When the Enron/Arthur Andersen scandals first surfaced, I admit I was a bit skeptical and somewhat contrarian. The idea that anybody familiar with the mores of Wall Street could be shocked at the symbiosis between Wall Street analysts and the corporate finance department was in fact shocking to me. Everyone knew of those relationships, and had known about them for many years. The first round of disclosures exposing the shenanigans of major public companies in the US didn't shake me; my initial thought was 'same old, same old' … nothing much new. In fact, I felt the media might be playing a few isolated incidents all out of proportion, having a field day attacking various icons in American culture … the FBI, the Catholic church and now the corporate boardroom including the 'independent' directors (of which I am one) and the supporting cast of 'independent' accountants.
However, in the case of corporate governance, and the accountants, I have to admit that the disclosures, particularly on the governance issue, have become increasingly disturbing for two reasons. First, the sheer magnitude. Not a day seems to go by without another major public company coming clean and confessing that some perfectly extraordinary things have gone on below the radar screens of the investment community. And secondly, so many of the questionable practices seem to have been approved, more or less, by the company's board.
To be sure, this column is aimed at private equity, and in particular venture-backed companies while they are still private. This, the threshold question is what impact the seemingly inexhaustible exposés will have in the world of venture capital. I am not sure I know the answer to that question at this early point in the proceedings. However, I think there are some warning signals which cannot be ignored.
First, before getting into the meat of the analysis, it is important to note some critical differences between a typical, widely-held public company and a venture-backed private firm. The board of a public company (like that of a private company), is composed of both inside and outside directors, the latter's special responsibility being the interests of the non-management shareholders. In a venture backed company, on the other hand, the independent directors (in many if not most cases) are formal agents of the outside shareholders. Assuming the bulk of the outside shareholdings are owned by venture firms, the directors in question are appointees of those firms … and often their employees. The interests of the outside shareholders, or at least the institutional investors, are unquestionably represented at the table with an inside seat when a board or committee meeting is held. The VCs may hold a different class of shares (preferred stock) than the other shareholders (common stock for angels, friends, family and management) and that can pose conflicts. But, nonetheless, the outside directors are clearly not under the thumb of management; quite the reverse is the typical case. Ownership and control are accordingly congruent.
As a consequence, one would think that in the venture world we would not see instances of the questionable practices which, in the public company arena, seem to have been occasioned by overly passive 'independent boards'. However, I believe that the legislative and judicial reactions to current events are likely to be profound, and will affect directors of both public and private companies significantly.
Thus, directors of venture-backed companies are routinely presented with conflict and corporate opportunity issues. Generally, it is not a dominant management or founder who are seeking to secure extraordinary benefits. The issues most frequently involved are the pricing of dilutive rounds of financing (assuming the same has the flavor of an inside trade) and corporate opportunity problems if and as the private equity fund with a controlling influence over the board happen to have invested in two or more portfolio companies which, as competitors, may be interested in a specific corporate opportunity.
My advice is based on the premise that, sooner or later, there will be decisions arising out of the current litigation landscape accompanied by tightly reasoned judicial opinions applying Delaware law which ratchet up appreciably the fiduciary aspects of a director's responsibilities. Judges read the newspapers like every one else and react accordingly. It is likely they will perceive a need to get the message across to corporate directors generally that passivity in the board room is no longer acceptable. The phrase 'fiduciary duty' (which I have argued is synonymous with the phrase, 'recovery for the plaintiff') will appear with increasing frequency in judicial prose.
To put this in a real world context, if the current malaise in venture capital, with low company valuations the order of the day, is succeeded by a recovery in those valuations (which we all hope will be the case), directors of venture funds which processed wash out rounds without regard to the niceties I have written about in the past will find themselves under attack by counsel for the minority shareholders.
Moreover, venture funds and other institutional investors, (e.g. corporate venturers, incubators, etc.) which enjoy portfolios which include direct competitors will have to mind their Ps & Qs. Thus a real life problem faced by many VCs is whether a venture fund should be barred from having investments in two or more competitors … i.e., whether a prohibition on investing in competitors should be built into the fund's operating procedures, including a requirement that no individual nominated by the venture fund serve on boards of the competitors. The closest fund document provision of which I am aware is the language which authorizes, in the appropriate circumstance, the general partner of the fund to withhold sensitive information about one or more portfolio companies from limited partners in situations where the transmission of that information could be prove to be a competitive disadvantage to the portfolio firm.
The point, however, is well taken in this context. If a private equity fund specializes in enterprise software or biotech, for example, it may well wind up investing in firms with similar objectives and on occasion competitors. And, if the fund is deemed to be in control or have a controlling influence over its portfolio companies (a requirement of ERISA if a VCOC status is needed), then the corporate opportunity issue has to be faced squarely. In the case of a potentially succulent acquisition candidate, which one of the portfolio companies gets the prize?
The foregoing discussion does not, of course, exhaust the possibilities for conflicts of a sort which give rise to the allegation of breach of fiduciary duty. The fact is that venture capital funds do indeed exercise a controlling influence over their portfolio firms; and, given the 'small world' phenomenon, several categories of transaction will raise conflict issues.
My sense is that, as Justice Holmes once said, 'hard cases make bad law.' I am not sure 'bad law' will be made as a result of what has gone on in the last couple of years; but I am quite confident that there will be hard cases and new law, at least in the sense of new interpretations of existing legal principles. The onus on directors will inexorably increase, with an emphasis on 'fairness' to minority shareholders. The watchword will be the phrase given to me when I was entering government service by a grizzled veteran, Lloyd Cutler. 'If you want to stay out of trouble, call the close ones against yourself.'