3.17 Governance Practices by Stage of Growth for Early Stage Technology Companies

Governance evolves.  The entire content of the earlystagetechboards.com website is to provide a manual and a set of best practices for early stage technology companies to obtain the best value from their Boards of Directors.  Governance, however, is not static.  Technology companies may start out with only rudimentary, if any, governance system.  Over time, as the company grows, its governance practices must evolve to ensure that the company and its management are performing to ever higher standards and receiving the oversight and advice that are appropriate to that stage of the company’s development.

Too often in the rapid change and hard work that characterizes early stage technology companies, governance is neglected.  The needed documentation and oversight are not considered or implemented until a problem is uncovered which jeopardizes a major transaction or an exit. 

Problems with poor documentation.  For example, in a typical tech start-up, all of the focus is on the development of the new product.  Scant attention is paid to accounting.  Shares and options are distributed widely because there is no cash to pay people.  Later, when the founders look to angels to finance the company, they are stopped in their tracks when the angel asks to see the financial statements and the share cap table.  The longer the gaps in the documentation exist, the greater the consequences.  As the company progresses, it may look to negotiate a financing or strategic partnership.  To close the deal, the company’s lawyer must write a clean legal opinion that all of the shares have been validly issued.  If there is not a clear paper trail formerly authorizing the issuance of all shares and options, he cannot deliver a clean opinion and the deal may crater as a result.

Serious consequences.  That said, early stage companies don’t have the resources to put in place the sophisticated documentation and governance systems required of more mature companies.  It may be helpful to explore the governance artefacts and systems which early stage technology companies should adopt at various stages of growth.  The discussion which follows is summarized in the chart attached in section 3.17.1.

Essential practice:  IP assignment.  To begin, from the date the technology company is founded, it is imperative that every founder, employee, director, contractor and advisor sign an intellectual property (IP) assignment agreement which assigns all rights and title to the company for any and all technical and business development done in the context of their association with the company.  There is no touchier subject for investors and acquisitors than IP.  The company must be able to show that every person or company who ever contributed to the IP has assigned all rights to the company.  This eliminates the possibility of some long-departed employee emerging years later to assert IP rights just as a transaction is about to close.  It can be expensive and time-consuming to deal with those alleged rights, and many potential acquirors would rather pass.  Best to eliminate the problem from the outset.  Buy or beg someone for a template that you can use for everyone associated with the IP.

Also, it is advisable to have everyone sign non-disclosure agreements (NDAs) and non-compete agreements.  This creates negative consequences for someone disclosing company secrets or using the company’s knowledge to complete with it.   The IP assignment, NDA, and non-compete clauses can all be included in every employment agreement or contractor agreement.  Again, buy or borrow a template.

Raw Start-up Stage.  A technology company typically starts up with a couple of people with a new idea to change the world. They set up shop in a basement or lab, incorporate a company, give themselves some shares, open a bank account and settle down to the risky business of wiring circuit boards or writing code.  Receipts go into a box.  The only financial information is the monthly bank statements, if they remember to download them in time.  They may be able to raise some financing from the “4Fs”:  Founders, family, friends and fools, in the form of subscriptions to common shares.  Advice and oversight is at best the labour of love from a kindly uncle or interested friend.    The hard-working founders measure their progress against the development schedule for their new project, working to get it launched before their meager funds run out. Customers and revenues are in the distant future.

At this stage, there is little governance or artefacts.  All efforts are on birth, development and survival.  Since the founders are accountable only to themselves and the other 3 Fs, this is appropriate.

Angel Stage.  The picture should change abruptly when the first angel investor writes a cheque.  At this stage, the company is showing some progress with the product.  They may have captured a few innovative customers who are willing to act as beta test sites to provide feedback on the initial product.  An angel investor can see a future potential and is prepared to risk a modest investment, but will likely want to see some controls and documentation put in place. An expense budget will be the first item.  The company will need to hire a part-time bookkeeper to pay the bills, mind the cash, and produce an income statement and balance sheet each month, and a report on the actual versus budgeted expenses. This will provide at least a modicum of control on the company finances.  The company may also discover that they have to file income tax returns and GST or HST returns at the end of the year.  As the requirements increase with the company’s growth, experienced accountants will need to be hired, and eventually a controller.

Until recently, angels were content to purchase common shares and stand alongside the 4Fs in the queue.  Often, if valuation couldn’t be agreed, the angels would make their investment in the form of a debenture which would convert to common shares at a discount, usually 20%, to the price paid by the next investor.  Currently, more angels are demanding preferred shares to give themselves a preference over the 4Fs on sale of the company or its assets.

At this point, the company should formally approve an Employee Stock Option Plan before it begins to issue options to employees and directors.  If options are issued before there is a formal ESOP, the accounting for stock options becomes very complicated. 

This is also the time to formally constitute a Board of Directors for the company.  Many would argue that the angel stage is too early for the overhead of time that a Board requires.  To the contrary, the time invested by a committed and experienced Board will repay itself many times over by guiding the company and its founder managers through the multiple challenges that companies encounter at the angel stage.  Directors of angel-stage companies are most effective if they can help management deal with ambiguity and imperfect information by challenging management`s thinking and advocating a course of action.  The need for pro-active identification of issues and mentoring management in their response is discussed at length throughout the earlystagetechboards website. 

  •  The Board should include at least one angel or independent director with experience in growing companies through the early stages. 
  • The Board should meet monthly, and spend the majority of its time reviewing the CEO’s operations report which should include at a minimum the status of the development schedule, the sales funnel, and the next financing. 
  • The Board should also review the monthly financial statements, and a report of the budget versus actual expenses.
  • The Board should formally approve all issuances of shares and options, and approve any term sheets to raise financing. 
  • The Board should establish a materiality limit for contracts and other transactions and formally review and approve all contracts which exceed this limit. 
  • All Board decisions must be captured in formal minutes which are filed with the company lawyer in the Minute Book.

The company should maintain an up to date registry to records the issuance of shares and options.  Regular updates should be filed with the company lawyer for the minute book, and at least at the end of every fiscal year.

This is a lot to accomplish for a company that is undoubtedly stretched for cash and human resources.  It may take a year or so to implement all of the pieces.  An experienced Chief Financial Officer or Operating Officer can manage all of this as part of their regular duties but few companies at the angel stage believe that they can afford the investment in that level of experience.  The return on the investment in these procedures is two-fold:  first and foremost, the company will be better managed.  The experienced Board can guide the company away from typical pitfalls and towards desirable goals.  A regular monthly review at Board meetings forces the management team to take stock and re-focus.  Secondly, maintaining proper records at this stage will avoid horrendous problems down the road when a major financier or acquisitor conduct formal diligence, as noted above.

Venture Growth Stage.  At the venture growth stage, the company is achieving its goals.  They have proven their business model as revenues are accelerating.  Early adopters are embracing the product, and the company is beginning to gain traction among mainstream customers. 

This is the point at which the company used to look for a Series A round of venture capital to fund its growth.  However, since the burst of the tech bubble in 2000-01 and the global financial meltdown in 2008-09, the venture capital sector has severely retreated.  The asymmetry of venture capital investments is also now becoming better understood.  As a result, many technology companies are looking elsewhere for expansion capital.  The angel networks are filling some of the void.  Whereas angels previously invested independently and somewhat secretively, angels are now formally organizing themselves into angel investment groups.  These groups aggregate the diverse talents and experiences of the angel members to improve the breadth and depth of diligence, and also syndicate investments to increase the quantum and share risk.  Along with the deeper diligence and larger investments, angels and syndicates are investing more often in the form of preferred shares.  Hopefully, the angels will accept a “simple” liquidation preference which on exit allows them to choose between recouping their investment with a small accumulated dividend, or, converting to common shares so that all shareholders are treated equally.  Venture capitalists invariably look for a “fully participating” preference in which they receive a multiple of their investment off the top, but then also participate pro-rata in whatever is left.  It will be interesting to see if angels are true to their name or become more greedy.

Financial controls and documentation increase at this stage.  The company will have an experienced accounting team with segregated duties, including a Controller and CFO or Director of Finance.  The investors will require the company to engage an external accounting firm, typically one of the big 4 (KPMG, Deloitte, pwc, or Ernst & Young), but they may also accept one of the excellent second-tier firms like Smyth Ratcliff, BDO Dunwoody, Grant Thornton, Meyers Norris Penney, or dozens of others.  The company will need to produce full accounting statements with notes prepared according to GAAP, IFRS or ASPE, and have the external firm either review or audit them. A history of reviewed, or better, audited financial statements by a recognized firm is very reassuring to potential investors or acquirors, so the earlier the company engages the auditor, the better.

The Company’s financial systems must strengthen in this phase.  The CFO must prepare an annual budget for the Board to review and approve prior to the start of the year including projection for the income statement, balance sheet and cashflow.  The CFO must report variances against the budget for each month and Board meeting, with a summary discussion, and a forecast for the balance of the year.  The accounting team will closely manage accounts receivable and payable to closely monitor and forecast cash balances.

The Company should compile and maintain electronically a due diligence binder containing copies of every important document in running the business.  These include all material contracts, and also financial statements, share cap table, sales funnel, development plans, investor presentations, product descriptions, list of Intellectual Property, market studies, and so on.  A detailed table of contents for a diligence binder is widely available online or from the company counsel.  A comprehensive and well-organize diligence binder is helpful and credible to the financing and acquisition processes.

One of the most frustrating financial statement requirements which appears at this stage is stock-based compensation.  GAAP, IFRS, and ASPE rules require that companies calculate an arbitrary value for the stock options which vest over the course of the year and recognize it as an expense on the income statement.  The calculation is arduous as it must be performed for every stock option and adjusted if the option is exercised or cancelled.  The amount of the expense is often significant and distorts the income statement.  Many companies resort to reporting an “adjusted EBITDA” calculation which removes stock-based compensation along with other non-cash charges so that readers, like the Board of Directors, can obtain a clearer picture of the company’s financial performance.

Another serious challenge arises when the company starts making sales into the U.S.  Most companies discover only after many months and sales go by that they may be required to collect and remit sales tax individually to each state in which they sell products or services, and in many cases, even at the city or county level.  In fact, there are 16,000 tax jurisdictions in the U.S.  The rules are complex and steadily tightening as the states grab every tax dollar they can particularly from foreign companies who don’t vote.  To mitigate the exposure, it is advisable that every contract and sales order include language that requires the U.S. customer to self-assess and remit state sales tax.  Many customers, particularly large ones and government entities do self-assess, but nonetheless the onus remains with the supplier.  U.S. state sales tax compliance is an area where companies should engage experienced help.  The large accounting firms can help, but at significant cost.  There are also boutique firms who specialize in U.S. tax compliance for small Canadian companies at more reasonable cost.  If the company opens up an office, or hires employees in the U.S., they may also be required to file income tax returns to the IRS and to the state government, with large potential penalties for late filings.

As the rules tighten, the exposure grows for Canadian companies.  US tax exposure is now an item of due diligence for investors and acquirors.  Target companies need to demonstrate that they are knowledgeable and in compliance with U.S. income and sales tax provisions and can reasonably estimate their exposure.  Companies that are not sufficiently diligent may be at risk not just from the taxes, interest and penalties, but also from the collapse of financings or acquisition.

The Board of Directors continues to broaden and deepen its oversight in this phase.  The Board may be restructured to ensure that there are a majority of either independent directors, or directors appointed by the investors. The Board should constitute an Audit Committee to continuously review the financial statements, accounting policy, and preparations and execution if the annual review or audit.  The Board should also strike a Compensation Committee consisting only of non-management directors to review and approve executive and Board compensation annually.  The Board should continue to meet monthly until the company is comfortable generating positive cashflow. 

The Company should also be holding formal Annual General Meetings to receive the financial statements, elect the Board of Directors, and in general account to the shareholders for the performance of the executive team.

Steady Growth, Preparing for Exit.  Once a company has penetrated its mainstream markets, it begins to mature.  It is not betting the company at every decision; it has an established base of customers, and a predictable revenue stream.  Profitability is in sight, if not already there.  Growth is more manageable.

With a more predictable business, the company can be run by the numbers with more focus on performance to budget.  Variances can be measured in the single digit percentages.

If an investment is needed to get the company to exit, it would likely be from a mezzanine private or growth equity investor for whom steady cashflow generation is more important than growth.

If the company’s goal is to exit, preparations should be well underway.  (Some commentators believe that exit planning should begin on the first day of business.)  The minute book should be correct and up to date and the diligence binder updated.

As the business becomes more predictable, the Board may only need to meet quarterly to review operations and the financial statements.  However, if the company is actively in exit mode, the demands on directors will increase significantly.  Some commentators suggest that a savvy Board can double the exit value of the company by orchestrating a competition among bidders and promoting the company’s strength.  There will be significant demand for the Directors’ experience and time.

If the company’s goal is to do an initial public offering (IPO), then the underwriter and their counsel will examine every aspect of the company in order to verify every statement in the prospectus.  This is the time when the work on the minute book, taxes, share and option registry, diligence binder, etc.  pays dividends in terms of shortening and simplifying the diligence component of the IPO.

Summary.  The chart in section 3.17.1 summarizes the components of governance for early-stage technology companies from founding through to exit.  As described herein, the requirements for proper processes and documentation can be onerous, even at an early stage of development.  Companies need to implement and maintain the governance and documentation system appropriate for their growth.  They ignore these requirements at their peril.  Seemingly innocuous oversights can create significant problems down the road and jeopardize significant transactions.  An experienced and diligent Board of Directors can avoid many common errors of early stage companies and also ensure that processes are observed and documents maintained.  It can mean the difference between success and failure.

Brad Feld, a recognized expert in  Board Governance for tech companies in the US, developed the following summary table differentiating the roles of Directors at different stages of growth:

Table 3.2  The Role of Board Members at Different Stages of a Company

Start-up

Revenue

Growth

Role of Board member /  Company Needs

Working / Active

Shaping / Nurturing

Governing / Monitoring

Customer Discovery and Market Development

High

Moderate

Low

Product Development

High

Moderate / High

Low

Sales and  Marketing

High / Moderate

High

High

Finance and Operational Controls

Moderate / Low

Moderate

High

Human Resources

Low

Moderate

High

Strategy

High

High

High

From “Start-up Boards – Getting the Most Out of Your Board of Directors”, Brad Feld, Mahendra Ramsinghani, Wiley, 2014.