Archive for the ‘Working Group on Director Accountability’ 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.

 

 

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: (9) Does an anemic IPO market deter VC investing?

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This is the ninth 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: Do you think than anemic IPO market will remain a deterrent to VC investing?

Yes I do.  I believe that an entire generation of American innovation is at risk as a result of the lack of IPO’s.  The statistics are overwhelming in support of my position, starting with the fact that over 90% of jobs created by VC-backed companies occur AFTER their IPO—and this has been the case for 40 years.  What concerns me the most about the IPO vacuum is that it is systemic and is the result of a “one size fits all mentality” when it comes to regulation of the securities industry.  A relatively unknown emerging growth public company with a $500 million market cap has different needs for research and trading support to provide liquidity for investors than IBM.  I remain surprised that this seems to be difficult for our policy makers to understand, but I am encouraged that the SEC has recently invited public comments for a 90 day period to address structural problems with the U.S. equity markets.

Specifically, the SEC wants to know if anyone from the public has thoughts on whether the current market structure is fundamentally fair to investors and supports capital raising functions for companies of various sizes, and whether intermarket linkages are adequate to provide a cohesive national market system”. The Commissioners expressed particular interest in receiving comments from a wide range of market participants. Comments on the Concept Release are due within 90 days after publication in the Federal Register.

For more on the SEC Concept Release, click HERE

I believe that the U.S. equity capital markets must be structured with the goal of promoting the growth of publicly held small businesses in America.  America had this structure in place prior to 1997, and we should take a hard look at what has changed to render the small company IPO extinct (contrary to popular belief, it first became an endangered species before the technology bubble).

images-15Compounding this problem is the fact that, with no IPO options, the consideration paid for companies in trade sales—acquisition by larger companies—has been declining.  Why should venture capitalists take the risks associated with starting up a new company, working through all of the difficulties with multiple financing rounds and executive changes over a six-to-eight or even ten-year period, only to get backed into a corner by a large multinational that dominates the sales channel and can wait them out?

The biggest problem the VC industry has today is that, absent access to public market capital, there are too few VC-backed companies that are self sustaining cashflow generators.  The biggest problem that the U.S. economy has today is unemployment.  You would think that maybe the stewards of the U.S. economy, our legislators, could make some structural changes to our small company capital markets regulations to fuel the greatest job creation engine in America—the entrepreneur driving an emerging growth company.  This problem goes way beyond venture capital—as 47% of all IPO’s since 1991 were backed by neither VC’s or private equity firms—this is an American problem.

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.

VC Governance FAQ: (7) How should institutional investors contact VC funds?

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This is the seventh 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; How should institutional investors contact VC funds? Directly or via an investment consultant? Do the traditional investment consultants have the background to conduct due diligence on the VC fund(s)?

Answer: First, nothing beats direct contact with managers.  I think the VC industry conferences in specific industry sectors provide a great forum for institutional investors to meet directly with VC funds.  Historically the two largest conferences have been sponsored by IBF and DowJones.  There are also sector specialty conferences, such as the IT Security Entrepreneurs Forum held annually on the Stanford campus, the bring out domain experts.I think that it also makes sense for institutional investors who don’t have the resources to do a full search to work with consultants—however, I will say that, in my experience, many consultants become gatherers of statistics and information—meaning paper pushers—and few of them actually bother to have a deep and current understanding of what is really going on in the market. I’ve actually been shocked at how clueless some consultants are about what is really going in the VC industry. I think the evidence supporting this point is in the fact that, because of the long term nature of the VC business, consultants will choose to back a certain fund and then assume that they can sit back and wait for five or ten years to see if they made the right choice.  This is a big mistake, and one of the root causes is because there is a low probability that the same analyst or partner in the firm that made the original “commit” decision is still going to be at the consultant even four years after the original decision to recommend the fund was made.  So I am suggesting that a lot of the “standard” recommendations by the consultants in VC are stale.  So you need to do research on the consultant’s process as well as directly meet with the venture firms.  Any venture firm that won’t meet with you probably doesn’t need your money and won’t give you the kind of respect in a relationship that you should expect, so that’s a great first cut in your process.images-13

VC Governance FAQ: (6) Are contract terms in partnership agreements shifting in favor of institutional Limited Partners?

images-10This is the sixth 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: You had some thoughts about contract terms. Do you think the trend is shifting in favor of institutional LPs to receive better terms?

Answer: Certainly as the sources of capital have become more  selective and scarce, the GPs have had to become more aware of LP concerns over terms. While  the GPs in top tier funds will still be able to maintain favorable terms (and  LPs will always want to get into their funds), even these GPs have made some  concessions to maintain a supportive investor base. For example, recent press  reports have indicated that at least two prominent funds had lowered their  “premium” carry structures, and made the payment of a 30% carry rate subject  to the return of a multiple of the investors’ capital. For those other funds  that are not oversubscribed, there will undoubtedly be some pressure on  terms. Though there has been a lot of talk about the terms suggested in the  recent guidelines published by the ILPA, these guidelines have not fully  caught hold (and some proposed terms –like joint and several liability  on clawbacks — may be seen as too extreme). Still, in the current fundraising  environment, there will certainly be some movement to provide an  alignment of interests between LPs and GPs, while trying to maintain the  appropriate incentives for the GPs.

VC Governance FAQ: (5) How are VC funds governed differently from the governance standards applied to their portfolio companies?

images-8This 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.images-9

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.

VC Governance FAQ: (4) How do you manage risk when backing serial entrepreneurs?

images-7This 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.questionnaire

VC Governance FAQ: (3) How can investors protect themselves against key-person risk from fraud in VC-backed portfolio companies?

images-4This 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.