A healthy disrespect for tradition underlies most dot-coms. But when it comes to governance, tradition is exactly what’s needed.
For many dot-com companies, the New Economy has proven to be an extremely harsh environment: Making money on the Internet is far more difficult than most had imagined. The idea that all you have to do is put up a snappy Web site, kick back and watch the money roll in is pure fantasy. In reality, consumers are reluctant to make purchases on the Web, many companies are losing money on every order they ship, and investors no longer buy the Oklahoma land-rush argument that being first to stake out a position is what it’s all about. As a result, dot-coms are disappearing like water in sand.
According to Spencer Stuart’s 2001 study of dot-com governance, “The perception in some quarters is that dot-coms have been allowed to operate largely unchecked, flouting many of the rules and practices that traditional, already established businesses have had to live (and die) by for decades. If more of these fledgling enterprises had been held to the same or even comparable standards, one popular refrain goes, more than a few might never have attracted funding in the first place, let alone find themselves in such dire financial straits today.”
To modify only slightly the title of the 1994 TSE report on corporate governance (“Where Are the Directors?”), one might also ask, “Where were the directors?” Are these business failures occurring because of inadequate governance practices? Are dot-com boards failing to provide management with the kind of support and direction needed for the long term? Is the prevailing board culture of the typical start-up dot-com unhealthy and dysfunctional? This article will attempt to answer these and other key questions about dot-com boards.
In March of this year, the TSE’s Joint Committee on Corporate Governance published an interim report titled “Beyond Compliance: Building a Governance Culture.” The report follows and builds upon the TSE Guidelines for Improved Corporate Governance in Canada (1994), and the Dey Report (TSE, 1999). One of the guiding principles of the joint committee’s report is that “behaviour is more important than structure.” In the words of the report, “We believe that what boards do, and how they do it, is more important than their structure… the challenge of governance today is to go ‘beyond compliance’ and to build a healthy governance culture.” The committee does not minimize the importance of corporate governance guidelines but stresses competencies of the board and how the board behaves. The committee emphasizes the need for a board to establish a relationship with management that moves beyond “examining past behaviour, checking boxes, and providing assurances” to a full, value-adding partnership.
To understand dot-com board compliance and culture, we interviewed more than 20 corporate directors. Half of them serve on traditional boards, while the other half serve on dot-com boards. Our panel members are experienced both as managers and as board members, in an exceptionally wide variety of industries. We focused on board behaviour as we explored a variety of important guidelines. We were not surprised to discover that practices in overseeing start-up dot-coms differ from those in more traditional organizations. Neither were we surprised to discover that many of these practices did not conform to established corporate governance guidelines.
However, we were most interested to learn that many of the objectives of sound corporate governance were, in fact, being achieved, or were alternatively inappropriate, as is the case with many dot-com boards. We learned that dotcom boards have serious shortcomings but also significant strengths, including, in many cases, a highly supportive culture. The key to understanding this special culture lies in the very different way that the typical dot-com board comes into being. As our interviews revealed, a dot-com board evolves. We describe the process below and then provide some interesting findings on how the unique way in which these boards are formed affects board behaviour.
AN EXTENDED FAMILY
The dot-com entrepreneur often has a humble start. In the beginning, working out of a basement or garage, the entrepreneur seeks advice from a relative or close family friend.
As the business scheme comes together, a small advisory group is formed to provide broader expertise and fresh perspectives. With the decision to “get serious,” the advisory group may be expanded to six or more members, nearly all of whom will be expected to invest in the fledgling enterprise. Those invited to be advisers, and later, investors, are frequently relatives, business partners of family members, or close family friends of the founders. That is why the dotcom board of many start-ups is like an extended family.
History, family ties, mutual respect, business relationships, and the simple joy of association draw the group together. The shared experience of starting with nothing but an idea, risking personal capital, establishing the business, and helping it grow has a powerful binding influence on everyone involved. This unique process creates a culture that is significantly different from a traditional board’s; it is more like the culture of a family business. As the Spencer Stuart study found, “Traditional vs. Web-centric firms spawned not only different cultures but also competencies and capabilities. [Dot-com boards] also attracted talent with fundamentally different views about the Internet, expectations of leaders, and approaches to personnel recruitment and development.” As we discovered, these differences are sometimes an advantage; at other times they are not.
INSIDE THE DOT-COM BOARD
Since being a close associate is often a prerequisite for membership on a dot-com board, directors know and trust each other, and understand that, at the end of the day, their personal and business relationships with each other will continue. These folks do not fly into Toronto or Calgary and fly out when the board meeting ends. The next day they are with each other, having lunch, conducting another deal, serving on a charity committee, or meeting for that weekly round of golf. This continuing, daily professional and social contact among dot-com directors differs from a traditional board, and has a much greater impact on decision-making, for better or worse.
By the same token, board decision-making is often complicated by the interpersonal relationships between directors and dot-com managers. Things can become extremely sticky when personnel issues must be dealt with. In fact, several members of our panel identified personnel decision-making as among the most difficult and unpleasant aspects of serving on a dot-com board. (For a more extensive discussion of this topic, see “Dot-Com Boards: Not for the Faint of Heart,” Ivey Business Journal, March/April 2001.)
Working with young entrepreneurs and growing a new business is clearly intoxicating. Yet dot-com directors also report that they enjoy a greater sense of involvement than on traditional boards. Directors also report that having a personal, and often substantial, stake in the enterprise generates a sense of immediacy. There is also the feeling of personal responsibility toward both fellow directors and managers, an onerous burden if the business fails. These psychological factors are seldom important for members of traditional boards.
Given the unusual business models that have emerged in the dot-com world, directors report that, for many, serving on a board is like “going back to school.” Their business acumen is still important, but they must master a steep learning curve if they are to be effective. Directors who have served on traditional boards also report being unaccustomed to the fast-changing business environment characteristic of the New Economy. This is why being able to quickly reinvent the business model or outpace competitors may be the difference between profitability and insolvency.
CORPORATE GOVERNANCE AND THE DOT-COM
While interviewing our panel of directors, we took care to discuss a range of TSE recommendations on guidance. We were aware that dot-com boards, as with the boards of most start-up firms, usually fall short of good corporate governance practice. However, throughout the course of our interviews, we also came to understand that the “extended family culture” discussed above engenders behaviour which often compensates for inadequacies in formal compliance. In this respect, and curiously so in view of their relative lack of maturity, many dot-com boards have moved “beyond compliance,” nicely exemplifying the joint committee’s principle that behaviour is more important than structure. Below, we explain how the behaviour of the dot-com board is affected by the extended family culture.
The TSE Guidelines for Improved Corporate Governance in Canada “support the constitution of boards of directors with a variety of backgrounds reflective of the functions of the business.” We observed that this diversity is a particular strength of dot-com boards. Directors consistently reported that dot-com boards have been established according to perceived organizational needs and not simply family ties. In other words, while board members are often sought from within personal networks, an invitation to participate will be driven by the need for a particular individual’s business background. We also observed that when diversity is achieved by selecting board members who are also friends or associates, boards tend to be cohesive, experience positive chemistry, and are able to make truly collective decisions. The ability to reach a meeting of the minds and do so amicably is an asset that should not be discounted.
The TSE Guidelines propose that every board should consist of a majority of individuals who are “unrelated.” An unrelated director is independent of management and free of any relationship or interest that could interfere with his or her ability to act in the best interests of the corporation. But dotcom boards typically consist of two or three principals in the firm (including the founder) and a few outsiders. This mix could not be described as “independent of management.”
However, given the financial investment and sweat equity of the principals, and the typical investment of the other directors, board decisions will almost always be in the best interests of the corporation, at least as well as the directors are able to predict. Also, several directors on our panel underlined the importance of having managers participate in board discussions and decision-making; one commented that it is unrealistic to expect a board to be more independent.
Most dot-com boards consist of from four to seven directors. The small size of dot-com boards is an advantage in coping with the company’s characteristic focus on immediate issues. Financial survival, not strategy, is the issue that consumes much of a dot-com board’s time. The need to move quickly demands rapid consensus, which is more easily reached by six people than among 16. One director observed that in a dot-com company, it is important to grow the board slowly so as not to overpower insiders. “Sometimes you are not dealing with wildly sophisticated managers and a bigger board might have too much influence over management.”
Frequency of Meetings
The frequency of meetings and interactions is usually much higher and more intense for dot-com boards than for traditional boards; the former sometimes meet more than once a month. In addition, dot-com boards communicate in a variety of ways, often making great use of e-mail and conference calls. The frequency of dot-com board meetings is often a direct result of severe financial crises, changes in financial markets, or other uncontrollable environmental factors including competitors’ initiatives. This underlines the idea that dot-com boards are much more focused on assisting management than they are on purely governing. By meeting frequently, the dot-com board is able to use its expertise much more effectively and intensively than a traditional board.
Most of the individuals on our panel of directors report they are compensated for board service almost exclusively in shares and stock options and almost never receive cash payments. Remunerating directors with shares or stock options is in accordance with the TSE Guidelines, which favour the idea that directors own shares. Recognizing the absence of cash flow in many cases, dot-com directors seem completely comfortable with performance-based compensation (in the sense that if the firm doesn’t prosper, the shares accumulate no value). This is in contrast with traditional boards, where cash payments for board service are common, usually without regard for performance. However, compensating directors with shares and stock options exclusively may limit the dot-com board’s ability to attract and retain well-qualified individuals who prefer to be compensated in cash.
The TSE Guidelines state that, “Each corporation should provide an orientation and education program for new recruits to the board.” New dot-com directors seldom receive any formal orientation, a situation similar to the one on many traditional boards. One director commented that new members receive, at most, a copy of the business plan, the latest sales and marketing information, and an unaudited financial report.
While acknowledging the limited resources of the start-up dot-com, we believe that the absence of new-member training is a potentially serious shortcoming. Aside from the need to bring the new director quickly up to speed on the business aspects of the enterprise, many new dot-com directors are also quite unfamiliar with the on-line world. As one director put it, “We are expected to learn the hard way.” Those directors whose own businesses are in the dotcom world remain up to date through their work. However, others face a steep learning curve, and the dot-com board that ignores this reality may be unable to capitalize on the strengths of those who don’t receive coaching or training.
A board member who receives good information on the affairs of the company will be a more effective director. Ideally, a director should receive highly focused reports on agenda items well in advance of board meetings. We discovered that no such ideal prevails among dot-com boards.
This is partly accounted for by the fact that dot-coms often do not have the resources available to pull such reports together. In addition, dot-com boards meet quite frequently, in extreme cases weekly, essentially making the preparation of such reports impractical. However, we conclude that the frequency of meetings and the extensive use of email and phone calls suggest that directors nonetheless remain well informed. The director who deals with a particular set of problems repeatedly over a few weeks has no need for written analyses.
A board must be accountable to shareholders. However, when the shareholders are the board members, they are directly accountable to themselves and to each other. Dotcom directors have serious concerns as to how fellow directors view their competence, a concern common among directors on traditional boards. Such personal accountability factors generate a substantial individual effort and an attempt to exercise the best possible judgment. In these circumstances, accountability is a very immediate matter rather than the indirect or even nonexistent accountability on a traditional board.
As we have seen, the typical dot-com board is much like an extended family. Relationships are close and it is quite common to see a web of other involvements and associations among board members. Unlike the sporadic contact among directors on a typical board, dot-com directors usually have more frequent contact through family activities, business relationships, community activities and social events. Furthermore, to the extent that directors have invested significantly in the company, they are far more like the value-adding partner in the eyes of managers, and not the necessary evil, as is often the case according to the joint committee. The intimacy of board meetings, the excitement of starting a new business, and the enjoyment of mentoring the younger entrepreneur engender a level of excitement not usually experienced on the traditional board.
We also noted that many dot-com boards have a considerable way to go before they adopt good corporate governance practices. However, the joint committee observes that “for smaller companies, in particular, it is important not to overburden boards with imposed structures that can be quite costly and are more appropriate for larger organizations.” As explained above, the extended family culture often compensates for the less-than-diligent observance of governance guidelines. Still, as stated in the Spencer Stuart study, “In the process of shedding some basic corporate governance traditions and guidelines to satisfy new economy needs, at least some of these emerging companies may well be unwittingly making a few potentially risky tradeoffs.” As these firms seek to expand and attract a wider community of investors, they will experience pressure to adopt higher standards.
The question remains: Why have so many dot-com firms failed if, as we argue, a healthy culture often prevails? We believe that the explanation lies in the fact that the Internet as a business environment is still largely uncharted territory. The business acumen of the “greay hairs” may often fail to navigate the reefs and shoals that lie out of sight. Too frequently, the unfamiliar environment of the Internet, and the way that consumers and other business partners relate to it, leads to the spawning of business models that are doomed to failure. In the end, a healthy governance culture appears to be an important—but not sufficient—condition for success in the New Economy.