Governance Is Critically Important for Pre-Seed and Seed Stage Ventures
By Dr. Michael J. Robinson, CFA, ICD.D
September 2024
The importance of governance for very early-stage corporations was made clear to me early in my career, when I discovered that I was a spectacularly unsuccessful angel investor. I had seriously underestimated the extent to which many founders do not have the experience, personality, nor mindset to be effective as a CEO. In addition, such individuals typically lack the ability to seek out and listen to feedback; that is to say they are not coachable. In an earlier article, I highlighted seven “surprises” for founders becoming a CEO for the first time, but I did not provide guidance for how a founder can improve their chances of success. The purpose of this article is to provide such guidance for the founders of pre-seed and seed stage ventures. In subsequent articles, I will highlight the governance challenges and suggest solutions for later-stage private equity corporations.
This article is based on my past first-hand experiences, including my time working in the venture capital industry. Those experiences are supplemented by insights gained by interviewing other individuals who have founded, provided direction to, or invested in early-stage corporations. Finally, the article includes ideas generated from practitioner-oriented academic research.
Founders come from varied backgrounds with diverse levels of business experience, but all share a passion to change the world. They begin their entrepreneurial journey by studying the market in which they plan to operate to identify a gap that they can effectively serve by developing a new product or service. Collaborating with potential customers the founder will develop and test iterations of their solution until they have identified a scalable business model.
The process described in the preceding paragraph is the Lean Start-up Model of entrepreneurial development, developed by two entrepreneurs from Silicon Valley, Steve Blank and Eric Ries. This model recommends that an entrepreneur spend their time focusing on customer development, agile engineering, and building minimum viable products (MVPs) to test with potential customers. According to Blank, the reason that most start-ups fail is an inability to develop a sustainable business model. The Lean Start-up Model has been extensively adopted by founders, and academic and practitioner research have provided validity to the model. For example, a 2017 study of U.S. start-ups found that the number one failure reason (40% of cases) was the lack of a business model.
Implicit in the Lean Start-up Model is the requirement that the founder has the knowledge and skills to enable them to attract the required resources, notably human and financial capital, needed to operate the business while it is searching for the scalable business model. In addition, it assumes that the founder has the capability to effectively manage those resources during that discovery process. In other words, the founder must articulate a clear vision for their corporation and then attract the resources and build an effective organization to pursue that vision. Many founders believe that building an organization is a relatively minor issue compared to the development of a scalable business model. This view is summarized in a statement made by Blank that “A startup is a temporary organization designed to search for a repeatable and scalable business model.”
The concept of a start-up being a temporary organization is interesting and misunderstood. It does not mean that developing an organization is not important, just that the organization needs to be able to organically adjust and grow as circumstances demand. Thus, during the pre-seed and seed stages of development, a founder must balance the need to remain flexible while still creating an organizational structure and related systems that are robust and scalable. Developing such a structure and systems is a major challenge, especially if a founder has limited experience with these issues.
Developing a strong governance framework during the earliest stages of a corporation’s development can help increase a founder’s chances of success. Many founders believe that governance has something to do with creating a “real” board of directors and can be left off their to-do list until the corporation has identified its business model. In reality, governance entails several issues including the creation of a corporate structure and decision-making processes that serve to attract employees, effective mentors, qualified directors, and investors willing to support the corporation’s development. Failure to invest the time and effort to develop effective governance systems can cause immediate and future problems. This perspective is reinforced in an interview with a leading early-stage legal practitioner who stated: “I think the primary reason that many entrepreneurs fail, or their corporations just fizzles out is that they do not develop the structures or the networks that are key for their success …I mean that too often the focus is on the product and the customer without regard to proper governance and corporate structures” (Robinson, 2023, p. 4).
In addition, having effective governance can help lower the impact of external events. While we all know that Covid impacted the world in multiple ways, there has been little reporting on its impact on entrepreneurs. One immediate impact of Covid was a decline in the amount of angel and VC funding available, and these investors became more discerning with respect to their investments. An individual with past success as a founder and investor summarized the issues as follows: “The current model of venture and institutional investing is that we get way more demand than we have supply. And we’re looking for a reason to say no. Governance is absolutely the easiest one to say no to, and I’ve seen it time and time again” (Robinson, 2023, p. 60).
A 2022 study by CB Insights found that this decline in funding was a significant factor in many start-up failures. In that year, the two top failure reasons were a lack of financing and investors (47%) which led to the venture running out of cash (40%). Accessing financing is important as 40% of founders that succeeded reported a need to have the resources available to be able to pivot their business model. The direct impact of Covid was identified as the number three start-up failure reason (33%), followed by disharmony among founders (21%), poor timing (21%), legal challenges (19%), founder burnout (16%), and a lack of a business model (16%). Note that a lack of a business model moved from the number one failure reason in 2017 to a tie for the seventh reason in 2022.
Disharmony among founders is not uncommon and unless effectively managed can lead to failure, possibly tied to legal challenges, as noted above. There are several important methods of ensuring that founder disagreements do not lead to corporate failure, and one such governance method is the development of an effective founders’ agreement. This agreement should be developed at the time of corporate formation when all founders are still friendly towards each other. I have observed cases where a founding team has a major disagreement when the business does not develop as expected, and one or more of the founders leave the corporation. This causes a significant problem if those individuals continue to own their founder shares after leaving the corporation as it is exceedingly difficult to attract investor financing when a significant shareholder is no longer actively working to create corporate value.
The value of a thoughtful founders’ agreement is highlighted by the following quote from a seasoned VC investor: “Founders’ agreements are very important and shouldn’t be overlooked, especially as it relates to founder vesting. The reality is that many founding teams are going to have some sort of issue come up at some point. If you’re going to have a team of three or four people in the company, one or two of those people may eventually realize that it’s not the right fit for them anymore or they want to go off and work somewhere else. You have to have some sort of mechanism in place that allows for a smooth transition that doesn’t destroy the company” (Robinson, 2023, p. 79).
Other aspects of a founders’ agreement include the initial allocation of founders’ shares, the assignment of corporate responsibilities, the expected contribution of each founder (both in terms of time and money), and a section on how to resolve disputes. I have observed situations where a group of founders decide to allocate founder shares equally, but where one or more of the founders continue to work in their pre-existing jobs. Those who join the new corporation put all their waking hours into making the new venture a success and can begin to resent the fact that their efforts are creating value for others who they see as not experiencing the same stresses or working as hard. Having a tough conversation up-front, and carefully documenting expectations, can help alleviate these potential future issues.
Another issue for inexperienced founders is that they do not realize that when creating a corporation, they are agreeing to accept three distinct roles. The founding team members are likely the sole shareholders, who then appoint themselves as directors, and serving as directors hire themselves as officers (managers). Each role has certain responsibilities, and a failure to make an explicit distinction as to what role they are serving when they make corporate decisions can lead to future issues.
In their roles as directors and officers, the founders have a fiduciary duty to act in the best interest of all shareholders (U.S.) or the best interest of the corporation (Canada and many other countries). In all cases, fiduciaries must not make decisions that solely benefit themselves to the detriment of others. In the U.S., this entails having a consideration of the interests of other shareholders when making corporate decisions, while in Canada and many other countries this duty requires considering the interests of a diverse group of external stakeholders. A violation of their fiduciary duty will expose the directors and officers to potential litigation if their decisions are questioned in the future. Establishing an effective board of directors, implementing effective management and board decision-making processes, and maintaining appropriate records, are three of the best ways for a fiduciary to mitigate their risks.
An example of a way in which founders can violate their fiduciary duty is as follows. For some inexplicable reason, one issue that arises in many seed and pre-seed corporations is that founders begin paying their personal expenses using corporate funds or start using corporate funds for personal non-business-related expenses. A founder must adopt the mindset that corporate funds are reserved solely for corporate purposes, and creating governance processes such as effective financial controls and reporting requirements helps to reinforce this requirement.
Attracting strong independent directors to agree to serve on the board of a pre-seed or seed board is difficult, so in many cases the directors will all be founders. If founders do decide to add non-founder directors to their board, then it is important that they choose highly qualified individuals who will challenge management assumptions, ask tough questions about proposed alternatives, and provide expert advice. Unfortunately, this is not always the case as some founders are not willing to be challenged. As one experienced VC investor noted: “Some founders are looking to add friends to their board who will agree with them. This is not helpful for the founder, nor is it a good use of time for a board member. … All too frequently, board meetings become sales updates by a CEO to ensure continued support. That simply becomes a reporting board, which is a tax on time and energy and does not increase the likelihood of success” (Robinson, 2023, p. 76).
Adding friends or family members to a board also exposes those individuals to significant personal liability. In one situation that I observed, a sole founder added a parent and sibling to their board, then raised significant capital from angel investors. It turned out that the founder was not as truthful as possible about the business opportunity and several of the investors became sufficiently upset that they threatened to personally sue the founder and their relatives on the board to seek remedies. The parent and sibling faced the risk of losing significant wealth, including their houses, for misrepresentations that the founder had made.
As noted in the CB Insights study, founder burnout was identified as a significant cause of start-up failures, and there are several steps that founders can take to mitigate this risk. One such step is to ensure that they build a dedicated support network of family, friends, and peer CEOs. In addition, developing an effective governance structure that includes mentors and perhaps independent directors would be valuable. Mentors are much easier for a founder to attract as they serve as advisors and thus have no legal duties to the corporation. In addition, mentors can be chosen for their ability to provide guidance to the founders with respect to a specific issue, as opposed to having to have a complete understanding of the corporation’s business as is required for a corporate director.
Both independent mentors and directors are valuable in that they can provide an external perspective when key corporate decisions need to be made. An outside perspective is valuable as it can challenge a founding teams’ assumptions and surface issues that the founders have not even considered. In addition, mentors can offer recommendations that expand the set of viable solutions to a problem. The importance of mentors has been well established in academic studies. Mentor support is often found in an accelerator program, and founders who listen to and consider guidance receive greater benefits from engagement with an accelerator. But how is a founder able to attract mentor support?
I recently conducted a study of the Creative Destruction Lab Rockies (CDL-Rockies) program, a member of one of the world’s leading accelerator programs, to try to answer that question. Attracting CDL-Rockies mentors is critically important as a failure to do so will result in a corporation being removed from the program. Analysing detailed data over the first three years of the program, I found that founders who demonstrate an understanding of the importance of governance and are committed to developing a governance structure that can attract financing are significantly more likely to attract a mentor. My study reported that founders who focused solely on product/market fit issues had a 72.8% of attracting a mentor, while a founder who also focused on building a governance structure and attracting financing significantly increased their odds to 90.7%. These findings illustrate the importance that sophisticated mentors place on founders being committed to developing effective governance and having a balanced perspective of their corporation’s development needs.
This article was intended to provide a founder with an appreciation for why thinking about, and implementing, an effective corporate governance structure is important even during the earliest stages of their corporation’s development. Developing such a structure is an effective risk management practice that can help lower the personal stress that a founder faces as they grow their venture. As an example, strong governance practices can help mitigate against founder disagreements causing corporate failure. On the more positive side, developing effective corporate governance will increase a corporation’s ability to attract external resources including employees and financing. Finally, strong governance can help attract independent advisors, or even directors, who can be extremely helpful in providing the founder with additional perspectives and guidance when crucial corporate decisions need to be made.
References:
Robinson, M.J., 2023, Founder’s Guide to Governance: Beyond a Good Idea, FriesenPress, Altona, Manitoba.