Start-up to Exit: Role of the Board

As a company progresses from early stage through growth to some sort of an exit (acquisition, IPO), the role of the Board must change so as to provide requisite skill sets to match the needs for these different company stages.

This was the primary take-away from the National Association of Corporate Directors-New England’s February 14 Boston Breakfast Meeting, which offered a panel of entrepreneurs who are leading growth companies (all of which had an IPO).

A typical trajectory for company expansion was identified:

First, a formative stage where the Board must lead the development of the technology and proving the business model.

Second, various stages of financing through growth mode and thereafter often an expansion through M&A.

Third, many companies themselves go public or are acquired.

Management must guide the evolution of the Board, identifying the particular needs at each stage, and easing people off and on the Board as appropriate.

Many emerging companies combine the chairmanship with the CEO role, which is not thought to be best practice. Indeed, in Europe, this is viewed as an inherent conflict of interest. Panelists noted that a strong, independent lead director is a counterbalance to the tensions created by the same person serving at the top of the company and of its supervising Board.

Aside from orchestrating the composition of the Board, CEOs must make sure that everyone is reasonably aligned; this means management and the Board but it also means dealing with the investors. There are particular tensions where early investors are looking for an exit while later investors tend to have a longer-term strategy. Does this mean the Board must always be thinking about exit, or sale? One panelist replied in the affirmative; you must look at the one, three and five year projections for your business, in terms of growth and business cycles; a sale, if not an overwhelming imperative, is always an option to be kept in mind.

A question from the floor asked whether Boards need to include someone adept at cyber security issues. While the panelists believed this was a growing trend and that cyber security was very important, growing companies have so many Board needs to fill and so few slots that, at least at an early stage, including someone with cyber capabilities is not the general practice. It was suggested that the company can have a series of advisory boards, one of which typically may be involved in the company’s science or business, but one could also be directed toward IT and cyber security issues.

Finally, what about founders? They generally were described as short on patience, and don’t want to stick around awaiting a liquidity event. There is sometimes tension as founders, moved aside into advisory or technical roles, may undermine the growth-oriented and exit-oriented management teams. How to you move a recalcitrant founder aside?

The consensus: very carefully.

Executive Comp and the new Administration

In the current state of lack of clarity as to where proposed deregulation by the new US administration may lead us, certain significant current aspects of executive compensation practices typical of larger enterprises may be subject to radical change.  Such changes can cause massive revisions to what are currently the standard models used in such circumstances.

These are complex areas but executives (and boards) should be alert to the following:

One million dollar rule: Public corporations cannot deduct CEO/highest paid employee pay if it exceeds $1M unless that pay is keyed to specific performance metrics.  If the corporate rate drops to 15% as proposed, there is less incentive for the company to limit fixed compensation.  Also, non-qualified stock options and performance based stock, exempt from the $1M rule, will become less attractive.

Incentive stock options: ISOs have fallen in favor as they deny a corporate deduction and the AMT reduces the tax advantages to employees.  The administration wants to repeal the AMT, which may help rejuvenate ISOs.

Deferred comp: Nothing is so confusing in the executive comp area as rules relating to deferred compensation under Section 409A (to defer tax on income until actually paid, close adherence to the controls in this Section must be observed).  Although Pearl Meyer (well-regarded executive comp consulting firm) states that the new administration has yet to address 409A, they also note that recent legislation has been proposed to alter or even reverse the practice under 409A, thereby upsetting many years of meticulous deferral planning.

SEC disclosure rules: No doubt these are under administration attack, but some are so entrenched in business practice that repeal today will not much matter.  I have posted re the pay ratio rule that is under clear seige even before its effective date, but existing rules requiring advisory say-on-pay stockholder votes and committee independence have lives of their own.  Say-on-pay may have the unintended company benefit of being the canary in the coal mine– better to learn of shareholder unrest, in this day and age, by means of a non-binding straw poll than to learn of it from a proxy fight or activist attack.

SEC: Reconsider (Kill?) Pay Ratio Rule

Just over the internet, via SEC Release: Conservative SEC member Piwowar, acting chair, has solicited input on compliance problems being faced by reporting companies in meeting the disclosure requirement, starting with respect to this year, of the ratio between CEO pay and median pay of all company employees. A Congressional mandate designed to shame CEOs into moderating the rise in their average pay, and a stupid idea from the onset, the pay ratio rule was delayed by years within the Commission even when the liberal Democratic majority was in charge.  Interestingly, Piwowar as acting chair is adopting the “bleed them til they die” approach, not waiting around for Congress to outright kill this disclosure requirement (as I am sure they will).  He went out fishing, whoops I mean asking, for companies to send to the SEC enough industry-driven excuses to support what is no doubt his goal: to defer effective date, and let companies stop spending time and money in gathering data, until Congress itself kills this foolishness.  You cannot “disclose” CEOs into pay submission, and Congress should have been ashamed of itself to even try.  There may be a lot good in Dodd Frank that gets shot down, but the pay ratio rule deserves its own quick death.

Directors vs Trump?

Directors must increase shareholder value.  That is the law in almost all instances; the variables are timing and selection of method.  Activist shareholders are likely to be the major watchdog over adherence to this obligation.

Trump pushes for domestic siting of facilities and, presumably, sourcing of components.  US labor and other costs are high.  Products will cost more to produce.  Such products may be at competitive disadvantage.  Trump cannot directly force the company to select US vs foreign growth.

What do directors do?  What policy postures should a board discuss with, or insist upon for, the CEO?  Trump’s unorthodox, direct approach already has impacted some corporate actions, and drawn philosophical criticism from many, including on the editorial page of the Wall Street Journal.

Boards, as the strategic leaders of a company, need to engage these issues now.  What guidance can they find?  Aside from knowing their industry and company, and aside from prodding management to engage these issues (though hard to believe management is not self-motivated), what outside resources are available to define the methodology of board actions? How does the board approach its minutes in this circumstance?  The answers to these latter questions will evolve promptly in the marketplace; even now, one day after inauguration, the National Association of Corporate Directors has proposed some guidelines for Board process.

Healthcare– Trends amid Chaos

It is common knowledge that in the delivery of healthcare most professionals believe that the trend will be away from “fee for service” and towards “fee for performance,” which means that providers will be paid to treat an entire population as opposed to being reimbursed for given visits or procedures. In practical terms, how will this trend play out?

James Agnew, Vice President of Corporate Development and Acquisitions for Tufts Health Plan and Tufts Health Ventures, an HMO unaffiliated with Tufts University but with an investment arm deploying capital into the marketplace, discussed some aspects of this trend at the Thursday morning breakfast meeting of the Boston Chapter, Association for Corporate Growth. Some high points are set forth below.

Big hospitals, providing healthcare in acute circumstances, are extremely expensive. One of the trends must be to bring healthcare out of the hospitals, to the extent possible, and provide healthcare through health systems, mobile medicine, in-home monitoring and similar solutions.

One overall consideration is how to deliver healthcare in the current regulatory environment. Cooperation between providers and payors (such as Tufts) will be essential. Tufts is active in all three healthcare delivery markets: commercial coverage, Medicare and Medicaid.

Electronic medical records is part of the solution, but extremely difficult to collect. Partners is paying about $1 billion dollars to install the EPIC software, after having spent hundreds of millions of dollars on a prior failed attempt. Agnew believes that ultimately electronic data will be aggregated and the companies which do the aggregation will be much like utilities; a provider or an insurer in search of data will buy the data from a central source the same way one buys electricity.

Tufts seeks investments or acquisitions in hospitals, regional health plans and companies that provide coordination of medical services. They are also interested in companies that foster “consumer engagement,” as healthcare moves more to the home and away from the hospital. They have an interest in wearables and telemedicine, but are slow to embrace direct investments in medical devices. They avoid the complexities of the pharma space.

The landscape is chaotic for healthcare today. The myriad directions in which Tufts is looking to expand and invest echo the complications of this environment.

The SEC is Watching– for now

Each year, the SEC issues a Press Release signaling its enforcement agenda for the coming year.  Although this year’s Release, issued today, likely does not reflect an agenda specifically approved by the incoming administration, it no doubt reflects the intention of the Commission staff and is likely to be pursued in large measure in the upcoming months.

There will be continued effort to protect retail investors from advice provided to them through electronic mechanisms (“robo-advising”), and from overpriced services in the form of wrap fee programs covering both advisory and brokerage services.

There will be continued focus on the manner in which products such as variable insurance products and “target date” funds are offered to senior investors by advisers and brokers.  These same advisors and brokers will be subject also to review of cyber-security defenses to protect investor data.

The Commission will continue its oversight of money market fund compliance, and will also inspect the inspectors by assessing the quality of FINRA’s own examinations of broker dealer firms.

Of course, the press release ends with the usual admonition: the list is not exhaustive and may change.  Certainly the focus on plain fraud against investors, and the whistle-blower program, will continue to occupy the attention of the Enforcement side of the house in 2017.




New Years Board Topics

What should corporate directors be worried about as they prepare for the New Year and the upcoming proxy season?

First, a post-election revisiting to prior strategic planning based upon a reassessment of economic and political assumptions, including impact of trade and tariff issues. But, what else?

An expert panel at the January 10 breakfast meeting of the New England Chapter of the National Association of Corporate Directors also discussed an anticipated de-emphasis of business regulatory pressures. Not-yet-enacted SEC rule-making pursuant to Dodd Frank concerning ban on executive hedging, executive claw backs and “pay for performance” may well never get enacted. There also is speculation that the recently adopted SEC pay ratio proxy regulation, which applies for Fiscal Year 2017 and is reportable in 2018 proxy statements, also may well be sidelined by the SEC. There is no expectation that the existing say on pay rules will be rolled back.

There is growing pressure from shareholders, including institutional shareholders, on director compensation. Boards may consider putting aggregate director compensation to a shareholder vote in order to get protection from litigation and criticism.

The SEC is on the hunt for misuse of non-GAAP reporting measures, which in recent years have shown growing variance from GAAP; both the metrics going into the non-GAAP numbers and the prominence of presentation of the non-GAAP numbers should be looked at closely by the board itself.

New income recognition standards are effective for the 2018 calendar year, and SEC requirements include disclosing in this year’s 10K, if not the actual numerical impact, at least the anticipated general impact.

Finally, certain companies are inviting more constructive activist investors to make an investment, and perhaps join the Board, in an effort to head off a more adverse activist approach; the buzz word for this practice is “validation capital.” Since institutional investors also have moved, to some degree, away from supporting independent activists and have themselves become more direct in engaging their portfolio companies, it is clear that our standard governance model of board-centric corporate management is becoming a dual model, as shareholders are forcing themselves into the board room and will be heard more and more in the coming year.

SEC Pay Ratio Disclosure

The SEC Rule requiring disclosure of the ratio of the compensation of the CEO to the median salary paid the company’s other employees was slow in coming; the law demanding such a Rule was a Congressional response to public pressure about growing pay disparity. The SEC from the beginning questioned the value of such a disclosure and the adoption of the final rule was long delayed.

It looks like the CEO pay ratio disclosure is going to be eliminated by the Trump administration.

The panel at the NACD Boston breakfast forum in November, all members of compensation committees, joined in the criticism of the Rule as a meaningless and incendiary disclosure. I believe it is fair to say that the panel concluded that future deliberations of compensation committees, although complex, will remain “business as usual.” Compensation committees are going to continue to apply common sense, informed to some degree by metrics and approaches suggested by the proxy advisory companies, to fix compensation for CEOs (and executive management) which they deem appropriate in the discharge of their fiduciary duties.

A question from the floor raised one heck of an issue: how smart is that approach (it was of course phrased politely)? Various people agreed, after the meeting, that the press, and perhaps consumers buying products from companies which have enormous disparities between CEO pay and median pay, could generate substantial negative reputational impact. There seemed to be a lack of panel sensitivity to this issue; it was a matter of “how to present disparity so it doesn’t hurt us” combined with an acceptance of disparity.

The panel did suggest that for retail companies, sales on the internet will skew the nature of the work force and decrease disparity between sales people and the CEO. It was also suggested that low-paying jobs are disappearing anyway. Not mentioned is the fact that manufacturing flight from the United States may create unemployed workers but will make the pay ratio seem better as lower paid workers will disappear. The “new economy” compared with the old economy also will tend to decrease the ratio.

Not mentioned at all was to attack the problem directly: drive down pay at the top and raise the lower wage.

So if it is business as usual with well-meaning and well-advised compensation committees, what happens in the macro world in the future? If there is enough public outcry about the pay disparity (which was part of the anger driving the Trump triumph), and if our larger employing companies don’t do much to address that disparity, and if we come upon another election, what will the politics of that election look like?

This issue presents tremendous tension for the implicit social contract in the United States. There is risk here; the Trump revolution may in fact be only the first, and perhaps one of the mildest, of the working class political revolutions we will encounter if current pay disparity trends continue.

(I held off posting this, written about a month ago, to consider its content and to see if passage of a month’s time would bring greater clarity to the issue.  I post it today as part of a discussion which might take place at Compensation Committees as we move into year-end.)

VC on the Board–Can that Director be Independent?

On December 5, the Delaware Supreme Court decided that certain directors of successful on-line gaming company Zynga were not “independent” as a matter of Delaware law, and thus were not eligible to approve a transaction which benefited the majority stockholder and another director, while allegedly detrimental to the company itself.

Most interesting was the disqualification of two directors who were partners in the Kleiner Perkins venture firm which owned 9.2 % of the equity in Zynga.

The Court noted that the company itself, in its NASDAQ exchange listing, did not designate these disqualified directors as “independent.” However, independence in Delaware is not exactly congruent with NASDAQ listing standards. The Court seemed primarily to premise its holding on the fact that Kleiner Perkins’ equity stake evidenced a “mutually ongoing business relationship. . . which [might] have a material effect on the parties’ ability to act adversely toward each other.” Although acknowledging that a personal or business relationship with a major stockholder does not necessarily compromise director independence, Strine then claimed that venture firms compete with each other to finance talented entrepreneurs, and thus partners in the venture firm might not be willing to make decisions that might disadvantage the entrepreneur.

The result is analytically somewhat anomalous. One could equally argue that, holding a 9.2% stake, the VC would be economically motivated to vote against anything that might hurt the company or its stock price. Here, the directors sold stock immediately prior to a substantial dip in its price, a result which presumably might have been apparent to a VC. Would not the economic interest of the VC in fact be adverse to the interests of two directors (one a controlling stockholder) selling a large amount of stock and possibly leading to a drop in stock price, particularly when as it appears that the sold shares were released from “lock-up”?

The takeaways: independence is in the eye of the beholder, each case is fact-dependent, and the tendency of CEOs to name marginally independent buddies to the board, while attractive in a common sense way, is not necessarily a great idea.  Finally, the case should not be read as a categorical statement that directors representing capital investors can never be independent under Delaware law; there were numerous ancillary factoids that may have led Strine to this conclusion in this particular case.

NOTE: Only for the lawyers reading this, the context has been somewhat altered to focus clearly the point. This was an appeal from a holding that a demand on the board, prior to a derivative action, was necessary as there was an independent majority of directors; the Supreme Court here reversed, declaring demand prior to suit unnecessary, because there was not a majority of independent directors available, based on the findings set forth above.  (If you are not a lawyer and you read this note anyway, hopefully you were not confused– but I warned you!)

A break from the law

Today we take a break from legal and business posts to consider a riddle:

What comes from Spain, is all freshness and light, has gorgeous floral topnotes of orange blossom floating above a core of tangerine and guava, is nervy and bold, has a muscular texture, has pear and quince notes mingled with brioche, chamomile and dried pineapple details?

Need more clues?  There is also a juicy acidity, light tannins, subtle hints of a lifted floral component, a voluptuous mouth-feel reminiscence of tropical fruit.  More?  How about grapefruit, a touch of white pepper (whatever that tastes like which is different from black pepper) and toast?

By now my astute followers will recognize it is a wine, on offer at a mere $195 for a whole case from my personal wine shopper.  Cheap stuff.

I am sure that the above list of attributes was composed by taking a large dictionary and stringing together every 14,237th word.

My understanding further is that if the wine were more expensive, they would take every 8,183rd word.

And by that standard– well, let me see. I once drank a magnum of 1929 Chateau Lafite.  It’s description from the wine merchant was indeed attached but I did not recognize it as that.  I recall, rather, asking my partner why an entire 20-volume set of the Oxford Dictionary of English Usage was delivered along with the decanter of wine.

I have just figured it out, and felt compelled to share with group.  Bottoms up.