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.


M&A in Q3

It is always interesting to see the Pitchbook report on the M&A market.  Highlights from Q3 deals (which of course are pre-election):

Median deal value increased to 8.4 times EBITDA; been rising all year.  Median deal value as a multiple of target’s revenue was 1.5 times, but greatly skewed by deal size; strategic buyers picking up firms with an enterprise value of over $250M paid 3.2 times revenue; below $25M revenue the multiple was flat at roughly one times.

Private Equity buyers continued to use only about 50% leverage, down from prior years.

Finally, 36% of reported PE deals had seller financing or earn-outs, down slightly from Q2; this ratio historically has been somewhat volatile.

Wonder what happens when the Trump tax plan induces repatriation of offshore cash held by some strategics– 8.4X EBITDA is already pretty heady stuff.  As they say: time will tell.

About Repatriated Off-Shore Corporate Cash

The devil is always in the details when it comes to taxes, and the assumption that companies will just look at the cash that is sitting overseas, and may choose to repatriate it onshore and pay 10% (under the Trump plan) and pocket the other 90% or send it out to shareholders is, shall we say, a large cart before a questionable horse.

First, Trump’s plan is mandatory; whether you bring the money on-shore or leave it off-shore, you pay the tax.

Second this is a tax on past profits, not cash.  What if the company has spent a large part of past profits?  It will owe a tax and will have to fund it with on-shore cash. Or borrowing?

Third, there is a fear that companies will use the extra cash to intensify acquisitions, which may drive up target value and in any event may not increase jobs.

Fourth, there are other plans on the table for this; Speaker Ryan’s plan differs in material ways.  Whose plan, or what hybrid, gets adopted.

Finally, and this has long fascinated me: when the Republican Congress which is always budget-sensitive runs into a combination of proposed tax cuts and increased military and infra-structure spending, what happens?

Will Congress roll over and build deficit?  Will they reduce tax cuts?  Will they cut spending?  If they cut spending, where? Not military; not infrastructure….Cost to borrow will go up also.   How much can be cut from social programs before voters get disturbed?

It just may be that the repatriation of offshore profits will be viewed by the administration as a needed revenue pop and thus increase the likelihood of its adoption in some form.

As with much this coming business season, stay tuned.  But get it out of your head that all US companies with international operations are about to be awash in free cash; it depends.

Supreme Court Tips the law on Tipping: Insider Trading liability standard set

You will read  that the United States Supreme Court unanimously re-established the “old rule” for liability for insider trading: if person A tips person B with material inside information, both parties will be liable for insider trading under the securities laws. This should not be analytically startlingly and, indeed, the Supreme Court had no trouble with it; how often do you see an unanimous decision? But the importance of this decision is that it overturns a cryptic 2014 case decided by the Federal Second Circuit (New York), which held that the government had to prove that the tipper and the tippee “needed to know that insiders . . . were improperly leaking confidential information in exchange for some personal benefit.” Justice Alito made analysis far simpler, removing the test of trying to measure the presence of personal benefit to the tipper: “[Tipper] would have breached his duty had he personally traded on the information here himself and then given the proceeds as a gift to[Tippee]. It is obvious that [Tipper] would personally benefit in that situation. But [Tipper] effectively achieved the same result by disclosing the information to [Tippee], and allowing him to trade on it.” The practical effect of this decision is significant, particularly as it comes from the Supreme Court so it is not likely to be messed with by a trial judge who is charging a jury. Practically speaking, if somebody has a relationship with another person which is sufficiently close as to induce the passing of inside information, both parties are going to have liability.

VCs: Present Practices and the Election

At the Boston breakfast meeting this week of the Association for Corporate Growth, venture capital fund managers discussed how they do business, and the impact of the presidential election. The answer: there will be changes in the business environment, but it is necessary to continue to evaluate investments based on fundamentals, as usual.

Dana Callow of Millennia Partners and Deepak Sindwani of WaveCrest Growth Partners agreed on fundamentals in selecting companies: you need to take a macro view, look for markets which are growing, have a reasonably long time line, and do not get distracted by inevitable changes in the world as you move forward in building great companies. If you build great companies, the money will follow.

The speakers were primarily focused above the seed/A-round of investing. Deepak’s fund is for “growth capital” for firms with revenues and EBITDA. Callow, whose fund focuses on healthcare, will invest with companies with zero to five million dollars of EBITDA, tending toward the lower end of the range, but clearly above the seed/A-round level.

The impact of the election?

For Deepak, whose investments are primarily in the B to B software space, his companies are most affected by “high end” immigration, corporate tax and trade. He speculated that the first two issues would be resolved favorably but trade was a “wild card.” He did not think that companies of less than $50 million dollars of sales would be substantially affected by the election in any event.

Dana similarly seemed unconcerned by the election, noting that the Affordable Care Act was destined for substantial re-write even in a Democratic administration, and that simplification of the approval process in the FDA would be a benefit.

Other significant takeaways include the following:

The investment focus has to be in a robust and growing vertical; Dana for example wants a space to be highly competitive, and looks for “forty or fifty companies” or else he thinks it is likely the wrong vertical.

Best IRR has come from funds with $250 million to $350 million dollars to invest. First time funds tend to be the most successful.

While seed money has mushroomed in the Boston market, A-rounds have become difficult. Growth capital at the low end is also difficult, but easier at the high end. Capital is generally available in the buy-out space.

Family offices are a significant support for raising funds. Family offices tend to be long term investors, and co-investors, and are favored by fund managers.

Finally, there was substantial emphasis on the quality of the CEO. You need to be in a company for the long run. The world will change, and you need a quality CEO to respond; some investment funds have venture partners whom they place on company boards or as advisors to assist in these responses, and they may even share in the fund’s carried interest.

Advice for Compensation Committees of Boards

The NACD panel on executive compensation set forth its perceptions of tasks for the public compensation committee for 2017. Set forth below are some significant take-aways:

The first job of the compensation committee is to figure out how to motivate executives to do the right thing for the company. Don’t get distracted by changing policies of the proxy advisory community (see the November 11th post to this site concerning changes in ISS parameters for measuring executive compensation).

What is the best way for the compensation committee to understand what motivates the CEO and executive team? The committee should stay very close to the CEO and include the CEO in its meetings. A suggestion to make sure that the committee also has its own time to separately consider compensation: an executive session held both before and after each committee meeting.

Executive compensation may be almost “out of control.” The audience was asked, “how many people here are in a company where the compensation committee target is to pay below the industry average?” There is a constant natural pressure, given human nature, to inflate CEO compensation. Coupled with research indicating that virtually every CEO views himself/herself as materially under-compensated, there is a problem which compensation committees may not be able to contain.

Although surveys may be valuable for lower echelon employees, compensation surveys for the C-suite should be looked at with great suspicion. Who did not participate? How accurate is the data? Most compensation committees do try to gauge compensation of chief executives of comparable companies.

There is growing pressure from the proxy regulatory companies on selecting the “correct” peer group for your company, as selecting an “aspirational” peer group will tend to drive up compensation.

See the following post re pay disparity.

Trump’s Impact on SEC reporting of Executive Comp

Those reading newspapers know that Mary Jo White, Chair of the Securities and Exchange Commission, resigned effective in January. What does this foretell for financial reporting of publicly-held companies?

This subject was discussed at the Tuesday morning meeting of the National Association of Corporate Directors/New England, where an expert panel chaired by Ted Buyniski of Radford (comp consultants) explored — or at least attempted to look into — the future.

Simply put: Trump promised to repeal the Dodd-Frank Act; several financial reporting provisions of that Act already are in force by SEC Rule (say-on-pay, say-on-golden parachutes, committee independence, independence of consultants).

Perhaps the most maligned, disclosure of the ratio of a CEO’s pay to the median pay of all company employees, also has been finalized, and is effective for the 2018 proxy season. Also, there are pending proposed rules, covering pay-for-performance disclosure, anti-hedging policy, and clawback from executives.

So what happens next? Will a new Trump-designated SEC chair and Republican majority (three of the five seats goes to the ruling party) put a hold on enforcement of prior disclosure provisions? Will they scotch anything that is pending? Who will be the new chair? (The named leading candidate, commission member Michael Piwowar, is known for his numerous, literate dissents from prior SEC regulatory pronouncements, and his course of action is reasonably predictable.)

As is true with much of the American governance infrastructure, we will have to wait and see. But nary a good word was said by the panel about the pay ratio disclosure requirement (roundly criticized in this space previously), and I wouldn’t bet a plug nickel that ratio disclosure survives for long.

For the broader implications of pay disparity, which the Congress attempted to address by requiring pay ratio disclosure, see a following post.

ISS and Executive Compensation

ISS, proxy advisor to institutions invested in publicly-held companies, has issued changes in its methodology for evaluating executive compensation in connection with recommending shareholder voting under the SECs “Say-On-Pay” advisory procedure. The big take-away is this: ISS is retreating from primary reliance on TSR (total shareholder return) and is considering other factors based upon its own policy survey of both investors and companies.

The test in assessing executive comp has been two-fold: a quantitative test which compares a company to its peers economically, and then a qualitative assessment which presumably accounts for differences between companies (for example, an executive doing a great job on a turnaround may have much weaker statistics than an executive in a more robust company, and thus the turnaround executive may appear to be over-compensated).

Compensation committees (and ultimately full boards) now will have to consider the following additional standards: return on equity, return on assets, return on invested capital, revenue growth, EBITDA and cash flow.

Some interesting factors: in the ISS survey the “least important” metric both for investors and companies was “economic profit,” which is indeed excluded from the list of new financial measures; investors were most heavily in favor of ROIC, and companies most favored earnings per share or EBITDA. When you think about it, these are expectable results; companies are managed by people who often have been economically rewarded, in option plans and otherwise, by robust earnings, while investors want to know their ultimate bottom line: what is their return on their invested capital?

Mass Challenge: Unexpected Geographies and Players

Each year for the past seven years, the MassChallenge program has accepted approximately 128 emerging companies in many industries, which become resident in the MassChallenge incubator (now in South Boston). For each of the last seven years, our firm has been a primary sponsor. Various firm partners, myself included, have mentored many companies. At last night’s award ceremonies, $1,500,000 in monetary awards were distributed to all kinds of businesses from high-tech to beauty aids to a vegan restaurant (hopefully soon to be a chain).

Although based in Boston (now with branches in Newton, London and Israel by the way), MassChallenge attracts an international cadre of emerging companies. The three largest cash award winners included a German company with U.S. operations in Houston, a South Korean company, and a Cambridge start-up that analyzes satellite imagery for commercial purposes.

Innovation is everywhere and some of the world’s largest companies, including those which you might not think would be interested in making investments and supporting emerging companies, were represented at the award ceremony, hosting tables or speaking from the stage. For example, I was seated at the table sponsored by State Farm, the insurance company. I learned that, in several cities, State Farm has representatives of its Innovation Office, and 90 persons are active in seeking  emerging companies for possible investment. The insurance industry is being disrupted, we were told, and it is necessary for any large enterprise to adapt to and become a part of the new economy.