By Michael
Volker
Better
Boards Build Better Businesses, Innovation and Competition, Innovative Early
Stage Funding, Capital Pool Corps Update, Local Events and Footnotes
Better
Boards Build Better Businesses
This
week, Catalyst Corporate Finance Lawyers together with SFU's TIME
Centre hosted a one-day seminar titled, "Better Boards Build Better
Businesses". This was aimed at early stage technology venture (from
startups through to junior pubcos) entrepreneurs, executives and directors. The
format followed a panel-discussion style along with some brief presentations and
lots of handout materials. Attendance was limited to sixty and it was completely
sold out. Some
twenty seasoned CEOs and directors presented their views on the subject.
There
were some excellent points made that I'd like to touch on in this column. These
points made were echoed the following day at a KPMG breakfast briefing to
local technology executives. KPMG put it this way: Management, directors and
auditors form the 3-legged corporate governance stool". The SEC
(Securities and Exchange Commission in the USA) has set some very onerous and
tough rules for determining who should be on a company's audit committee and the
qualifications of such persons.
There
are so many new - and complex - rules that even small public companies will end
up hiring a full-time compliance officer just to keep up with these!
Assembling
an able and committed board of directors is one of the first, and most
important, steps an entrepreneur must take when building a viable venture.
However, it is becoming increasingly difficult for a young company to attract
quality board members. Due to the poor governance practices we have seen lately
in corporate boardrooms, more rules and regulations are imposing an increasing
burden on the shoulders of board members. This increased emphasis on good
governance is spilling over into the junior public markets and even private
companies.
An
ideal board for an emerging technology firm is a small, three to five person
team composed of experienced and committed directors who can also serve as
mentors to the CEO. The panelists noted that low profile hands-on directors are
much better than highly visible but less involved people. They also noted that
chemistry among board members is very important meaning that they respect each
other’s views and welcome different perspectives. That’s why board members
with complimentary backgrounds, expertise and skills make an invaluable team.
A
board’s first task is to define its mandate. What is expected of board
members? What’s their role? How can they best contribute their talents? It was
noted that, especially for public companies, directors on audit committees must
have not only knowledge of accounting matters but also directly related
experience. Strategic guidance was noted as being a key part of a board’s
mandate – helping the CEO formulate the company’s vision and monitoring its
strategy. And, of course, compliance with all applicable laws is a given
responsibility.
Being
a director of a company, especially a small closely held one, used to be a
loosely defined and not particularly onerous undertaking. That’s no longer
true. Company directors are facing increasing personal liabilities. These might
arise from a company's failure to remit taxes, labor/wage disputes, or defective
and claims for harmful products just to name a few. Although Directors and
Officers (D&O) insurance may cover some liabilities, it's virtually
impossible to get 100% protection. D&O insurance is very expensive – if
you can get it. Corporate indemnification may also help somewhat but for
cash-starved companies, it provides little support. Bottom line: there is no
safety net for a director.
Active
directors know that they’ll be spending anywhere from one to three, maybe
more, days per month if they’re serious about their role. And, they’re
always on call and at risk.
So,
what attracts someone to a company’s board? An entrepreneur who exudes passion
and commitment to his vision is a great start. An exciting project with
interesting people draws others in. Sharing financially in the success of a
possible big win, helps too. It’s not a charitable proposition with only
remote prospects for a distant payoff.
What
is a fair compensation package for a director? Historically, companies have been
content to simply allocate a percentage of equity (around 5%) in stock and
options to the entire board. Cash fees are rarely given. This is rapidly
changing to reflect the increased involvement and liability taken on by
directors. Although the panelists offered numerous models for coming up with a
fair deal, they all equated to a very practical rule of thumb: take the CEO’s
compensation package – stock options and salary – and divide it by a factor
of three to five (depending on the number of directors) and use this number of
stock options and fee for each director. For younger companies, the fee
component may be reduced in favor of increasing the options. In essence, the
company is recognizing that a team of five directors would be at least
equivalent in value to the CEO. Although time they spend may be less than
one-fifth of the CEO’s, the difference is made up by industry experience and
know-how. Stock payments should be made up front but should vest over time
(usually three to five years).
A
company should pay a cash fee to directors. It can start out modestly, and
increase this as its revenues and cash flow rise. Some companies like to pay a
per diem or per-meeting fee while others prefer a monthly retainer. I like the
latter because a per-meeting fee or a per diem rate suggest that the director is
only working at those times. I maintain that a director, although not
necessarily always engaged, is nonetheless always on call. Even a modest
$1000/month retainer can command a certain level of fiduciary obligation.
Tom
O'Flaherty, one of the attendees
commented, "I
thought that one panelist clarified things a lot when he said that a director
was worth about 25% of a CFO. One could re-phrase this to say that a board (we
are talking here about smaller tech companies with maybe four or five
independents) should cost a company about the same as one VP position. Or, a
person serving on about five boards (which is feasible) should be able to earn
about what a VP position would pay (which is a decent living). This notion
actually scales for the larger companies who may pay a VP position (that is, one
level down from the CEO) $400,000 per year, and may have a board of 12
independents."
Bob
de Wit provides his insights on the
seminar:
When
it comes to building a better board, start-ups are confronted with a number of
tough issues: Who are the right types of Directors? What makes a good board
"tick?" How do we retain good Directors on a shoestring? When is the
right time to put together a board?
Experts
on the panels included noted independent directors such as Morgan Sturdy, Jim
Fletcher and Basil Peters, along with domain experts like Jim
Heppell, Mark Zastre and Michael Hagerman, among others.
Some
key points by the panels included:
-
Board
compensation should be determined relative to that of senior management. For
example, each board member should receive a combination of cash and equity
that pays them for their time equivalent to what the CEO makes, on a
per-unit of time basis.
-
Two
other rules of thumb on board compensation: An HR expert suggested that each
board member should receive, annually, one quarter of the CFO's
compensation, in the form of cash and/or shares and options. A Venture
Capitalist suggested that board members in start-ups should get $500k at the
end of a [successful] 5-year commitment.To determine the number of shares,
work backward. Assume that at the end of Year 5, the Director should receive
$500k in capital gains as a result of the shares/options provided.
-
The
proper role of a board of directors is to protect the interests of
shareholders and to challenge management, especially the CEO. They are not
there to provide support - that's best left to a board of advisors.
-
A
good board is put together with functions and chemistry in mind, and it
shouldn't be formed too soon.
-
A
CEO shouldn't also be the Chair of the Board. The Chair needs to be a
facilitator who makes sure the other Directors are there to defend the
interests of the shareholders, not management.
-
If
you're paying your board purely with stock options, the options should vest
immediately, not over time as in the case of stock and cash-based
compensation.
-
Board
dysfunction most commonly occurs when the board has been picked
indiscriminately or if the Board Chair is weak.
-
Audit
committees are taking on a new importance and new legislation has increased
the importance of having someone on your board with substantial competence
in finance.
-
Liability
issues for Directors, in the context of recent scandals, have recently come
into focus. Director's and Officer's insurance has become very expensive and
out of reach for most start-ups.
-
As
a Director, if you disagree with the rest of the board on a given topic,
vote against it, do not abstain.
The
day ended almost as soon as it began and the audience went away well informed.
The "Building Better Boards" seminar will be repeated in early 2003.
If you're interested in attending, email: time@sfu.ca.
Thanks
to Tom O'Flaherty and Bob de Wit for these comments!
Innovation
and Competition
Competitively
speaking, we ought to be ashamed of ourselves. Canada has slipped to 8th (from
#3 last year and #16 in 1994) place in the World Competitiveness Report.
Our failure to keep up with the competition, our declining secondary school
enrolment rates, and our productivity environment are to blame. Michael
Porter, the Harvard expert in these matters, notes that we have poor
linkages between the private and public sector. [That's why in B.C. we've got
orgs such as the BC Advanced Systems Institute and the NewMedia
Innovation Centre. They do a great job albeit with minimal funding.] Over 10
years ago in his report on competitiveness Porter suggested that we become an
innovation-driven economy. Where did Canada score high was in competition in the
tech industry, the quality of its business schools, internet access, and its
ethical corporations. Other barriers cited included government overspending,
regulatory burdens, weak currency, and inadequate credit facilities.
On
another measure - changes in per capita GDP - we inched to 10th spot, up from
8th last year.
Here's
how the countries ranked in the World Competitiveness Report:
1.USA
2.Finland
3.Taiwan
4.Singapore
5.Sweden
6.Switzerland
7.Australia
8.Canada
9.Norway
10.Denmark
11.UK
12.Iceland
13.Japan
14.Germany
15.Netherlands
Creative
Early Stage Funding
Speaking
of innovation, we could use some in the early stage financing department. Here's
an idea.
One
of the biggest weak links in the "innovation chain" is funding for
proof-of-concept or prototype development - i.e. taking ideas from the R&D
lab to the practical demonstration stage. In B.C., the Science Council used
to fund such projects and the BC Advanced Systems Institute still does,
albeit with very constrained funding. Currently, the SRED (Scientific
Research and Experimental Development) program of our beloved tax department is
the best, and cheapest, source of support. And, it still amazes me how many
companies continue to leave money on the table even though some $1.5 Billion is
paid out under this program. On R&D salaries, for example, private companies
in B.C. (and only inn BC) can get back $.685 on each dollar paid. The only
problem with this is that the money has to be spent first and then claimed back
(there's no allocation or competition involved - as long as the work is bona
fide R&D, you get your dough). That still puts it out of reach of many
innovative scientists and entrepreneurs. So, here's a solution.
Let's
say you need $500K to do R&D to get your idea to a prototype stage so that
you can then attract investors by showing them more than a pipe dream. If you
get investors to put some of their RRSP money into a VCC (B.C. Venture Capital
Corporation) which then in turn invests in an R&D project in a private
company, investors can get back anywhere from 68% to 141% of their money - if
the project fails! If the project is a smashing success, they stand to get many
multiples. But the downside of taking such a risk is not too tough to swallow.
Hard to believe?
It
works like this. Suppose you put $10K into your RRSP this year. You'll get back
$4.3K immediately in tax savings (assuming you're in the top bracket). Then when
your RRSP puts $10K into a VCC, you'll get $3K back from the Province (i.e. 30%
VCC tax credit). If the money is spent entirely on R&D and the company
agrees to discontinue its efforts if the outcome of the R&D is unfavorable,
it should receive as much as 68.5% (SRED program) back on its R&D costs,
i.e. $6.85K on $10K. The company liquidates and this cash flows back to
investors (via the VCC). Add it up: $14.1K. Not bad for a flop! Even if you
don't use an RRSP or the VCC, you'd still get back as much as 68 cents on the
dollar from the SREDs alone. This may just be the way to deal with the
disappearance of funds for this type of seed investment.
Another
federal program that shouldn't be overlooked is Technology Partnerships
Canada (TPC). This program, often criticized by the press as a give-away,
makes $300 million per year available to companies to fund the gap between
R&D and commercial release. This fund is for large projects and provides
capital in the form of a loan that is repaid from project revenues. There are
three technology areas that are supported: environmental, enabling, and
Aerospace. Of the $1.9B already spent under the program, B.C. firms have
received $229M. There's a less well-known component of this program, i.e. $30M
allocated to projects of less than $1.5M. Since TPC contributes one-third of
project costs, that means that up to $500K in support is possible.
For
much smaller projects, e.g. under $50K, NRC's popular IRAP program, is still a
great resource.
Capital
Pool Corporation (CPC) Comments and Update
In
this column, I keep track of Capital Pool Corporation ("CPC")
companies as defined by the TSX Venture Exchange (the former CDNX) because they
may provide funding and management to, and in the process acquire, technology
companies. They provide companies with an alternative to traditional venture
capital financing. It lets the public investor get into the game.
Originally,
these CPCs were limited to raising $750K. After legal and accounting fees, this
didn't leave much for actually doing acquisition. Recently, though, the Exchange
has permitted a combination of CPCs in order to up the ante. A good example of
this is a recent pioneering effort by David Raffa of Catalyst
Corporate Lawyers. The combined three CPCs to provide a pool in excess of
$1.5M.
They
merged three CPCs: Stratos Biotechnologies Inc., Nucleus Bioscience Inc.
and Brightwave Ventures Inc. This gives the three merging CPCs a number
of advantages over all of the other CPCs out there:
*
it gives them more capital to work with ($1.5M vs. $500K)
*
it gives them enough capital to complete a QT without a financing should same
not be possible because of market conditions
*
it gives them the ability to advance down $375,000 prior to completion - thus
eliminating the need for a separate bridge financing
*
it gives them another 15 months of life before suspension (90 days to merge and
then a year to do the QT)
*
no one is diluted in the transaction as everyone merges on cash value - in fact,
it is partially anti-dilutive as many of the stock options held by the
principals of each CPC will drop off the table as not everyone will stay
involved.
This
will put the combined CPC way ahead of all of the other CPCs in terms of being
competitive. It should mean that it will be able to attract better deals and
negotiate better deals because of the amount of capital on hand.
Got
a hot one? Let them know about it!
Check our Capital
Pool Corporation chart (in .pdf format) for
a complete list of the CDNX's CPC and VCP companies, thanks to
David Ing of Pacific International Securities. This list is
updated on a regular, e.g. monthly basis. It is now current to the end of
October, 2002.
An introductory
article explaining CPCs may be found at http://www.bctechnology.com
Local
Events
A
complete calendar of technology events can be found on T-Net's
Events page. There's a new group in town called TACI (Technology
Associations Collaborative Initiative) which also has a tech calendar - check www.techvenue.com/calendars/taci.
Footnotes
If
you're an entrepreneur looking for a place to get your company started; there's
some great space available at Harbour Centre downtown. The New Media
Innovation Centre (NewMIC) and SFU's TIME Centre have teemed up to
provide not only office space but also access to various resources, e.g. tech
advisors, access to capital, mentors, etc. Worried about the high cost of being
downtown? Well, not to worry - they'll even reduce the fees and take some
payment in the form of equity. Check www.sfu.ca/time
for contact info.
A
reminder: SFU's TIME Centre is open for business - business folks, that is. TIME
is an acronym for Technology, Innovation, Management, and Entrepreneurship.
TIME supports the growth and development of the tech industry in B.C. TIME
features a "Business Centre" (looks like an airport business lounge)
which is open to technology entrepreneurs and business people to use as a
drop-in downtown office facility. Need to plug-in? Make some calls? Do some
work? Hold a meeting? There are some great facilities for holding your company's
AGM. Why hang out at MacDonald's when you can work productively at the TIME
Centre? Drop by and check it out! It is located at SFU's downtown campus at 515
West Hastings St.
Michael
Volker, a technology entrepreneur, is Director of the University/Industry Liaison
Office at Simon Fraser University, Chair of the B.C. Advanced Systems
Institute, Chair of the Vancouver
Angel Network and past Chair of the Vancouver
Enterprise Forum. He owns shares in many of the companies he writes about. Copyright,
2002.
What
Do You Think? Talk Back To Mike Volker
Tech Futures is
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technology companies.
Contact: risktaker@volker.org
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