Archive for the ‘Corporate Governance’ Category

Governance Models That Don’t Scale: The World According to Charles T. Munger and Jean Jacques Rousseau

JJRMungerCan you name five benign dictators who have ruled successfully for any meaningful period of time (non-fiction)? Can you name five successful, long serving CEO’s (excluding Warren Buffett) whose governance histories are free of the “high-beta” associated with outliers such as Larry Ellison and Steve Jobs?

It’s not easy. Why? Because enlightened dictators and their corporate CEO equivalents are very, very rare; maintaining immunity to the intoxicating effects of power challenges basic human nature.

It is in this context that I found “Corporate Governance According to Charles T. Munger”, a brief article from the Stanford Closer Look Series, thought provoking if not practical. The article was written by David Larker, Director of the Corporate Governance Research Program at the Stanford Graduate School of business, and Brian Tayan, a researcher with Stanford’s Corporate Governance Research Program.

The authors summarize and explain Berkshire Hathaway Vice Chairman Charles T. Munger’s unorthodox view of a model for corporate governance.    According to the article, Munger believes that corporations and their boards should empower their CEO’s more, not less. Munger’s effective CEO, modeled, of course, on Warren Buffet, should be unencumbered by rigid process and freed of unnecessary, excessive checks and balances. Why? So that the CEO can lead effectively. How? In Munger’s construct, CEO’s police themselves, holding themselves accountable to their loosely overseeing directors by binding themselves to a trust based system. And corporate directors should reward these CEO’s for creating shareholder value, while deliberately underpaying them in terms of their annual salary-based cash compensation. According to Munger, and as quoted in the article:

“Good character is very efficient. If you can trust people, your system can be way simpler. There’s enormous efficiency in good character and dis-efficiency in bad character … We want very good leaders who have a lot of power, and we want to delegate a lot of power to those leaders…The highest form that civilization can reach is a seamless web of deserved trust—not much procedure, just totally reliable people correctly trusting one another.”

I agree with Mr. Munger completely, while asking the same questions raised by the authors at the end of this article:

“The trust-based systems that Munger refers to tend to be founder-led organizations. How much of their success is attributed to the managerial and leadership ability of the founder, and how much to the culture that he or she has created? Can these be separated? How can such a company ensure that the culture will continue after the founder’s eventual succession?”

Unfortunately, and founders notwithstanding, the collective global capitalist experience since private property rights were invented and enforced has shown that there aren’t enough of those people on this planet.

kozlowskimug1For a specific cautionary example, I am reminded of Tyco International and its former CEO, Dennis Kozlowski. Kozlowski was recently paroled, almost twelve years after his indictment, ultimate conviction, and after serving over eight years in Attica, for a $134 million corporate fraud (this amount represents a small fraction of the losses suffered by public shareholders). The disgraced former directors of Tyco International (vintage 1999), seemingly highly trustworthy and accomplished men and women, also come to mind. This group, along with the enterprise builders at Enron, Worldcom, and Adelphia, to name just a few, are at the top of my list of examples of poor corporate stewardship and help explain why Mr. Munger’s model for corporate governance is still-born.

But I did say the article was thought provoking, as Charles Munger’s corporate governance philosophy, in my view, evokes Jean Jacques Rousseau’s concept of the Lawgiver.  Author Alex Scott summarizes Rousseau’s core thesis from the Social contract succinctly in this excerpt from his book, The Conditions of Knowledge: Reviews of 100 Great Works of Philosophy :

“The general will always desires the common good, says Rousseau, but it may not always choose correctly between what is advantageous or disadvantageous for promoting social harmony and cooperation, because it may be influenced by particular groups of individuals who are concerned with promoting their own private interests. Thus, the general will may need to be guided by the judgment of an individual who is concerned only with the public interest and who can explain to the body politic how to promote justice and equal citizenship. This individual is the “lawgiver” (le législateur). The lawgiver is guided by sublime reason and by a concern for the common good, and he is an individual whose enlightened judgment can determine the principles of justice and utility which are best suited to society.”

I agree! Let’s find that individual and give him (or her) the keys to the public policy car! Munger’s corporate lawgiver, the enlightened CEO, is also an admirable model worth aspiring to emulate.

As with Rousseau’s 1762 treatise, history has sadly shown us that we lack sufficient incorruptible raw material across the entire history of mankind to render the “lawgiver” experiment successfully scalable, be it in public government or corporate governance.

The unbridled exercise of power is the ultimate intoxicant, and very few humans can responsibly limit the flow of that drug, especially not when they have are given the opportunity to administer it to themselves.

 

 

Pascal Levensohn in New York November 8: Speech at Museum of American Finance on Risks to Angel Investors

MoAF_GREEN_GREY300I first visited the Museum of American Finance a couple of years ago, and it is not only a great space,it is a useful resource for visitors interested in a wide range of current exhibits on current capital markets topics, as well as documents and artifacts related to capital markets, money and banking. The collection includes stocks, bonds, currency, checks, prints, engravings, photographs, objects and books. The Museum has an extensive collection of stock and bond certificates from the Gilded Age, from companies that include US Steel, Standard Oil and the New York Central Railroad.

But I am coming to the Museum to talk about the leading of edge of startup financing in the digital age and about real time investment risk management in the new Wild West– crowd-funded Silicon Valley post the lifting of the ban on General Solicitation. While new entities and forums are sprouting daily to facilitate aspiring venture investors to fund new ventures with as little as $2,500, the investing risks are no different than they were during the time of the iconic entrepreneur Andrew Carnegie.  And, to be clear, the risks of failure then and now remain very, very high.

My talk on November 8 is about some of the immutable laws of risk in startups. While you can package optimism in many different wrappers, in my view it is essential, especially for unsophisticated accredited investors, to understand critical concepts such as equity dilution from follow on rounds. And most important, they need to have some due diligence process in place before they writ the first check, as well as a similar re-evaluation process whenever they are called upon to fund a follow-on round.

I look forward to a lively discussion on November 8 at 12:30 PM.

New Video: Key Startup Investing Risks for Friends, Family, and Angel Investors

Establishing a mutual understanding between investors and entrepreneurs as to what each expects from the other is essential to a harmonious beginning for a new venture.

The future is likely to be challenging;  if entrepreneurs expect to be able to count on additional support from their friends, family, and Angel investors, several key risks that must be addressed in advance.  This video focuses on four of those fundamental risks:

(1) A startup’s high probability of failure;

(2) The mathematics of dilution;

(3) The tendency to misunderstand a company’s stage of development and, therefore, its capital needs;

(4) Understanding the risks associated with investing good money after bad and knowing when to call it quits.

Some important statistics:

In 2012, the average amount of seed or angel capital raised per company was $880,000 (Source: Pitchbook)

61% of seed-funded companies will not be able to obtain follow-on funding (Source: CB Insights)

Those seedlings that won’t find capital will be the victims of the so-called Series A Crunch

While seed investments increased by 64% in 2012, Series A investments declined by 2%. This defines a supply/demand imbalance exists between institutional VC capital and the ‘Seed Crowd’ .

It is a tribute to America’s innovation culture that, while most startups fail, we are currently experiencing such a boom in seed financing in the United States. Institutional venture capital is not increasing; on the contrary, the industry continues to consolidate by firm and is declining in total.

Being aware of the risks inherent to startup investing and having a clear understanding of the basic parameters of dilution mathematics should be helpful to investors and entrepreneurs alike.  If you are an entrepreneur, this video may be very helpful to you so that you can explain these risks to your investors.  If you are an investor in very early stage companies, this video provides useful perspective on risk and portfolio management.

This video is Chapter 2 of the Entrepreneur Essentials Video Series.

Introducing the Entrepreneur Essentials Video Series

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I’ve written about board governance challenges for startups since 1999, publishing one book, a series of three white papers, and many articles and blog posts on this topic. Because I am both a venture capitalist and a technology entrepreneur, I understand the different perspectives of entrepreneurs and investors from both sides of the boardroom table.

With this new video series, I updated and expanded fourteen years of collaborative work and have structured the content to focus on the entrepreneur’s perspective. The first video will be released on September 5.

Stay tuned for

Chapter 1      Board Dysfunction: Root Causes and Solutions

Chapter 2      Managing Risks in A Startup: Four Key Issues

Chapter 3      10 Things You Need to Know About VC’s (Before You Meet Them)

I intend to help management teams get much more of the flavor of the issues they will undoubtedly face as directors of startups.

Chapter 1, Board Dysfunction: Root Causes and Solutions, updates the material I have developed with other experienced investors and entrepreneurs, emphasizing the challenges that entrepreneurs face.

In these videos, I don’t just ask difficult questions, I answer them.

To learn more, go to my Facebook fan page Entrepreneur Essentials

Liquidity for Venture Backed Companies Still Comes Largely in One Flavor—Cash Acquisitions

Denis Dougherty of Intersouth Partners was recently interviewed by Brian Gormley of The Wall Street Journal on the decade-long liquidity crisis that continues to plague the venture capital industry. Responding to the question “What do you see as the biggest investment opportunity for venture capital in 2013?”, Dougherty said, “If we have a broadly rebounding economy, the big corporations would begin to buy products and programs that they want to have, not just the ones that they have to have. Venture capitalists that have an inventory of acquisition-ready companies will do well.”

I agree with Dennis. My concern, based on my direct experience negotiating half a dozen acquisitions sine 2008 (three in 2012), both inside and outside of technology, is that the negotiating environment for such ‘acquisition-ready’ companies is fraught with challenge from the seller’s perspective.

Recent reports reveal that mergers and acquisitions still account for over 90% of liquidity events for venture-backed companies in 2012, a lamentable condition that has plagued the US innovation ecosystem for close to a decade. In my view, many acquisitions of emerging growth companies often lead to the burial of promising technologies by incumbents more focused on protecting market share than on delivering the best product or service to their customers… (think Linksys, Flip…)

It is critical to know the state of the art in merger terms leading to an acquisition and in post-merger covenants, particularly with respect to the release of cash consideration held in escrow or as a holdback by the buyer.

Shareholder Representative Services (SRS) has produced another excellent report that investors and management teams should scrutinize very carefully before engaging in merger negotiations.

I have one general comment to make about the SRS report before reviewing its key findings:

In any negotiation, just because the average term is X, you should not abdicate your responsibility to improve your position and negotiate to get a better outcome for yourself.  You may consider some terms to be acceptable in the agreement because your lawyers tell you “it’s the market” in the heat of battle.  That might be OK, but it also might be a rock that will not always be floating above your head…

Old Rag copy


Because the current world of venture-backed exits remains dramatically and asymmetrically skewed to the advantage of the acquirer, the aggregate statistics in the SRS report reveal a landscape pockmarked by buyer-friendly terms. Challenge yourself to do better as a seller!  More on this topic to follow…

I’m Back!

DSCN2594After a one-year hiatus, I am back.  Stay tuned for new posts on venture capital, corporate governance trends, and current public policy issues that impact investors and entrepreneurs. I have also done a lot of hiking throughout America and Europe in the last year and will share highlights from my hiking experiences as a new topic.

Over the past year I’ve made meaningful personal and professional changes. Today I am healthier, happier, and more energized than ever. I look forward to sharing my thoughts with readers and welcome all constructive comments.

How Have the Demographics of Public Corporate Boards Changed Over the Past 25 Years?

Spencer Stuart recently previewed their annual public board governance analysis in the November 2011 Harvard Business Review, comparing board demographics in 1987 and 2011.  Some highlights and my thoughts on the implications:

Directors are older:  boards whose average director age is 64 or older:  1987, 3%; 2011 37% .  This may have as much to do with director liability issues as it does with the increased oversight responsibilities associated with being a public company director.  It takes more time to be a public company director– more formal meetings, more preparation, and more informal consultation.  Older directors have more time and also have the flexibility to accept the liability risks as their other corporate responsibilities diminish.

Director compensation is up: average board retainer plus meeting fees per director: 1987: $36,667; 2011 $95,262. The 1987 figure equates to $69,428 in 2010 inflation- adjusted dollars, or a real increase in director compensation of 38%.

*Smaller is better: public company boards with 12 or fewer members: 1987: 22%; 2011 83%. In my view, this is one of the most positive trends among public boards, as smaller groups generally work together more cohesively than larger groups and larger boards are most often dominated by smaller groups within them– sometimes formally, most times de facto.

More independent directors: the independence rules have become more clearly defined, with Sarbanes Oxley’s passage in ’02 driving the trend.  1987:68%; 2011: 84%.  Having more independent directors, however, does not necessarily correlate to having a more effective board– let’s not forget models of director independence, such as Tyco and Enron, that were emblematic of poor board governance.

Still dominated by white males: in 2011, 9% of boards have no female directrs, 16.2% of corporate directors are women, and 15.3% of directors at the top 200 companies are African-american, Hispanic, or Asian.

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New Book by Professor Mannie Manhong Liu and Pascal Levensohn– Venture Capital: Theory and Practice, published by the University of International Business and Economics Press, Beijing

I never expected to have my first book published in China, much less in Mandarin, but that goes to show how much the world continues to change.  My contributions to this undergraduate textbook, Venture Capital: Theory & Practice, are the result of two important collaborations.  First, the body of collaborative work on corporate governance best practices that I have developed since 1999 with other venture capitalists and professional service providers to the venture industry; and, second, the direct collaboration on venture capital that resulted from meeting Professor Mannie Manhong Liu in the summer of 2007 at the  Symposium on Building the Financial System of the 21st Century between China and the US, sponsored by the Harvard Law School together with the CDRF (China Development Research Foundation) and PIFS (the Program on International Financial Systems).

Venture Capital started in China in 1985, when the first government-sponsored venture capital firm was established. The industry built slowly until a few years into the new century. In 2006, China’s total venture capital investment reached $1.78 B, becoming number two globally, next to the US; the US venture capital investment was $25.6B that year, accounting for 67.9% of the world total ($37.7b).  While China was far behind, accounting for about 4.7% of the total, nevertheless, China became number two and has kept that status ever since.

Venture Capital is a popular buzzword in China. Renmin University was among the first universities to create a venture capital major in the School of Finance and teach venture capital for undergraduates.  In recent years, many universities have followed, teaching venture capital as an elective course. In October 2010, our new textbook will become available.

Mannie and I share a strong interest in research in the field of venture capital and private equity. Mannie was working for Professor Josh Lerner at Harvard Business School before she returned to China to teach these subjects. The backbone for my contribution to our effort is the best practices work “for practitioners by practitioners” that I have developed in the area of venture capital through the multiple articles and three white papers that I’ve written.

Mannie was invited by a publisher in Beijing to write a textbook for undergraduate students in China; she in turn invited me to join her as the book’s co-author. Writing the book was a very intensive task, and both of us have worked on it for many months, with Mannie and her team translating my work and both of us discussing the context of the content for the Chinese audience.

Venture Capital: Theory and Practice, is in Chinese and is categorized as one of  “China’s National College Major Investment Textbook Series for the ‘Twelfth Five-Year Plan.’” The book has three parts and a total of 12 chapters. The Theory includes chapters on the venture capital concept, entrepreneurship, and a simple history; The Practice covers fundraising, business plan construction and analysis, investment due diligence, post investment monitoring and exit; and The Future emphasizes early stage investment, especially angel investment, as well as Cleantech VCs and socially responsible investment.  In the last chapter, Venture Capital in China, we explore the amazing development of China’s unique venture capital industry.

This textbook combines the strength of my Silicon Valley experiences as a venture capitalist and Mannie’s research as a professor, and it will help strengthen Chinese college-education programs in this particular field.  The book draws on and acknowledges important contributions from the members of the Working Group on Director Accountability and other experts in the field of venture capital.  I’ve donated all of my royalties from the book to the Society of Kauffman Fellows, which reported on the publication of this book in their July report.

VC Governance FAQ: (10) Are limited partner defaults on capital commitments triggering a wave of lawsuits in the venture industry?

images-11This is the last in our series of 10 frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: I’ve read that some GPs are suing LPs for not making capital calls. The LPs claim that they are cash constrained and/or the VC fund has not performed. Why throw more money their way? Do you see a trend here of broken contracts?

Answer: First, it would appear that the reports of numerous LP  defaults exceed the reality. Based upon discussions with industry  participants, most institutional LPs have, in fact, met their  obligations to make capital calls. Second,  the decision of a GP to sue an LP over a default is most often the absolute  last resort. The GPs are not in business to institute litigation — this a  distraction for the GP and added publicity that neither GPs nor LPs desire.  When the LP Agreement is executed, all of the parties enter into a contract  with the expectation that both LPs and GPs will honor their respective  commitments. The GPs have committed their time, and have built an organization  to implement an investment strategy and program for the fund. They should be  entitled to rely on the contractual obligations of those sophisticated  investors who agreed to support this program over the long  term.

VC Governance FAQ: (8) How can a limited partner exit from a VC fund?

images-16This is the eighth in our series of ten frequently asked questions from investors in venture capital partnerships.

Susan Mangiero, CEO of Investment Governance’s Fiduciary X, asked me the following:

Question: What happens if an LP wants to exit a VC fund? What are their rights?

Answer: The options here are limited, and they are (1) the LP can try to sell their interest, including the obligation to fund future capital calls, to a fund that acquires secondary interests.  The good news is that a robust market exists for such interests in venture capital partnerships today; or (2) default.  If you do wish to sell, the GP needs to approve the transfer, and the standard partnership agreement language leaves this decision in the “sole discretion” of the GP.  There is no free lunch if you change your mind several years into a 10-year-plus partnership participation. And there shouldn’t be, which also means that either the secondary market buyer will take their pound of flesh by buying the LP’s interest at a substantial discount, or the GP will by offering the interest and its economic value on a discounted basis to the other LP’s.  It is far less disruptive to the GP and to the GP-LP relationship for the exiting partner to sell to a secondary buyer, but these buyers are totally financially driven and are going to get the best deal possible for themselves.