Insight 13 | The Case for Better Governance at Venture Backed Companies
There is a classic (and consistent) fact pattern in venture capital financings that goes, more or less, like the following:
One or more founders create a new company, initially bootstrapping via personal savings, family & friends and/or other angel investments, until raising the first “institutional” round of venture financing. The VC that leads the first round of financing (typically called the Series A round) will get a board seat. Then, every 12–24 months the founders will raise new rounds of VC financings at (hopefully) higher valuations than the A round, adding more directors to the board.
Then, let’s say that in year 5 or 6 of this company, things are not going so smoothly anymore. Maybe the executive team has not hit all their milestones or maybe external factors have slowed the growth of the company. This is when good governance (and board leadership) really matters and where typically conflicts of interest may come into play.
Why conflicts? Because the interests of venture capital investors (who hold preferred shares) may diverge from the interests of the founders and employees (who hold common shares). In such contexts, VCs are referred to as “dual fiduciaries”: they owe fiduciary duties both to the fund (to maximize return on investment) and to the stockholders of the company on whose board they serve (to maximize the long-term value of the stock held by the common stockholders). These issues turn into relevant questions of duties of loyalty.
So when do these conflicts matter the most? Typically in down-round financings (if the company raises funds at a lower valuation than the previous round), recapitalizations (raising at a lower valuation including reductions in liquidation preferences and/or reverse splits of the stock to reduce the equity ownership of existing investors) or at the sale of the company. This is when directors should pay close attention to their fiduciary duties and where, unfortunately, many directors don’t understand to whom they owe their duties [disclosure: we have been involved in VC litigation and have witnessed depositions of board members whose understanding of governance is limited to inexistent].
Evan Epstein, the Founder and Managing Partner of Pacifica Global, has written an article explaining some of these issues and arguing for better governance at venture backed companies. To read the full article, please go to this link at his Medium page.
Pacifica Global was founded in San Francisco to serve as a leading corporate governance advisory firm. The mission of Pacifica Global is to help public and private companies solve some of their most complex corporate governance conflicts and challenges.