Lateral Capital Management, LLC

Selecting Early Stage Directors: Five Essential Vetting Questions

by John O. Huston, Ohio Tech Angels

Angel investors can really help the companies they invest in by helping them understand the profile of effective directors and by making introductions to potential candidates.

Background – There are a lot of “old person’s tales” about how to get a great Early Stage director. For example, company CEOs and their investors often think that writing a check plus possession of deep domain expertise in the new company’s space translates to an ideal director candidate. Terrible thinking. Or sometimes it is presumed that “independent directors” cannot remain “independent” if they make a cash investment in the venture. This is another ludicrous argument. These observations suggest that both Angels and investors could use some counsel regarding the factors in director selection.

Five Essential Vetting Questions – Savvy entrepreneurs who have built highly effective Boards suggest that these “vetting” questions will help companies do it right. By vetting, we mean questions to ask candidates and yourself about what you might really be getting.

  • Do they understand the Business Judgement Rule and Directors’ dual duties of care and loyalty? Entrepreneurs are far too busy to teach directors the basic legal aspects of their fiduciary duty to all shareholders, including the Zone of Insolvency (if operative in their state).
  • Have they ever served as a Director of a start-up that had a lucrative exit or one that ceased operations? Merely having served as a Director of another enterprise is inadequate experience for helping lead an Early Stage company to an exit. This is doubly true if the enterprise was either a Not-For-Profit enterprise or a public company. Not all Board experience is relevant to ESCs. Particularly dangerous are those directors who have served on boards of Publicly Traded Companies (PTCs) if they assume startups are just smaller versions of large companies. They might also presume that babies are just small adults.

If they don’t get this distinction, they will swiftly become fatigued upon realizing the amount of care and feeding ESC’s demand. The first three agenda items for BOD meetings of ESCs striving to hit positive cash flow should be: a) Cash on hand (to the dollar); b) Current burn rate; and c) The No Cash Date (meaning when the cash on hand will be depleted at the current burn rate). Are these ever agenda items at PTC Board meetings? Not likely. Additionally, all of my ventures that have achieved lucrative exits missed payroll and struggled to stay standing at some point. CEOs need to find Directors who won’t be stunned when such a typical crisis arises.

  • Will they make it easier for me to raise my next round due to their “star power” + network + ability + willingness to write follow-on checks? If the venture has neither achieved Survival Cash Flow Break Even (SCFBE) nor has enough cash in the till from the last round to reach it, then its survival hinges on the kindness of investors. This is because such a venture cannot “sell its way to survival” without more funding. Lacking sufficient cash to win enough customers to reach positive cash flow obviously makes investors more indispensable than customers. Even when raising more capital is not essential for survival, “star power” directors who refuse to invest further can scare off other investors. Directors are the epitome of “insiders” so when they won’t invest in the next round they are ensuring it will be harder to fill. In my experience, no amount of “Star Power” compensates for failing to find their checkbook. Such signaling can be fatal.
  • If I must add VCs to my cap table to achieve an exit, what experience/relationships does the candidate have with VCs? Savvy entrepreneurs have heard tales of woe about negative deal drift that occurred after the VC term sheet was signed. This is often caused by the CEO’s all-consuming immersion in fielding VC due diligence questions at the expense of keeping the business on plan (which was assumed in the negotiated valuation). Having a Director lead the VC vetting process plus assist with some of the due diligence lowers the odds of missing forecasts, which often causes more onerous terms at a deflated valuation being demanded prior to closing.
  • Has the Director candidate ever asked me a question that I had not previously considered? Many entrepreneurs suffer self-inflicted problems caused by believing things about their business that are not true, and disregarding others that inconveniently are. This can arise from “Desirability Bias” which posits that we believe things that we want to be true. Incidentally, I use this as a handy excuse for why my results from backing life science ventures are so repulsive. My desire is to improve patients’ outcomes and knowing patients will benefit has caused my willful blindness regarding whether hospitals will pay for the product.

Seasoned startup directors can help avoid these blunders, but ideally will also ask entrepreneurs many “first time questions” they had never heard before. Ventures often burn through all their resources and close their doors, not due to their wrong answers to obvious questions, but due to overlooking the questions that determine their survival. And, savvy entrepreneurs take the long view, knowing this is not their last venture. Extracting as much learning from this outing, whether it succeeds or shutters, can make their next one even more rewarding.

Finally, and to emphasize the point, I would never recommend a Director who would not invest in the venture. If they receive options (as all outside directors should), they are investing. All outside Directors should also be expected to invest cash in the venture and receive options to boost their returns. CEOs who refuse to provide compensation should heed the apothegm: “Pay peanuts, attract monkeys.”

Clearly, Exit Goal Congruence (EGC) with the CEO increases with the size of a director’s investment, but as discussed, the ability to invest in future rounds is more important than the size of one’s first check. Furthermore, I think that if any venture needs to routinely rely on an angel director’s specific technical knowledge (versus her/his network and business acumen), this means the company is woefully understaffed!

Summary – Angels should encourage entrepreneurs to “take the long view” when assessing whether director interactions will likely be illuminating or merely agreeable. The more future capital an entrepreneur’s start-up will require, the more she/he should vet Director candidates on their ability to help attract it. This is trebly true if the desire is to exit without seeking VC funding. When interviewing prospective Angel Directors entrepreneurs should ask themselves “Why do I think this Director will increase the odds that my venture will be successful?” Angel Director candidates can assist by providing honest answers to the five questions above.