VC Board Management Best Practices: 5 Early Warning Signs of Trouble

imagesStartups, the engine of American innovation and an important source of job growth nationally, took a severe beating in 2009 because so few were funded by the venture community. While the freedom to fail remains a given among emerging companies, a creeping risk aversion among investors inhibiting new capital formation for long-term, illiquid investments threatens an entire generation of American entrepreneurs.

This should be particularly unnerving to our elected representatives because strong startups have proven their ability to grow rapidly and produce jobs, particularly if they go public. Public companies such as Google, Cisco and Intel, all initially venture-backed, today represent 17 percent of U.S. gross domestic product and have created a total of more than 12 million good jobs. The most important startup centers are Silicon Valley, metropolitan Boston, Seattle and Austin and, increasingly, northern Virginia.

Many venture capitalists and other capital markets experts believe that 2010 will be a better year for achieving IPO liquidity because a number of well established companies that remain private have reached sufficient scale to attract much-needed public equity funding. But this is a small minority of the venture-backed universe, and the majority of fledgling technology companies continue to face existential challenges. A significant but largely unheralded problem for many is that they are managed poorly at the highest levels, and this lack of stewardship can lead to a company’s demise.

images-1About two-thirds of CEOs who initially take the top job at a startup are eventually replaced, but many venture capitalists approach the likelihood of management change as an afterthought, even though driving an orderly process for management succession represents the venture capitalist’s most important role as a corporate director. Much of the explanation for this surprisingly common problem can be traced to misaligned interests between the board and the CEO, a situationthat is only aggravated by stressful economic times.

While most startups experience CEO change as they evolve into a self-sustaining company, venture capitalists who sidestep the process associated with this managing reality set the stage for operational turmoil and key personnel defections.

images-2I believe venture capitalists and CEOs must put their differences aside so that these startups can survive and ultimately thrive. Among the reasons for the differences of approach to managing CEO change among venture investors is that early-stage players often forge a strong personal, as well as business relationship, with the CEO. This relationship is often absent among later-round venture investors. And the issue of equity dilution, always high on the CEO’s agenda, often clashes with the agenda of all venture backers. Things get even hotter when a startup fails to meet projections, requiring more capital than originally anticipated, an all-too-common scenario today.

Many founders find it particularly galling to be found wanting in their management skills at precisely the time that their fledgling companies experience rapid revenue growth and markedly improved performance. The sweat they have poured into the research and development phase is the foundation for the company’s budding success. Many founding executives view the situation as one of betrayal by their venture backers, sparking the collateral damage mentioned above.

Much can be accomplished to mitigate these stresses if startup boards and CEOs become more transparent and put sound management strategies into place.

It isn’t particularly difficult to turn this situation around. Venture capitalists need to take a proactive approach and manage toward the reasonable expectation of CEO change from day one. This means engaging CEOs in a frank discussion of their strengths and weaknesses, constantly assessing CEO performance, and forging a relationship with the CEO-founder that can transcend a management change. This creates a win-win for both parties. The outcome could be a new role for the founder, preserving his ability to make a productive contribution to the company.

Venture capitalists also must stop ignoring clear early-warning signs that the time has come to replace the CEO.

Here are five common early warning signs of trouble in the corner office:

  • A CEO does not react constructively to board member suggestions, is increasingly inflexible in considering strategic board changes, or stubbornly clings to a plan that is not working.
  • Significant company problems are obvious but the CEO goes into denial, sometimes by seeking seats on outside boards, scheduling frequent vacations, or getting involved in political, community or charitable endeavors. A CEO often missing-in-action because of these activities has usually lost the requisite “fire in the belly” that a venture-backed startup CEO needs.
  • The CEO cuts off the flow of information to the board and typically initiates few calls to board members. Typically, every director should hear from a CEO in advance of board meetings, as well as once or twice a month to celebrate good news, discuss a setback, or simply discuss a basic management issue.
  • A CEO increasingly pleads ignorance of a problem, complaining that other executives did not keep him informed. But the CEO doesn’t present a clear case and a plan to remedy the situation or tries to toss problems back in the board’s lap.
  • A CEO starts referring inquiries from board members to other executives as a loyalty test, putting out the word that no executive is to communicate with a board member without first getting approval from him. It’s a red flag when subordinate executives give board members scripted, vague answers in response to questions.

Venture capitalists and other members of startup boards must become much more involved in their assessment of the company’s long-range strategy. To do this, they have to first learn to work better together through more frequent communication, both in and out of the boardroom. They must master the art of compromise in the boardroom and focus on the real goal – maximizing the odds of success of their startups. This is imperative for America as startups and venture capitalists begin a new and pivotal year.

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4 Responses to “VC Board Management Best Practices: 5 Early Warning Signs of Trouble”

  1. Nathan Beckord Says:

    Interesting post. "Fear of being fired" has got to be among the top concerns of startup founders, probably just behind "fear of running out of money" and perhaps just ahead of "Google just entered my market."

    It sounds like the main takeaway is the importance of frequent, candid communication and transparency. Here's a question, though: if it's clear a founding CEO has reached his or her limit in growing the company, how often do VCs try to arrange a new role so he/she can stay involved? (e.g. 'chief evangelist' or 'strategy' or something). Also, any tips for CEOs to pre-emptively tee this up?

    One more q: of the two-thirds of founding CEOs that are eventually replaced, what is the most common company stage or funding round that it happens? (this would be helpful to understand to help set expectations)

    thanks, Nathan Beckord

  2. pascallev Says:

    Thanks for your comment. In my experience we have moved founders into successful positions as Chief Technology Officer, President of International Sales, and Executive Vice President Corporate Development. These have been "real" positions as opposed to just placeholders. In one case we allowed a founding CEO who was truly the Chief Evangelist for the company to establish an independent sales organization and receive premium commissions for closing business– a strategy which proved to be extremely successful. The key is pre-emptive communication– from both sides. It is critical to have conversations that lead to self awareness of the founder's limitations and to mutual recognition between the board and the founder that an end-game is in sight, even though it may be several years away. To answer your last question, the most common stage at which this occurs is during the transition from product development to accelerated revenue growth. Some CEO's can take a company through R&D but can't deal with customer-facing requirements because they are internally focused as opposed to customer driven. Others can take a company from $1 million to $10 million in revenue but can't manage a team of 50 or 100 people. Nowadays, there is no clear financing round associated with these milestones– it could be a series B or a Series AA.

  3. Paul Gomory Says:

    I have done many "replace-the-founder" CEO searches over the years. Your emphasis on communication is key here (as in all our relationships in life) – but the Venture Capitalist must also be a communicator. VC's who are over-committed with board seats and new-deal chasing are not going to proactively initiate calls to founder/CEO's who have "gone silent." And they aren't going to return my phone calls and be immediately available to interview high-value (and therefore short-fused) candidates in a timely and responsive manner.

    A CEO search should NOT begin until the founder/CEO TRULY is on board 98% with being replaced. [Founders rarely get to 100%.] The tactic of "let's get a recruiter working, see some candidates, and then the Founder will come around to it once he/she sees great candidates" only prolongs the search, and most importantly it is a colossal waste of those first few good candidates: Nothing scares off top-tier candidates (who always have other options) than Founder/Board friction, and sensing that the Founder will a problem going forward. If the change is to be made, Founder needs to be on board with it, or gone. Paul Gomory

  4. pascallev Says:

    Thanks for your comment. You accurately point to an occupational hazard when dealing with VC's who are over-committed– but the it is the fiduciary duty of a director to exercise oversight in their role on the board. VC's who are not responsive or proactive need to be reminded of this by the board chairman or lead investor. The consequences of passive or passive-aggressive behavior by VC board members who want to avoid the responsibilities associated with a founder replacement can be severe, and it starts with losing money on their investment.

    To your second point, I agree that Founders need to be on board with the replacement process or else they must be gone. The nuance, which I am sure you see often, is that some founders may say they are on board but actually they are not, and the downside is that they may work to undermine the process. I've unfortunately lived through that experience once. The impact to the company was severely negative as windows of opportunity vanished because the outgoing founder was not truthful with the rest of the board and poisoned the well for competent replacements to come on board until the company had run out of runway and the viable candidates disappeared.

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