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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