeed often the legality) of certain management policies. In the more advanced stages, the insurgency may focus on questions which threaten closely held prerogatives of management. Insurgent directors may force the formation of board committees such as compensation, succession and finance. They can be principal advocates for strengthening the remit of these committees – most notably the succession committee. Their determination can often put them on a collision course with management.⁸

The culture of an insurgent board tends to be unsettled and often chaotic. Previously board culture had been driven by the reality that directors served at the sufferance of management. Much of that changes once the insurgency begins. As with all revolutions, things get chaotic before they have any chance to begin to settle in and become better organized.

Because insurgency boards are initially dominated by one or two proactive members, both the agenda and the culture of the board tend to be initially defined by their visions. During the early insurgency, the evolving culture may be dominated by personal agendas or specific ways of looking at a series of issues. These perspectives might not constitute best practices. Even though they probably will not survive the insurgency process, the early dominance and leadership of these members will go a long way to define the transitional culture and the chances of the revolution being successful.⁹

Much of the insurgent culture will be set as a result of confrontations with management over issues relating to board prerogatives, procedures and practices. As leadership evolves within the board it will be important that it cultivates and extends this process. Unlike senior management, which proposes then implements actions, the board reviews proposed actions against the standard of their obligation to protect and extend shareholder value. As a result, board members must inherently have a longer view.¹⁰

Insurgent board members tend to see their participation in an evolving, rather then static, light. Quite often the first outside board members are brought on because management or investors has felt the need to bring in ‘adult supervision’ or to augment the resources available to the company by expanding the board.

As reality begins to sink in, the insurgency may become more strident. At the breaking point, the struggle between the insurgent board members and the management team will resolve itself in one of two ways. If the management team prevails, the board will settle back into in-house status – possibly to mount an insurgency at some future date. If the board prevails, the door will now be slightly more open to the emergence of a collaborative board.¹¹

The rules of engagement of an insurgent board tend to be fragmented. But, as the board evolves towards the collaborative stage, they are often formalized into a set of written rules which guide the board’s deliberations. The emergence of a collaborative board requires two processes to successfully move in tandem. The first is the evolution of the rules of engagement and their formalization. The second is the adoption of these rules and their application by the board and its members.¹²

An example of this process came out of my experience with a client’s board.¹³ The company was bidding on a major contract which would significantly impact its future. Management presented the proposal during a board meeting. One of the board members, who had significant experience with the potential client, had two important reservations about the proposal. The first was that it was focused on what the management team thought the client needed rather than what the client seemed to be asking for. The second was that the proposal had been inadequately red-teamed. When it became clear that the CEO and his team had moved into defensive positions on the adequacy of the proposal, the Chairman of the Board suggested an executive session involving only board members – but none of the senior management team.

Once the CEO and his team had left the room, board members settled down to discuss the concerns of their colleague. The discussion was quite detailed because of the combined board member knowledge of this particular client. In this case, they had the advantage of several direct, personal relationships either within the client or within organizations that worked closely with it. Through a combination of discussions and teleconferences, the board was able to drill down and develop a very clear picture of the client’s expectations as well as the areas in which the proposal, as it was currently written, did not meet those expectations. Finally the board was able to develop recommendations for members of a more effective red-team – which would thoroughly vet the proposal.

When the Chairman invited the CEO and his team back in the room things were pretty tense. The management team had spent their time¹⁴ trying to figure out ways to counter the objections of the board member. But when they got back around the conference table they were in for a more pleasant experience than they had expected. The Chairman reviewed the work that the board had been doing in executive session and proposed that two of its members present their recommendations to management. The CEO had the good sense not to oppose the suggestion. As the board members began to lay out their research and findings – and detail their recommendations – I watched members of the management team begin to take notes and listen intently. By the time the presentation was completed the CEO clearly appreciated the significance of the board’s contribution. The recommendations, including the recommended membership for the red-team, were accepted on the spot.

There was an additional significance to these events. As a result of this experience, management more fully appreciated the contributions that the board could make. They also became aware that the combined experience and contacts of the board were far more valuable than they had previously thought. They became aware that the board had saved them from a significant embarrassment – from botching a proposal for a major contract – from embarrassing themselves and the company in front of a potentially very significant client.

Management also became more sharply aware of the board’s potential contributions in the area of population and management of red-teams. Whereas, in the past, management had selected red-team members that they were comfortable with, now they were prepared to follow the recommendations of the board and except participants with a more adversarial or ‘devil’s advocate’ perspective.

Page 1 Page 2

1. It is worth noting here that there is a class of corporations that never make the journey from adolescence to maturity. Many of these companies will achieve a stability which avoids the professionalization of the board of directors or, for that matter, the corporate culture. Quite a few of these companies achieve modest success – meaning that their gross revenues might rise to the 100 million to 300 million dollar level. There’s nothing wrong with this strategy or results. Given the right CEOs, it is a result to be expected and honored.
2. This attitude betrays a self-serving misunderstanding of the appropriate role of a board of directors and the tension that should naturally exist between it and the management team.
3. A friend told me of an experience that he had while serving on a board. He described it this way, “I got to feeling like a cultivated mushroom. Mostly they kept me in the dark and the only time that I saw any light was when they opened the door to throw in another load of crap (sic).”
4. In conversations with founders of start-up companies I’ve often heard “we have a board because our lawyer told us we need one.” I have encountered management which attempted to transfer accumulated liabilities to the board in an attempt to escape their own fate as failed management. The resulting lawsuits were not pretty.
5. There is a particularly nasty variation on this example – I have talked to representatives of venture funds – venture partners – who have been successfully sued because their agenda – to protect and extend the interests of their institutional investors – conflicted with the interests of the shareholders of the company on whose board they insisted on having a seat.
6. The longer serving board members tend to be complicit. Their experience and relationships with the management team leads them to try to defend the status quo against the insurgency fomented by the new class of directors. These battles can often become highly personal and lead to some truly tumultuous board meetings. I’ve not found a way around this experience. It is simply a necessary, if uncomfortable, part of the process.
7. As an example, the interests of these shareholders can sharply diverge from those of a management team which may be focused on current compensation at the expense of retained earnings. This class includes holders of options and warrants – often the source of he first shareholder challenges to management.
8. I have used the attitude towards a role and function of the board of directors as a screen for CEOs. CEOs who believe that the prerogatives of a board should be severely limited and the board members sit in order to certify management decisions and provide legal cover, tend to do better in smaller companies – usually companies that have yet to witness the formation of an insurgent board. I once had such a CEO tell me that the entire concept of a collaborative board was ‘Pollyannaish’. This comment told me more about the person and their understanding of corporate governance than about the possibility that a board of directors could establish a collaborative relationship with a senior management team.
9. Remember that an insurgent board is a half-way house between the in-house and collaborative stages. All revolutions need to either eventually settle into a new, fairly stable dynamic or return to the old one – revolution is simply too costly to become the norm.
10. One result of this failure has been the dominance of relatively short term perspectives and management compensation packages which have been based on short term metrics. Shareholders have suffered because of this dereliction of duty. One of the principle functions of the board of directors is to insist on a longer, strategic view and to protect shareholder interests against a management team’s tendency to rig compensation to their own benefits and at the expense of shareholders.
11. See my article Battle at the Cottage Gate, published in Amazing Pace: Turbo-Charged Business Development, PublishAmerica, 2007
12. This process also requires the acceptance of these rules by management before the board can become truly collaborative.
13. I had augmented this particular board. When the engagement started, there was only one outside director on the board. By the time the following events took place the board had a majority of outside directors and the CEO had ceded the title of Chairman of the Board to one of them.
14. In this case, close to two hours