This is the fifth 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: Please differentiate between the governance of a VC fund versus the governance of companies in a VC fund’s portfolio? Is one more important than the other?

Answer: This is a very important question, and it starts with recognizing that VC funds, as partnerships, are governed very differently from portfolio companies, which are corporations.  The VC fund may have one managing partner that sets the tone and controls the entire firm, or it may have a collegial distribution of governance among several senior partners.  The best way to understand how a VC fund is governed begins with an analysis of the fund’s investment committee, its deal due diligence process, and the specific allocation of the fund’s investment capital among the individual partners.  An important question to ask is, do the partners evaluate themselves and each other on an annual basis or at all? You might be surprised to learn that many VC funds lack an internal feedback loop, that the partners may not communicate openly among each other, and that the partners themselves may lack a formal measure of accountability among each other, even though the economics are divided formally in the management company agreement.

Turning to portfolio companies, the board of directors is responsible for the governance of the company, and here we have a very interesting dynamic which often leads to board dysfunction—the VC directors have inherent conflicts of interest as representatives of their funds and as fiduciaries who must act in the best interests of all of the shareholders.  In addition there is a major tension and conflict between the management team and the VC directors—the management wants more share ownership, and the common equity is at the bottom of the seniority stack behind the various series of preferred equity rounds.  The VCs want capital efficiency, which means they want management to do more with less.  Compounding the complexity is the fact that most VC-backed companies replace their CEOs twice between the founding and the liquidity event.  So you can imagine that the VC boardroom governance equation is very complex and rife with opportunities for problems.

This is the fourth 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: Are there ways to mitigate the team risk when in fact VC funds often back a particular team or particular CEO?

Answer: When we back serial entrepreneurs, it is critical to assess where they are today in their lifetime achievement and performance potential curve.  By that, I am reminded of the fundamental risk in looking at track records—“past performance is not indicative of future returns.”  It amazes me how many investors chase performance and don’t pay attention to the current team composition at the VC manager, to the current dynamics of the partnership.  Ideally you want to back a proven winner who is still hungry enough to deserve a seat at the table.  Venture capital is totally a hits- driven business, but there are very few hitters, either VCs or entrepreneurs– who are able to hit multiple home runs.  When you look at VC’s, you want to find VC’s who are magnets for great entrepreneurs, whether they are first timers or veterans, and rely on the VCs’ pattern recognition ability to make that judgment call in picking a winner.  One way to mitigate risk is to assess how deep the team is in the VC organization—remember that you are making a 10 year bet on a team, and few teams stay together through an entire cycle.

This is the third 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: Given recent instances of VC-backed company fraud and questions about the management team, how can institutional investors protect themselves from key person risk?

Answer: You are asking a fundamental question here about trust, which relates to your prior question.  I could restate your question by saying, how do I know that I’ve backed someone as a GP who is trustworthy?  The answer is, you have to do your homework on that person, which means that you have to make a full range of reference calls to people who are not on the person’s reference list.  This takes resources and time.  If you are not equipped with the resources to do the work, then you need to rely on someone else’s process—but again that has to be an independent third party whose due diligence credentials are also trustworthy.

Let me turn the table on you a little bit because I sit in your shoes all the time– as a venture capitalist who bets on entrepreneurs, my greatest challenge is to sit across the table from a very enthusiastic person and judge their credibility—will they actually do what they say they are going to do?  Will they work 24/7 to get the job done?  How will they behave when unforeseen challenges occur—which they always do?  Institutional investors have to do the same thing because they are betting on people, and they need to establish a considerable measure of trust if they are going to sign on to a 10 year commitment to invest in illiquid assets.  This is the toughest part of our jobs—as I look back over my the 14 years I have spent in venture capital as part of my 29 year finance career, the biggest mistakes I have made have always been related to key person risk, as opposed to picking the “wrong” technology.

I will be the keynote speaker at the America Midwest Regional Final competition of the Global Security Challenge (GSC) on September 22nd in Chicago.  This event is part of a global competition to deliver innovative solutions to pressing cybersecurity problems.  The GSC Security Summit 2009, which will be held November 13 in London, will see the culmination of the six regional finals held around the world in September and October.  The Summit will include the final pitches from each regional finalist in the SME and Start-up categories, as well as the ‘Dragon’s Den’ style closed-door Q&A with the expert Judging Committees. The award categories are:

• Best Security SME
• Most Promising Security Start-up
• Most Promising Security Idea

Top contenders from previous Global Security Challenge competitions have subsequently raised over $55 million in new capital.  The current open competition is for the “Most Promising Security Idea”:

The GSC committee recognizes that there are many potentially disruptive innovations that have yet to reach commercialization. Through the Most Promising Security Idea category, the GSC encourages innovators to continue to pursue their ideas and efforts. The award is designed to support and promote researchers, infant companies (with no revenue), and any other inventors who just have an idea for a security solution.

The winners of this category will receive:

• $10,000 cash grant, sponsored by Accenture.
• Mentorship from Mark Shaheen, managing director of Civitas Group.
• Unparalleled networking opportunity with government officials and industry leaders.
• Invaluable publicity.
• Examples of our areas of interest are (but are not limited to): biometrics, detection sensors, cyber security, video surveillance, RFID, personnel protection, encryption software, data-mining, biotechnologies, and explosive trace detection. Who can Apply?: Eligible entrants must be a company, or one or more individuals, whose idea did not generate revenue in 2008.Deadline for Submissions: September 1, 2009 at 11.59 GMT.

For more information on the GSC CLICK HERE.  I am proud to be involved with this competition as it represents the type of innovation challenge that drives entrepreneurs to develop breakthrough ideas into real companies.

Organizational challenges and governance questions appear to be gaining the upper hand in faltering efforts by the White House and DHS to address America’s cybersecurity.  Last week two respected leaders in the cybersecurity realm, Melissa Hathaway of the White House and Mischel Kwon of the Department of Homeland Security Computer Emergency Response Team (DHS CERT), announced their resignations.

Below I quote from reports by the Wall Street Journal and the Washington Post:

From the WSJ’s Siobhan Gordon on Melissa Hathaway, reported on August 4, 2009:

The White House’s acting cybersecurity czar announced her resignation Monday, in a setback to the Obama administration’s    efforts to better protect the computer networks critical to national security and the global economy. The resignation of Melissa Hathaway, Barack Obama’s choice to monitor the nation’s online security, is a blow for the administration, which had made the position a priority. The resignation highlights the difficulty the White House has had following through on its cybersecurity effort.  In February, the White House tapped Ms. Hathaway, a senior intelligence official who had launched President George W. Bush’s cybersecurity initiative, to lead a 60-day cybersecurity policy review. Ms. Hathaway completed her review in April, but the White House spent another 60 days debating the wording of her report and how to structure the White House cyber post.  National Economic Adviser Larry Summers argued forcefully that his team should have a say in the work of the new cyber official.  The result was a cybersecurity official who would report both to the National Security Council and the National Economic Council. Supporters said that arrangement would cement cybersecurity as a critical security and economic issue; detractors said it would require the new official to please too many masters and would accomplish little.  “It’s almost like the system has become paralyzed,” said Tom Kellermann, a former World Bank cybersecurity official who served on a commission whose work influenced the White House’s cyber planning.

From the Washington Post’s Ellen Nakashima, reported on August 8, 2009:

Mischel Kwon, the director of the Department of Homeland Security’s U.S. Computer Emergency Readiness Team, submitted her resignation letter this week. … Kwon, who is the fourth US-CERT director in five years, was frustrated by bureaucratic obstacles and a lack of authority to fulfill her mission, according to colleagues who spoke on the condition of anonymity.  In March, another Homeland Security cybersecurity official, Rod Beckstrom, resigned, citing a lack of support inside the agency and what he described as a power grab by the National Security Agency.  The resignations, although unrelated, point to a larger inability of the federal government to hire, retain and effectively utilize qualified personnel, experts said.

[Note: Beckstrom has recently become the CEO of ICANN]

While these resignations do send a message, we must be equally concerned about positions that get less daily press but are equally critical because they deal with the details of policy implementation.   In my view, the fact that we are now seeing departures from people who are in critical execution positions raises a red flag, particularly because it appears that organizational dysfunction and lack of coordinated leadership are at the root of these departures.  From government’s perspective, the cybersecurity problem is difficult to address effectively because it is widespread, new, and amorphous relative to other types of criminal activity (for example, a bank robbery by an armed gunman).  It also crosses many disciplines and therefore touches multiple competing government bureaucracies.

Our nation’s policy leaders need support from empowered lieutenants to execute on policy. As a nation, we cannot afford to take our collective eye off the ball as we address the challenges faced by the U.S. economy, the U.S. capital markets, and America’s cybersecurity.  President Obama’s ambitious agenda will stand or fall on the ability of people to implement the Vision.  While critics are quick to seize upon the Administration’s mis-steps, whether you support the Administration or not, we should all be very concerned when we see highly respected domain experts voting with their feet.

The vast scope of the cybersecurity challenge and the urgency with which we must address it present us with opportunities to contribute at many levels. Let’s not stand down but rather rise up to meet this challenge head on, even if we must do so incrementally.

On June 25th I moderated a panel on the implications of America’s
Innovation Crisis for Cybersecurity at the National Press Club in
Washington, D.C.  The full transcript of the slides integrated with my
prepared remarks is now posted at www.levp.com .  This event was sponsored by the non-profit Security Innovation Network.

At the end of the panel I asked each of the panelists, Bob Ackerman of Allegis Capital, Professor Randy Katz of Berkeley, and Dave Robbins of BigFix, to answer the following question:

“In closing, I would like each of our panelists to comment on the most
important change that they would like to see implemented in order to
promote the protection of our nation’s critical infrastructure.”

Bob Ackerman’s answer follows:

“The solution to the critical needs of our country  – whether it is in reinventing our economy or the innovation that is essential to protecting our nation’s critical infrastructure – will depend on the creativity and drive of entrepreneurs. At precisely the same time that political leaders are calling for expanded innovation to meet our national needs, there appears to be an almost all out assault on entrepreneurship in America – by deed if not by word.  Capital and talent are the two most valued and at the same time portable assets in the global economy.  For more than three decades, the United States was the destination for the best and brightest minds from around the world.  In the US, brilliant entrepreneurial risk takers found the resources they required to implement their dreams and an environment that rewarded those that took the risks associated with innovation – and succeeded.  Today, we are making it increasingly difficult for the best and brightest to come the US and stay to contribute to our economy. For those that are here, we are increasing the regulatory hurdles associated with building successful businesses while increasing the taxes associated investments make in long term innovation.  Stock options – once the great wealth builder for employees in start-up companies – have had much of their value striped by regulatory changes.  When combined with the current political overtones that suggest people who have achieved wealth must have somehow “cheated”  – we have created an environment where the risk/reward associated with high risk entrepreneurial innovation is seriously out of balance.  At precisely the same time where we are more dependent than ever on an innovation-driven economy and our competitors have borrowed our historical playbook – we are effectively erecting barriers to innovation in America.”

How should we respond?  We need to attract and retain the talent and capital necessary to fuel the engine of innovation.  We need to attract capital and encourage focused, systematic innovation through modifications in our tax code.  Lower tax rates for long term innovation is an excellent place to start.  We need to rethink our approach to regulation with a more constructive understanding of the levels of risk associated with (and appropriate regulation) companies as they grow and prosper.  A successful start-up company and a multi-billion dollar global player should not be subjected to the same level of regulatory oversight – in most cases. Further, our immigration policies need to focus on encouraging the world’s best and brightest to come to the United States, benefit from our educational system and remain here to contribute to our economy.  Today, our policy in this area can almost be described as “Here’s your PhD. – now go home!”.  Rest assured – the capital will follow the talent.

In parallel with the above, we need to take concrete steps to encourage companies to grow in the U.S.  This is a combination of the steps I have previously mentioned while making it easier for young companies to go public – tapping the capital they need to continue growing and adding high paying jobs to our economy.  Regulatory reform can address some of these issues but the venture industry also needs to take responsibility for re-invigorating the investment banking environment upon which a vibrant IPO market is dependent. This is an area where experience will matter.  For example, venture professionals who have lived successfully through these challenges in the past – have an invaluable historical perspective that can contribute to this revitalization.  Unfortunately, many have left or are leaving the industry.  Why – it’s become harder and harder to be successful while the rewards are being diminished.  They either retire – or they follow the entrepreneurs who are voting with their feet and talent and moving to greener pastures – in other countries.

I am at an early morning session where Jason Calacanis, CEO of mahalo.com, Nick Denton of Gawker, and Jeff Jarvis of BuzzMachine and the New York Daily News, discuss the challenges of printed media’s transition to online digital media. This topic and Twitter are big themes at this year’s Ideas Festival, with everyone from Steve Brill to Michael Kinsley, Norman Pearlstine and Katharine Weymouth discussing the former and Peter Hirshberg driving an army of Tweeters at #AIF09 to develop a use case for the latter.

What amazes me is that the discussion on the demise of the traditional media model amounts to a collective shrugging of the shoulders by these experts.  Given that the business model for traditional newspapers is so broken, the disagreements as to the way forward run very deep.

Some of the suggestions in this morning’s breakfast discussion include that every print article should disclose  metrics as to how many people have read it in order to establish popularity benchmarks—this becomes a way of judging market reach as well.  Risk: ‘The New York Times could become the Paris Hilton Times’.  This tension between the eroding credibility and gravitas of the “traditional press” and the “deep but unverified assertions” of many blogs is at the heart of the problem.  Building a business model that scales to capture the high ground of credibility at a large scale online is in the process of evolving.  100-journalist strong online media news organizations are now thriving (meaning profitable), per the panelists.

Chaos currently reigns. Jeff Jarvis recommends reading Clay Shirky’s Thinking the Unthinkable.

Commenting on Twitter– the speakers highlighted the asymmetry of Twitter between The Followed and Followers. Finally the discussion has turned to the fact that Twitter makes no money.  The speakers believe that the Twitter business model will turn into search-based advertising and feel that Twitter is so revolutionary that the successful business model for Twitter is at hand.

I’ve been a Twitter skeptic but am starting to see it as a useful public utility for crisis situations and spontaneous viral group eruptions (from the incipient Iranian revolution to the Aspen Ideas Festival).

Follow me on Twitter @plevensohn and check out #AIF09 in the Twitter stream to see what is going on at the Aspen Ideas Festival in real time.

Scott Draughon, Anyck Turgeon, Robert Rodriguez, Pascal Levensohn

At 4 pm EDT on June 17 Robert Rodriguez, chairman of the Security Innovation Network, and I will discuss the recession’s implications on the continuing pace of American innovation on MyTechnologyLawyer, a live radio show.

The title of the hour-long show is “The Innovation Crisis in America.” The format for the show will be conversational, and I expect that our hosts, Anyck Turgeon of Crossroads Systems and Scott Draughon, originator and the main host of the show, will elicit some provocative answers through their questions.

Among the questions that we will discuss:

What is Innovation?
What supports the argument that there is an innovation crisis in America?
How does Silicon Valley fit into the innovation ecosystem?
How has global competitiveness changed over the past decade, how do observers measure changes in competition, and what does this mean for America?

Listeners can tune into the show live by going to this link: CLICK HERE

The show will be recorded and accessible for downloads at your convenience at www.mytechnologylawyer.com/crossroads .

There is plenty of ink flowing with speculation on the future of the venture capital industry.  Phil Wickham, CEO of the Kauffman Fellows Program, has a constructive perspective on this topic, which he expressed in his CEO recap in the Kauffman Fellows Program eBulletin that was published on June 2.

Below, I’ve quoted his key observations from the newsletter, with which I agree:

“… I [have] found two camps regarding venture capital: the majority believes venture is the answer to all our needs (mostly entrepreneurs) and the minority seems to think that the entire industry couldn’t fall of the edge of a cliff fast enough (mostly policy and academia). I have to say that the whole thing alarmed me, since we so strongly believe that the answer is nuanced and solidly in the middle of these two extremes. The CVE’s [Center for Venture Education] DNA is that of an “entrepreneur-first” organization, growing out of the culture and values of Mr. K [Ewing Marion Kauffman] and his Marion Labs team that put together and operated the Kauffman Foundation.

Since our full independence from the [Ewing Marion Kauffman]Foundation in 2001, our focus has been to anticipate as much as possible the evolution of the entrepreneur’s needs and opportunities, since we are management’s primary service provider. As a result, we have included the unique expertise of tech transfer funds, angel groups, corporate venture funds, international government seed funds and even foundation investors in the Kauffman Fellows Program as we strive to build a curriculum with maximum value for our customers.

… We’ve concluded a few simple things. First, that entrepreneurial capital is about enabling scale, and the value we deliver as an industry is much the same at any stage or in any environment. Second, that the CVE’s intellectual capital built up over the past 15 years is broadly applicable across all forms of entrepreneurial capital. Third, within that body of knowledge, our evolving expertise in leadership and managing the human dynamic has far more long-term impact than anything else we do. Finally, we are starting to discover that there is a much broader opportunity to spread this leadership know-how to all of the players in the eco-system: university researchers, entrepreneurs, LPs, government policy experts and service providers. We think that if – across the globe – each positional player can come to understand their own and each other’s roles and put their collaborative talents and energies behind the entrepreneur’s imagination, the world will be a better place for our children to inherit.”

In 2007 the National Academies published an important essay by Norman Augustine, former CEO of Lockheed Martin and a deep thinker on America's slipping global competitiveness, titled "Is America Falling Off the Flat Earth?".  This brief monograph is required reading for anyone seeking facts about how America's global competitiveness is declining– as well as clear recommendations for the way forward.  Mr. Augustine touches on the declines in education, in business, in technology, and he diagnoses the self-inflicted nature of a society's successful development that leads in this direction. At its core, this essay is a passionate  appeal for coordinated national action to catalyze a multi-disciplinary program designed to win in a radically new global playing field.

What Mr. Augustine refers to as the competitiveness ecosystem includes the innovation ecosystem.  It is clear today that the global financial crisis which began in early 2008 has only accelerated the negatives, both by catalyzing further spending cuts in critical areas of long-term research and by worsening the odds that our government will recognize the immediacy of the need for the allocation of critical financial resources to get America's innovation train back on track.

A couple of my favorite quotes from the essay follow:

Perhaps the most incisive summary to be found, as far as the nation's competitiveness ecosystem is concerned, comes from the 2,500 year-old writings of Aeschylus:

So in the Libyan fable it is told
That once an eagle, stricken with a dart,
Said, when he saw the fasion of the shaft,
"With our own feathers, not by others' hands,
Are we now smitten".

In America, we are to a considerable degree living off past investments, the comparatively strong position the nation held at the end of World War II, and the prevalence of English as the predominant language of business, government, and technical education.  But the impact of those discriminators appears to be diminishing.  Simply stated, we have been eating our seed corn. . . . We are witnessing a gradual, albeit accelerating, erosion rather than a single cataclysmic wakeup call. . . . Charles Darwin observed that "it is not the strongest of the species that survives, nor the most intelligent, but the one most responsive to change."

While there's been a lot of "Change" in Washington in the last few months, we are still at the bottom of the mountain.   The challenge ahead of us requires our policymakers to understand that the Change we must be investing in now is open-ended, risk-tolerant, and all-consuming. It is the long-term change that will protect our nation's posterity, and, by its very nature, is not politically expedient.  Sadly, the posterity baby has been thrown out with the bathwater many times in the course of the development of America's national obsession with immediate gratification, and we are paying a heavy price for this short sightedness today.