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Public companies have a well defined corporate governance structure that makes for certain uniformity among governance practices. What about the corporate governance of private companies?
You need to distinguish between private companies owned by venture capital or private equity groups (PEGs) and all other private companies. Companies owned by PEGs generally have a separation of ownership from management (although Partners in PEGs often serve in management roles early on, for example as acting CEO), and in some respects are managed more like public companies. PEG private companies may be more likely to have independent directors (members of the PEG or outside consultants brought in as board members). In addition they tend to have more active boards as well as frequent board meetings (expecting periodic reports and a willingness to quickly replace a CEO or other management who are not performing), audits of financial statements, and the use of compensation professionals. Private companies that are not PEG owned are generally family owned or controlled and this leads to a number of challenges.
What are some of the governance challenges facing family-controlled companies?
The board may be dominated by members of the family and/or management. So the first challenge is to have truly independent board members in sufficient numbers to make a difference. Second, most family-owned private company boards do not have formal committees, such as audit, compensation and nominating committees. These functions tend to be minimized or overlooked, or done on an ad hoc basis by the entire board. Third, many private companies do not have independently audited financial statements. The statements are often not even reviewed by the board, which raises a series of issues in its own right.
Are âindependentâ directors on family owned company boards really independent?
To the extent that there are independent directors, their skill set tends to be quite narrow. They are on the board to help with access to customers or for specific industry knowledge; they are often friends of the family and are chosen not because they will be real âindependentâ directors, but rather to assist the businessâmore like consultants rather than directors. This leads to substantive issues in trying to implement even the most basic structures of board governance in these private companies. The whole perspective, standards, expectations and challenges seem to be quite different, even though most private companies would greatly benefit from having more traditional corporate board governance. This is not to suggest that private companies apply all the principles of public company governance, but having at least some of the rudiments would make a big difference.
Do representatives of PEGs really qualify as independent directors?
An August 2013 Delaware Chancery decision demonstrates the importance of having real independent directors, especially in a conflict transaction, and calls into serious question the practice of considering PEG partners as independent directors even if they disclaim beneficial ownership. After eight years of litigation, the Court found that the sale of Trados to SDL was entirely fair to the Trados common stockholders and that the Trados directors had not breached their fiduciary duties in approving the transaction. The case involved a common fact pattern: the sale of a venture-backed company where the holders of preferred stock, with designees on the board, receive all of the proceeds but less than their full liquidation preference, the common stockholders receive nothing, and management receives payments under an incentive plan.
In 2005, a holder of five percent of Tradosâ common stock challenged the sale, alleging that the entire fairness review applied because a majority of Tradosâ seven-member board was interested in the transaction, since two directors were management who received payments from the sale, and four of the directors were aligned with the preferred stockholders. The court found that the plaintiff showed at trial that a majority of the directors were interested in or had a conflict, and therefore the business judgment rule did not apply and reviewed the transaction under the much more stringent entire fairness standard, which requires defendant directors to show the fairness of the process and the sale terms. The court found that all of the Trados directors who were principals in PEGs were conflicted because the funds wished to sell. An additional board member designated by one of the funds was not independent, even though not an employee of the fund, since he had âa sense of owingnessâ to the fund. VC firms have short lists of their favorite independent directors that often were CEOs of companies they invest in. Although critical of the sales process, the court (noting that the entire fairness test is a âunitaryâ test based on price and process), concluded that the deal was entirely fair because the evidence showed that the economic value of the common stock at the time of the transaction was zero.
Why is this decision important for PEG backed private companies?
Designees of PEGs on boards may be found to be conflicted. The Trados directors ultimately prevailed, but only after years of litigation, which is almost inevitable if the court finds that a majority of the board is conflicted and therefore applies the entire fairness standard. While it may be difficult to recruit qualified independent board members, their participation in a well-designed board process will help avoid after the fact scrutiny and the application of the entire fairness standard. This case shows that private companies would do well to follow some of the best governance practices of public companies, especially in conflict transactions.
What about private companies seeking an IPO?
Private companies backed by PEGs are always vigilant about the path to an IPO. It is important for private boards that believe the company is on a path to an IPO to start acting like a public company board before the IPO. For example, most biotech companies typically form board committees, starting with audit, compensation and governance, and begin to function more like public boards. Forming such committees are related to the timing of the IPO, generally at least a year before the planned offering. In order to comply with the director independence requirements under stock exchange rules, private boards need to evolve from a focus on insiders, founders, C suite officers to independent directors. This is often challenging due to the reluctance of PEG board members to step off the board at the right time and the limited number of qualified independent director candidates who are knowledgeable about the industry sector.