(Note: This is the second in a series of articles that describe best practices for corporate governance at successive stages of growth of early stage technology companies. You can view the first article, "Governance Practices by Stage of Growth for Early Stage Technology Companies", at section 6.13.)
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 meagre funds run out. Customers and revenues are in the distant future.
At this stage, there is little governance or artifacts. All efforts are on birth, development and survival. Since the founders are accountable only to themselves and the other 3 Fs, this is appropriate.
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 upon, the angels would make their investment in the form of a debenture, which would convert to common 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 (ESOP) 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. This is discussed at length throughout the www.earlytagetechboards.com 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 that are filed with the company lawyer in the Minute Book.
The company should maintain an up-to-date registry to record the issuance of shares and options. Regular updates should be filed with the company lawyer for the minute book, or at the very 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, and 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 conducts formal diligence.