Entrepreneurship M4 SLP for Paula Hog

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Chapter 2 Selecting the Best Legal Structure for Growth

Now you’ve got an idea of the basic kinds of equity and debt strategies that you might use in your search for capital. But before you start looking for money, you should decide on the best business format for you, even if you’re already in business. Choosing the appropriate legal structure—proprietorship, partner- ship, corporation, or limited liability company—or changing the structure that you currently have is a complex issue because of the inherent tax consequences and liabilities of the owner(s), and because the structure selected will deter- mine what capital-formation options are available to you. Many factors will affect your choice, including the number of owners involved, the need for man- agement flexibility, and the level of interaction with the public. This chapter

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will give you an overview and comparison of the basic business formats to consider, both at the outset of a new venture and periodically throughout your company’s growth.

Proprietorship A sole proprietorship is the simplest business form: an unincorporated compa- ny that is owned and operated by one person who directly and personally owns the assets used in the company. To establish a sole proprietorship, you need only whatever licenses are required in your line of work—there are no annual fees required to maintain ownership. All profits and losses flow directly to you and appear on your federal tax returns. In lieu of social security taxes that are paid equally by an employer and an employee, your company’s net earnings are subject to self-employment tax. Generally, any payments for personal cov- erage under hospitalization, life insurance, or medical plans can’t be deducted as a business expense, but payments for employee coverage are deductible. You may establish a retirement plan and deduct contributions as an adjustment to total gross income, but not as a deduction from income.

The biggest advantages of a proprietorship are that you maintain exclusive control, it’s simple (compared with other forms of ownership), there are lower start-up costs, and you are not taxed as both an individual and a business (commonly referred to as double taxation).

The primary disadvantage is that, as the proprietor, you are personally responsible for all business liabilities, and therefore, creditors may force you to use your personal assets to satisfy the company’s debts. (However, insur- ance may be available that will limit your liability for business debts.) Another significant drawback that becomes relevant if you want to raise capital is that the proprietorship structure significantly limits the range of available money- raising strategies because there’s no way to share equity, and you’ll need to personally guarantee any debt.

The proprietorship may seem to be the most appropriate structure for a typical “mom-and-pop” operation, but if the business fails, you and your fam- ily could face disaster. For most small businesses, it’s better to choose a form of ownership that provides for limited personal liability.

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Selecting the Best Legal Structure for Growth 27

Partnership In a partnership, the assets used in the company are generally jointly owned by two or more parties, and the parties agree to share the profits, losses, assets, and liabilities in proportion to their equity in the partnership, unless specified otherwise in the partnership agreement. You can create a partnership with ei- ther a written or an oral agreement, but a written agreement is preferable.

General Partnership In a general partnership, any or all of the individual partners may be liable for the debts and obligations of the partnership. For example, if three general part- ners form a business that later runs into financial difficulty, and only one of the three has sufficient personal assets to satisfy creditors, then that partner will be responsible for 100 percent of the obligations (not a prorated share based on her actual ownership of the company). Whether she will later seek reim- bursement from the other partners doesn’t affect her obligations to third-party creditors. There are no formal officers; your partnership agreement assigns the management functions.

General partnerships are typically found in professions that are service-ori- ented (such as law, accounting, and medicine) and not capital-intensive. Many states require that you file a certificate of partnership or similar document; fail- ure to do so may prevent your partnership from making use of the courts of the state in which it conducts business. Although the partnership must file a tax return, the individual partners (not the partnership itself) pay in proportion to their ownership as reported on the annual K-1 return filed with the IRS. Income and expenses flow through to the partners in accordance with the partnership agreement, and the applicable payroll taxes must be paid directly.

The primary advantages of this arrangement are that you have a high de- gree of flexibility, that profits and losses can be shared disproportionately and flow through directly to the partners, and that you avoid double taxation.

A general partnership’s biggest drawback is that each partner bears unlim- ited personal liability. Also, the partnership technically terminates whenever one partner withdraws, which heightens the impact of the entry and exit of any partner. And once again, you’re limited in your money-raising strategies: Either the partnership takes out a loan that the partners personally guarantee, or you raise equity capital by admitting a new general partner. Most investors in a partnership prefer a limited partnership (discussed next) because of the

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controlled liability that it offers and because they probably won’t have to be involved in day-to-day operations.

Limited Partnership A limited partnership (often referred to as an LP) includes not only the general partners, but also one or more partners who are not bound by the obligations of the partnership. A general partner usually forms an LP to secure additional capital or to spread risk without forming a corporation. The general partners are still personally liable for all partnership debts, but each limited partner’s liability is based on his capital contribution to the partnership. All management functions concerning the day-to-day operations of the business are delegated to the general partner. The limited partners may not exercise any significant man- agement control, or—by law—they may jeopardize their limited-liability status.

LPs are common in real estate development, oil and gas exploration, and motion-picture ventures. Nearly every state requires that you file a formal cer- tificate of limited partnership before the LP is valid. If the partnership isn’t legally formed, the limited partners’ liability is the same as that of the general partner.

The primary advantage of this structure (from a capital-formation perspec- tive) is that the limited partners’ potential liability is limited to the extent of their capital contribution, making them more willing to invest. The primary disadvantage is the general partner’s unlimited liability.

Corporation In a corporation, a legal entity (as opposed to individuals) owns the assets of the business and is liable for the debts. A corporation offers the greatest flex- ibility in raising money from venture investors and is the structure that inves- tors find most comfortable. For federal income tax purposes, the distinguishing characteristics of a corporation include:

Continuity of life. All state corporation laws provide that a corporation will continue to exist until articles of dissolution are filed, even if the own- ers (shareholders) die, go bankrupt, retire, or give up their interest in the company. Limited liability. A shareholder isn’t personally liable for corporate debt or claims against the corporation, except in special circumstances, such as the misuse of the corporation to perpetrate a fraud.

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Free transferability of interest. Shareholders may generally sell all or part of their interest to any buyer without the consent of the other shareholders. Centralized management. The board of directors (elected by the sharehold- ers) has the authority to make independent business decisions on behalf of the corporation.

The details of forming a corporation vary from state to state; however, virtually every state requires that you file articles (or a certificate) of incor- poration. Once you choose the state in which you’d like to incorporate, you’ll have to meet a number of registration requirements in order to obtain (and maintain) corporate status and to enjoy the protections that the state affords corporations. Observing all the legal formalities will help protect shareholders from personal liability.

General Characteristics of a Corporation A corporation is owned by its shareholders, who may be individuals, partner- ships, trusts, or even other corporations (except for S corporations, to be dis- cussed next, there is no limit to the number of shareholders a corporation may have). The corporate entity is separate and distinct from its shareholders, and the shareholders’ personal assets aren’t available to satisfy corporate obliga- tions. The corporation’s creditors may look only to the corporation’s assets for payment, a protection commonly referred to as the corporate veil. If a corpora- tion is involved in a number of lines of business, separate corporate subsidiar- ies (corporations owned by another corporation) may be created to protect the assets of one business activity from the liabilities of the other(s).

Management responsibility is vested in the company’s board of directors, which is responsible for overall policy decisions as well as the company’s gen- eral direction and business plan. The board appoints officers to manage the day-to-day operations.

Unlike a partnership, a corporation is a tax-paying entity; federal and state tax returns are filed, and taxes are paid on the profit of the corporation (unless the corporation elects an S status, as discussed in the next section). Losses are not passed through to the shareholders, but may be carried forward as an off- set against the corporation’s future income. The board may elect to distribute after-tax profits to the shareholders as dividends; the shareholders are then taxed on these dividends at their individual rates (known as double taxation).

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The document that determines the mechanical aspects of the corporation’s governance is known as the bylaws. The bylaws may not exceed the scope of the articles of incorporation or the authority set forth in the state’s statute.

Subchapter S Corporations If your corporation meets certain IRS requirements, you can choose “S” status, which affects how the corporation is taxed on the federal level. An S corpora- tion must have no more than 75 shareholders, who (with very few exceptions) must be both individuals and U.S. residents, and the corporation cannot have two classes of stock with different financial interests. The management respon- sibility is the same as in a regular corporation (which is taxed under Subchap- ter C of the Internal Revenue Code), but the S corporation doesn’t pay federal tax on its income. Rather, the profits and losses are passed through to the shareholders and are declared on the individuals’ tax returns. The main reason to elect S corporation status is that you avoid the double taxation inherent in a Subchapter C corporation.

Managing the Corporation: Duties and Responsibilities For all types of corporations, the acts and decisions of the board of directors must be made in good faith and for the corporation’s benefit. The directors’ legal obligations fall into three broad categories: the duty of care, the duty of loyalty, and the duty of fairness.

Duty of care. The directors must carry out their duties in good faith with diligence, care, and skill in the best interests of the corporation. Each director must actively gather the information needed to make informed decisions regarding company affairs. In doing so, the board member is entitled to rely primarily on the data provided by the corporation’s officers and professional advisors, provided that she has no knowledge of any ir- regularity or inaccuracy in the information. I’ve seen cases in which board members were held personally responsible for misinformed or dishonest decisions made “in bad faith,” such as failing to properly direct the corpo- ration or knowingly authorizing a wrongful act.

Duty of loyalty. Each director must exercise his powers in the interests of the corporation and not in his own interest or that of another person or organization. The duty of loyalty has a number of specific applications: The director must avoid any conflicts of interest in dealings with the corporation

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and must not personally usurp what is more appropriately an opportunity or business transaction to be offered to the corporation. For example, suppose an officer or director of the company was in a meeting on the company’s be- half and a great opportunity to obtain the distribution rights for an exciting new technology was offered. It would be a breach of this duty for him to try to obtain those rights for himself and not first offer them to the corporation.

Duty of fairness. The last duty that a director has to the corporation is that of fairness. For example, questions may arise if a director of the company owns the building leased by the corporate headquarters and is seeking a significant rent increase. It would certainly be a breach of this duty to allow that director to vote on this proposal. The central legal con- cern here is that the director may be treating the corporation unfairly in the transaction because her self-interest could cloud her duty of loyalty to the company.

When a transaction between an officer or director and the company is challenged by a shareholder, the officer or director has the burden of dem- onstrating the propriety and fairness of the transaction. If any component of the transaction involves a substantive conflict of interest or conduct that may amount to fraud, then the courts might rescind the transaction in question. In order for the director’s dealings with the corporation to be upheld, the “interested” director will have to demonstrate that the transac- tion was approved or ratified by a disinterested majority of the company’s board of directors.

To meet the duties of care, loyalty, and fairness to the corporation, follow these general guidelines:

Know the principles of corporate law. Work with your attorney to develop written guidelines on the basic principles of corporate law as they apply to the duties of officers and directors. Keep the board informed about recent cases or changes in the law. Work closely with your corporate attorney. Do this as a general rule. If the board or any director is in doubt about whether a proposed action is in the corporation’s best interests, consult your attorney immediately—not after the deal is done. Keep good records. Keep careful minutes of all meetings and comprehen- sive records of the information on which the board bases its decisions.

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Be prepared to show financial data, business valuations, market research, opinion letters, and related documentation in case a shareholder challeng- es an action as being “uninformed.” Well-prepared minutes also serve a variety of other purposes, such as written proof of the directors’ analysis and appraisal of a situation, proof that parent and subsidiary operations are being conducted at arm’s length, or proof that an officer had the authority to engage in the transaction that is being questioned. Be selective in choosing candidates for the board of directors. Avoid the nomination of someone whose name lends credibility, but who is unlikely to attend meetings or have any real input into the management and direc- tion of the company. I have found that choosing such people only invites claims by shareholders of corporate mismanagement. Similarly, don’t ac- cept an invitation to sit on another company’s board unless you’re ready to accept the responsibilities that go with it. Focus on the best interests of all shareholders. In threatened takeover situations, be careful to make decisions that will be in the best interests of all shareholders, not just the board and the officers. Any steps taken to pro- tect the economic interests of the officers and directors (such as lucrative “golden parachute” contracts that ensure a costly exit) must be reasonable in relation to the actual degree of harm to the company. Avoid conflicts of interest. Any board member who independently sup- plies goods and services to the corporation should not participate in board discussions or votes regarding his dealings with the corporation. This will help avoid conflict-of-interest claims. Proposed actions must be approved by the “disinterested” members of the board after the material facts of the transaction are disclosed and the nature and extent of the board member’s involvement is known. Assess possible conflicts of interest. Periodically issue questionnaires to officers and directors regarding their recent transactions with the company to assess possible conflicts of interest. Use a more detailed questionnaire with incoming board members and newly appointed officers. Always cir- culate these questionnaires among board members prior to any securities issuances (such as a private placement or a public offering). Provide directors with information. Provide directors with all appropri- ate background and financial information relating to proposed board ac- tions well in advance of a board meeting. An agenda, proper notice, and

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a mutually convenient time, place, and date will ensure good attendance and compliance with applicable statutes. A meeting of the board of directors is not valid unless a quorum is present. The number of directors needed to constitute a quorum may be fixed by the articles or bylaws, but it is generally a majority of board members. Handle board members’ objections properly. Board members who object to a proposed action or resolution should either vote in the negative and ask that such a vote be recorded in the minutes, or abstain from voting and promptly file a written dissent with the secretary of the corporation.

The advantages of the corporate form of ownership include limited liabil- ity for owners and the ability to continue the business easily, even if there’s a change in the shareholders. However, a corporation can also be more expensive to form and maintain than a proprietorship or a partnership, primarily because of the filing and annual fees imposed by state agencies.

Limited Liability Company The limited liability company (LLC), which has grown in popularity in recent years, is touted by many as the business structure of the future and lends it- self to a wide variety of capital-formation options. The concept, developed in Germany and popular in Europe and Latin America for many decades, was introduced in the United States in 1977 by the state of Wyoming. The LLC re- ceived its strongest endorsement in 1988, when the IRS stated that for federal tax purposes, an LLC would be treated as a partnership, not a corporation, provided that it met certain requirements (discussed later). This encouraged virtually all states to pass legislation recognizing LLCs. The flexibility, security, and tax savings of an LLC can be significant, and the structure lends itself to the management and structural flexibility that’s needed for just about all capital-formation strategies.

You should structure your LLC so that it qualifies as a partnership under federal tax laws, which means that it must lack at least two of the corporate characteristics—continuity of life, limited liability, free transferability of interest, and centralized management. Some states have adopted “bulletproof” statutes, which provide that an LLC formed in that state will automatically lack at least two of the four characteristics and will always qualify as a partnership. The

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majority of states, however, have “flexible” statutes that allow LLCs to include some or all of the corporate characteristics, with the attendant risk that if the LLC has too many corporate characteristics, it will be taxed as a corporation.

Flexibility for Owners If you establish an LLC, you’ll have tremendous flexibility in structuring its economic and management arrangements. The owners of the LLC, who are referred to as members, may elect to manage the LLC themselves or may des- ignate one or more managers (who may or may not be members) to manage the business and operations of the LLC. Capital contributions to the LLC may be in the form of cash, property, or services, and the profits and losses may be allocated among the members in any manner they choose as long as it com- plies with tax laws. As with a corporation, you may create multiple classes of membership, including a “preferred” level that mimics the types of equity that venture investors prefer to purchase.

Forming the LLC Most states allow any legal entity to be a member of an LLC. However, most statutes require that an LLC be formed by two or more people or entities that sign and verify the articles of organization filed with the secretary of state. To issue a certificate of organization, most states require that you file only the bar- est of information, such as:

• The name of the LLC • Its duration (not to exceed 30 years) • The purpose of the organization • The address of the principal place of business and the registered agent

(who has been designated to receive official documents) • The amount of cash invested and the description and value of any

other property contributed to the LLC • Any additional contributions that may be required in the future • A reservation of the right to admit additional members and a statement

of the terms on which they can be admitted • A reservation of the right to continue the business and the vote neces-

sary to achieve continuation • Whether there will be a centralized management team

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The most important documents in the formation of an LLC are your operat- ing agreement, which is essentially a substitute for the corporate bylaws, and the member control agreement, which is essentially a substitute for the share- holder agreement or the partnership agreement.

Advantages of an LLC • Members of an LLC enjoy the same protection from personal liability

that the officers and shareholders of a corporation do. • The LLC itself does not pay federal income tax. If properly structured,

it will be classified as a partnership for tax purposes and be exempt from state income or excise tax. It allocates taxable income to its mem- bers, who pay at their personal rates (which avoids double taxation). The members can write off the LLC’s losses to the extent of their tax basis in the LLC, including their share of the company’s debts. In con- trast, shareholders in an S corporation can write off losses only to the extent that such losses exceed the money that they have contributed to the company in the form of capital stock and loans.

• Management authority can be delegated either to specific members or to professional managers who are not members of the LLC.

• Once the operating agreement is formed, there are few other formali- ties like those that corporations must follow, such as holding annual meetings or issuing stock certificates.

• There are no restrictions on the number or type of owners (unlike an S corporation).

• There are no restrictions on multiple classes of stock (unlike an S cor- poration).

• Distributions of property can be made by LLCs without the realization of taxable gain (unlike an S corporation).

Disadvantages of an LLC • In most states, the death or withdrawal of a member will trigger the

dissolution of the LLC. However, under most operating agreements, members may elect to continue the company’s operation. That’s what usually happens.

• A member who is also a manager may be required to treat her share of

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the income as self-employment income subject to additional taxes to fund social security and Medicare.

• In some states, an LLC doesn’t qualify for state tax credits or sales and property tax exemptions for which corporations qualify.

Evaluating Your Selected Legal Structure Once you’ve selected the best structure, as your company grows, periodically evaluate whether the structure still suits your company’s needs. You might want to change the structure because of:

• The need to raise additional capital for business expansion • A change in tax laws • Increased risk resulting from additional dealings with creditors, suppli-

ers, or consumers • A shift in the business plan that affects the distribution and use of

earnings and profits • An opportunity to develop a new technology, either in conjunction

with others or under the umbrella of a separate but related subsidiary or a research and development partnership

• The retirement, death, or departure of a founder • The need to attract and retain additional top management personnel • Mergers, acquisitions, spin-offs, or an initial public offering planned

for the near future

These situations arise as a business grows and evolves, as shown in the example in Figure 2-1. In this example, a small retail business starts out as a sole proprietorship. Once the store is open and running, the owner decides to share ownership with a key employee, so the business becomes a general partnership. Eventually the owners need to remodel, so they bring in a passive investor to help with the cost; the business is now a limited partnership. Let’s say sales increase, prompting the hiring of new employees. The two general partners and the limited partner incorporate to better protect the assets of all the partners against claims of and liabilities to third-party creditors, but they choose to become an S corporation to preserve their “pass-through” tax status. When they open a second store, their attorney advises the three owners to form two additional corporations, one as a parent “holding company” and one for the operations of the new store. This prevents creditors of one store from trying

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Figure 2-1. The Evolving Legal Structure.

to proceed against the assets of the other store. This structure also becomes helpful when a fourth individual is offered shares in the second store—to raise capital—but not equity ownership in the first store. Finally, two years later, the owners consider growth through franchising, and they form an LLC to handle the franchise operations. An LLC will also better insulate the assets of the two company-owned stores from possible claims down the road by a disgruntled franchisee.

Making the best business-structure decision early could create savings for you and avoid the unnecessary expense of converting to another structure

SOLE PROPRIETORSHIP (Inception)

GENERAL PARTNERSHIP (Second owner added)

LIMITED PARTNERSHIP (Passive investor added)

CORPORATION (SELECTION) (Steps to protect assets of owners)

HOLDING COMPANY (Restructuring due to growth)

STORE #1

STORE #1 STORE #2 LLC

FRANCHISING HOLDING CO.

STORE #2

HOLDING COMPANY (Implement franchising)

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down the road. For these reasons, if you are just starting a new business ven- ture, consult with qualified legal and tax advisors prior to making a decision.

Corporate Governance and Reporting in the Age of Scrutiny In the early 2000s, we saw the collapse of Enron, Arthur Andersen, and World- Com, and investigations at AOL Time Warner, Tyco, Qwest, Global Crossing, ImClone, and many other companies. As a result, the public’s trust in our corporate leaders and financial markets—by employees, shareholders, or bond- holders—had been virtually destroyed.

In response, Congress acted relatively swiftly (and some say hastily) by passing the Sarbanes-Oxley Act, which was signed into law on July 30, 2002. The SEC, the NYSE, the Department of Justice, Nasdaq, state attorney generals, and others also responded quickly to create more accountability to sharehold- ers and employees by and among corporate executives, board members, and their advisors. Central themes included more objectivity on the part of board members; more independence and autonomy for auditors; more control over fi- nancial reporting; stiffer penalties for abuse of the laws and regulations pertain- ing to corporate governance, accounting practices, and financial reporting; and new rules to ensure fair and prompt access to information and current events that affect the company’s current status and future performance.

These events led to an age of scrutiny—an era of validation and verifica- tion. The roles of the board and its committees were refined, reexamined, and retooled. Now, best practices, procedures, and protocols have been rewritten, and the costs of implementation have become burdensome and expensive. In- ternal controls and systems have been redesigned to ensure compliance with the rules, and managers are held accountable for enforcement and results. The CEO’s job description has come to read, “Forget the gravy; where’s the beef?” and includes less pay, fewer perks, and less power in exchange for more per- formance and less tolerance for error or abuse. CEOs now live in an era that features more accountability and shorter tenure. The collapse of the financial markets, the failure of Lehman Brothers, the housing market meltdown, the Stanford and Madoff scandals, the federal debt debate, and the S&P downgrade, all of which took place between the publication of the second and third edi- tions of this book, have not in any way eased these concerns. Leadership and good governance are more important than ever, especially in an era of distrust. Investors must have confidence that company leaders will be guided by strong

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ethical and moral values, integrity, transparency, fairness, and respect for their fiduciary obligations to minority shareholders.

The Impact on Privately Held Companies Why do privately held and emerging-growth companies need to be aware of the requirements of Sarbanes-Oxley? There are a few reasons:

1. There has been a “trickle-down” effect of requirements for accountability and responsibility in corporate America that affects board members and executives of companies of all sizes as shareholders look for better, more informed leadership.

2. Some of the provisions of Sarbanes-Oxley apply to private companies. Section 802, for instance, forbids the illegal destruction of documents before litigation.

3. If a private company plans a strategy that includes an IPO or a merger, it is best to be prepared prior to the offering. This includes having gov- ernance practices, accounting reports, and financial systems as close to the requirements of Sarbanes-Oxley as possible in order to avoid any problems in these areas that could serve as impediments to closing (be ready for a high level of due diligence questions in M&A that focus on governance practices and dig deeper into financial, compensation, and accounting issues).

Corporate Governance Best Practices Audit A natural place to begin the review and analysis of corporate governance prac- tices is a legal audit that focuses on ensuring that systems and internal process- es are in place to comply with all laws and regulations. The legal audit should include recommendations for improvement and provide a series of compliance training programs for officers, directors, and managers with significant finan- cial or reporting responsibilities.

Among the topics and questions to be examined and discussed during the corporate governance best practices audit are:

• The size and composition of the board and the relationship of its com- position to the performance of the company. There is a definite trend toward smaller boards with higher ratios of outside directors.

• The independence and objectivity of the audit committee, which must meet Sarbanes-Oxley requirements.

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• The knowledge, skills, and discipline of the compensation committee. • The overall structure of executive compensation and stock option

plans. Pay for performance, fairness issues, linking reward with the meeting of strategic objectives, the reduction of excessive perquisites, the board’s ability and willingness to stand up to the CEO, and other such matters are all issues that require examination.

• Internal control processes to ensure that the board is fully and prompt- ly informed, is adequately performing its oversight role, has systems in place to manage and mitigate enterprise-level risks, and is addressing “red flags” in a timely and proper manner. It is critical to have a written statement of corporate governance policy in place.

• How closely and effectively the board monitors the integrity and ac- curacy of the company’s financial statements and reports (without mi- cromanaging the process).

• The compensation system for the board members and the extent to which board members’ compensation influences their objectivity. For example, are directors required to own (or not) a specific amount of company stock?

• The transparency of communications with shareholders and the finan- cial markets. Are the requirements of Regulation FD being met?

• The effectiveness of the board’s strategic and business planning skills. Have clear goals been set for the executive management team? How well is the team implementing these goals, and how closely is its per- formance being monitored?

• The risk management procedures that are in place. The audit should include a comprehensive review of the officer and director liability insurance policies as well as other types of risk management, such as information/data security, physical security, and so on.

• The succession plans that are in place for both the board and the ex- ecutive management.

• How well the skills of the various board members match up with the company’s current medium-term (and long-term) strategy. Have changes in the company’s business model caused shifts in its focus, triggering a need for new directors with a different set of skills? What procedures are in place for replacing directors whose skills now may be obsolete?

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• Any proactive steps that the board is taking to maximize shareholder value, such as the leveraging of existing intellectual assets.

• Whether the board has a nominating committee. Are its policies and criteria clearly articulated? If so, how closely are these policies fol- lowed? What due diligence is done on prospective candidates (and vice versa)?

• Whether there is a performance review process for board members. Why or why not? If so, how effective have these reviews been in im- proving the performance of individual members or the overall board?

• Whether board meetings are held both with and without the CEO pre- sent to encourage candor and objectivity. Who selects and appoints committee members? The board? The CEO? Do the bylaws allow for a nonexecutive chairman? If so, have the differences in the responsi- bilities of the chairman and the CEO been clearly articulated? Is there good chemistry between the chairman and the CEO? Why or why not? Are periodic meetings of only the independent directors held?

• The frequency of board meetings. Who sets the agenda? How effec- tive are the meetings? Are there minimal attendance standards? How often do the committees meet? How many committees are in place, and how well do they function? Are they adequately reporting to the entire board? Are lines of authority between the committees and the entire board clearly established?

• Any contingency plan that the board has in place should the company become financially distressed. Does the board understand that its fidu- ciary responsibilities may extend to other types of stakeholders, such as creditors and vendors, as workout plans and strategies are being developed?

• Whether the board has a formal orientation program for new members. If so, when was it last updated?

• Whether the composition of the board reflects gender, ethnic, and racial diversity. How many international members are there on the board? What is the average age of board members?

A corporate governance process must be put in place for both privately and publicly held companies that upholds the integrity of the company’s lead- ership in the eyes of shareholders and employees, that creates truly informed

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board members who have the power to act based on timely and accurate in- formation, and that protects the authority and fosters the courage of the board to take whatever actions are necessary to fulfill its fiduciary obligations. In reexamining the roles, functions, and responsibilities of board members, it is no longer sufficient for directors to merely make a periodic meaningful con- tribution to the strategic direction of the company; rather, they must now be proactive as defenders of the best interests of the shareholders and of the em- ployees, participants, and beneficiaries of pensions, 401(k), and stock option plans. Board members and corporate leaders should assume that their meetings will be in “rooms with glass walls” and that their actions will be examined under a microscope.

Establishing Effective Boards of Directors and Advisory Boards The quality of an entrepreneurial company’s executive and management team and the staff members selected by that team are critical to your growing com- pany’s long-term success and to meeting its growth objectives. But whom can the senior management team typically turn to for advice and guidance? Who provides the general policy and direction to the company’s executives concern- ing which specific growth plan is built and executed? For most growing compa- nies, the answer is twofold: (1) a formal board of directors and (2) an informal advisory board (or a series of advisory boards for specific purposes).

These two boards are often confused, but they actually play very different roles and have very different responsibilities. The board of directors is required under virtually all applicable state corporate laws and has very specific fidu- ciary duties with regard to the shareholders of the corporation, as described later. The basic governance structure is that the shareholders elect the direc- tors, who in turn appoint the officers. It is the role of the directors to set broad goals and policy objectives for the company that will benefit and protect the interests of the shareholders, and it is incumbent upon the officers to develop and implement plans to meet these goals and objectives. A strong director has broad-based business experience, strong industry knowledge, a useful Rolodex, adequate time to devote to truly understanding the company’s key challenges and weaknesses, and the objectivity to challenge decisions made by the man- agement team; she is a good listener and sounding board for the team and has generally been well trained by the university of hard knocks. A good director

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does not easily get discouraged if the company goes off course, nor does she view the world through rose-colored glasses. Board members should take their fiduciary and stewardship responsibilities very seriously, especially in this post– Sarbanes-Oxley and post-Madoff era; should not be too casual when it comes to critical tasks, such as preparation for and attendance at board meetings; and must not take confidentiality lightly or pursue what appears to be a personal agenda. Each board member and the board as a whole must be constantly guided by questions such as: “What is in the best interest of our shareholders?” and “How can we efficiently and creatively drive shareholder value?”

On the other hand, an advisory board is not required or governed by state corporate laws, does not owe the same levels of fiduciary duties to the share- holders (and hence cannot generally be held as responsible for its acts or rec- ommendations), and can be much more informal with regard to the number of meetings and the agendas for meetings. A single advisory board can be assem- bled for general purposes, or a series of advisory boards can be set up for very specific purposes, such as technical review, marketing strategy, recruitment and compensation, or research and development. An advisory board can also be an excellent way to get a second opinion on certain matters without inter- rupting existing relationships.

Leaders of growing companies will often set up an advisory board in con- nection with the capital formation process in order to demonstrate to prospec- tive investors in the business plan that the officers of the company have access to a credible and objective source of advice and contacts, without filling up pre- cious board of directors seats. The board of directors seats are usually initially set aside for co-founders and investors, and many prospective advisory board members may be reluctant to accept the responsibility that comes with a board of directors seat, especially at the outset of the relationship. Of course, the “showcase value” of putting together a bunch of names of people who barely know you and who will never show up for any meetings dilutes the credibility that you sought to establish when you appointed the advisory board. Prospec- tive investors will put varying weights on the strength and composition of the advisory board in making their final investment decisions and will often want direct access to the advisory board members as part of their due diligence pro- cess and to ascertain the depth of their commitment.

One critical difference between a board of directors and an advisory board is the management’s ability to accept or ignore the recommendations of any

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advisory board, a flexibility that it does not have when a mandate comes down from the board of directors. Also, because members of the advisory board do not owe the same duties to the company and its shareholders, they can be used in mediating disputes among the officers or between the officers and the direc- tors. They can also be used to identify potential board of directors candidates or be a recruiting ground for eventual seats on the board.

Since the rules governing the advisory board are not set forth in a corporate law statute, it is critical that you be very clear concerning your expectations of each advisory board member, and also how they will be compensated for their efforts. The best way to capture these objectives and rewards is to prepare a description of the rules and duties of advisory board members.

In the early stages of the company’s development, the rewards to advisory board members should be structured in a fashion that encourages a long-term commitment and provides for their being proactive, not merely reactive, con- tributors to the company’s growth plans. Governance challenges will evolve as the company grows and evolves, as set forth in Figure 2-2.

Figure 2-2. Governance Models.

A. The Early Days

= Shareholder

= Board

= Advisory Board

= Special Committees

= Leaders and Executives

= Coach or Mentor

The founding shareholder is chief cook mâitre d’ and bottle washer from a govern- ance perspective. This person wears the hats of the shareholder, board member, and leader all at the same time and must learn to segregate decision making and

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record keeping according to applicable state corporate laws and liability protec- tion best practices.

B. Initial Growth Phase

E E

In the initial growth phase, there is now a wider pool of shareholders, which may include some owners, such as angel investors, who are not actively involved in the day-to-day operations of the company. The board is likely to be expanded from one to three or five. There are a few more executives reporting to the founder now that the company is growing, and some delegation of control must be en- trusted to the management team.

C. Rapid Growth Phase

B SC

L CAB

The shareholders may have now increased to include a venture capital firm or even a corporate strategic investor. Communications with all shareholders and transparency in governance is now critical. Decision making must be well docu- mented and strongly substantiated. The board has probably appointed members to several key committees, including audit (to oversee finance), compensation (to oversee recruiting and HR), and nomination (to ensure board diversity, good governance, and board member pipelines). The leaders of the company may have one or more executive coaches or mentors/consultants and may be members of peer networks, associations, and industry groups, such as the Entrepreneurs Or- ganization (EO; www.eonetwork.org), based in Alexandria, Virginia, for advice and guidance. One or more advisory boards may have been put in place to augment

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the governance at the formal board of directors level and to be a sounding board to the leadership on a wide variety of strategic planning and operational matters.

D. Established Company

B SCs

L CAB

Special ABs

(General)

The shareholders may now include both voting and nonvoting shareholders as well as nonvested employees who have option plans. The board continues to increase in size and in the number of committees, including an executive com- mittee. The board may also now have its own special advisory board and teams of special advisors giving it guidance and drawing on a variety of matters, trends, and best practices. The company’s leadership and management team is likely to have evolved into a financial organizational chart, presiding over a number of operating divisions, regional and global operations, and new subsidiaries (which will require their own governance structures). The leaders of the company may now have a variety of general advisory boards (in areas such as scientific/techni- cal, customer/vendor, innovation, corporate social responsibility [CSR], diversity, and so on) that augment its interaction with the general advisory board as well as its interaction with outside lawyers, accountants, and consultants. The company may also be involved in joint ventures or other structures where separate govern- ance practices and leadership teams must be put in place.

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