Dr. Earl R. Smith II

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

One of the greatest pleasures in writing these columns has been the e-mails I receive. After each new one, two to four dozen of you take the time to let me know what you think about what I’ve written, to relate experiences or to let me know how what I’ve written has proven useful. I have been amazed and honored by how universally positive the comments have been and by your willingness to share your experiences. You’re eagerness to engage in extended discussions about the columns is a warming experience. Such responses are the greatest gift that a writer can receive. For that, I thank you.

Much of what I receive is so insightful that I’ve decided to occasionally devote a column to discussing reader responses. For this column, I am going to draw on a number which focused on issues of Boards and corporate governance. I’ll put each issue forward in the form of a challenge that a CEO might face. In each case I’m going to describe the context of the response, excerpt from the e-mails and then ask you what you would do you if faced with such a challenge. I’ll summarize the responses and give you my proscription in a later column.

The e-mails were in response to statements that I made regarding prudence and risk. I wrote that a sitting Director who had an incentivized agreement for successful business development as part of their compensation package was in an untenable position. Their own self interest conflicted with their fiduciary relationship with the shareholders. George wrote as follows:

“If a board member brings in a deal to the company with a net worth $100 and takes 20% of the deal. Are not the stock holders $80 ahead in the game; all shares have increased in value – including the minority shareholders. Why does it matter that $20 went to the board member (assuming all is above board – no pun intended) – the same 20% could have gone to the expense line paying an inside sales person under their comp plan if they brought in the same deal?”

So put on your CEO hat. This issue has come up in a discussion with your senior team as a direct result of a request by a Board member for such an arrangement. You need to decide. What do you see as the principal risks, if any? How serious are they? How do you balance the interests of the Director, the Board, the shareholders, your team … and manage to stay away from major exposure. What actions would you take to mitigate the risks? How do you keep yourself and the Director from being the target of a minority shareholder lawsuit for conflict of interests?

The second issue came up in several e-mails and was explored in length during a Northern Virginia Technology Council event. I was on a panel that was focused on Boards; their management and function. Prior to the event I had received a number of e-mails relating to the practice of having representatives of venture capital investors serve on Boards of Directors. These e-mails were in response to my statement that no Director could honor their fiduciary obligation to shareholders if they were primarily pursuing an agenda which could either limit or diminish shareholder value. Other e-mails had focused on provisions in term sheets and were in response to my position that a CEO is on shaky ground if he enters into any agreement which inherently limits shareholder value.

Thanks to Dave, Don and a pair of Johns for framing this issue and particular thanks to Bryan, a fellow panel member and CEO, for discussing the situation in such an open and forthcoming manner. Here’s what you, as a CEO, find yourself facing:

You have been negotiating for funding for some time now. You have finally received a term sheet. But, once you start to read it, two issues jump up. The fund is insisting that one of their partners sit on your Board of Directors. They are also insisting that, since their representative cannot be paid for Board service, no one on the Board shall be compensated in any way for their service.

The first problem you see centers around the nature of the obligations that a Director assumes. Clearly, the representative of the fund will be protecting and extending the value of the investors position (a position which, by the way, frequently does not involve ownership of common shares) rather than the interests of the common shareholders as a group. The argument that the interests are coincident seems to pale when you reflect that the fund’s interest is relatively short term while you and your shareholders are in it for the long haul.

Your second problem centers around the possibility that you might, in order to get funding, severely restrict your company’s ability to build an effective Board of Directors. Most individuals of substance require both compensation and adequate insurance protection before agreeing to serve on a board. But this term sheet prohibits such arrangements. In a paranoid moment you consider the possibility that the hidden agenda of the fund is to maintain a balance of power by excluding any such professionals, but you leave that issue for another day and time.

So put on your CEO (and, this time, also your shareholder’s) hat again. How do you assess the risks of putting a person on your Board of Directors that may pursue an agenda which directly contradicts their fiduciary relationship to the shareholders? How would you react, as a shareholder, to the presence of such a member? What do you do about it? How do you respond to the limits on compensation? How do you respond to the term sheet? What would you be prepared (and just as importantly, not be prepared) to agree to in negotiations with the fund? It’s your company, how would you respond?

Both of these situations are ‘real life’ dilemmas that CEOs might face. In some ways they are tests of character. In others, they are tests of knowledge of the law and a complex set of regulations. Fundamentally they are tests of your experience, prudence and ability to see complex issues clearly … and to find solutions that open up possibilities while managing risks.

What would you do?

© Dr. Earl R. Smith II

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Related Articles:

• Officer and Director Vetting

• Non-Profit Board Member Selection – Excellence Breeds Excellence

• The CEO’s role in board member selection

• Determining Board Compensation Structure

• Good Governance – Balancing Eight Key Factors

• Board Compensation – Cash versus Equity

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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 11:37 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.