Management: Corporate Governance
Dot.Com Boards Are Flouting the Rules
They're small and packed with insiders. Does it matter?
Take a look at the board of directors of one high-flying Silicon Valley dot.com. At first glance, it looks like a throwback to the days when the words "corporate governance" drew blank stares from management. Just six directors sit on the board, three of whom are current executives. That far surpasses the average level of insiders on most boards: 18%, according to the latest board-of-directors survey by Korn/Ferry International, executive-search specialists.
Nor do two of the board's three outside members appear to meet a standard increasingly accepted in Corporate America for director independence: no business ties with the company on whose board that director serves. In the case of this dot.com, one director--the chair of the compensation committee, no less--works for a company that is owned by a major investor and has current business dealings with the dot.com. Another is one of the company's original venture capitalists. He, too, has worked closely with management since long before its initial public offering. Only one of the six directors has no overt connection to management.THRILLED. So is the company's incestuous board structure facing intense criticism from a host of hot-under-the-collar institutional investors? "Not at all," says Timothy A. Koogle, chairman and CEO of the company in question--Yahoo! Inc. "We are very careful about everything being at arm's length." Indeed, most investors are thrilled to have a piece of the action, since Yahoo! boasts one of the most dynamic stocks in history. Since its April, 1996, IPO, Yahoo! shares have risen a split-adjusted 15,936%, jumping 24% on the news that it was being added to the Standard & Poor's 500-stock index. And if its board looks as much like that of a startup as a company with a $91.6 billion market capitalization, in many ways it is both.
Yahoo! is hardly alone. In many fast-growing technology companies, a new board model is springing up that bears little relation to the one that governs most of Corporate America. Centered in Silicon Valley, the trend is spreading fast, thanks to the flood of venture capital and the lure of IPO millions that are whisking startups from the drawing board to the big leagues in record time.
Yet it's hardly limited to the dot.com world. From high tech's best-known stars to its rising up-and-comers, many are shrugging off concerns over conflicts of interest to argue that some standards considered "best practices" at mainstream companies are irrelevant in their ultracompetitive world. Rather than being a liability, small boards peopled with insiders and well-connected outsiders can create a strategic advantage, say high-tech advocates. "This is less about governance and more about practicality and the speed with which these businesses have to compete," says Dan Levitan, a managing partner at Maveron LLC, a venture-capital fund that helped finance drugstore.com Inc. and eBay Inc."DRUNK." There's an irony here. Just as mature companies are finally accepting the idea that a large, diverse, and independent board is a good thing, many tech companies are flouting the notion altogether. And as long as their stocks continue to zoom ahead of those of their stodgier peers, they've come in for remarkably little criticism. Even TIAA-CREF, the huge pension fund that has been among the most active in pushing for improved board standards, says it has no current plans to approach Yahoo! to discuss corporate governance. That's true even though the company has clearly reached a stage where "it should be moving toward a more traditional model," says Kenneth A. Bertsch, director of corporate governance at TIAA-CREF, which holds $167 million worth of Yahoo! shares. Adds Andrew E. Shapiro, president of Lawndale Capital Management LLC, an activist investment firm in San Francisco: "Smokestack companies are much more sensitized to governance than Silicon Valley companies. [Valley] shareholders are drunk off of good times and high multiples."
Of course, that greater sensitivity didn't come about by accident. The whole governance movement--and the now-common standards that activist shareholders have battled to achieve--occurred because many boards in the '80s became extremely lax about looking after shareholders' interests. Only after such giants as General Motors Corp. or Sears, Roebuck & Co. ran into problems while their boards seemed asleep at the switch did activists push directors to take a much stronger oversight role.
That's clearly not the case in today's cutthroat technology markets. Advocates of Silicon Valley-style boards point out--rightly--that neither these companies nor their boards are underperforming. On the contrary, many in Silicon Valley argue that their tightly knit, heavily invested boards deserve much of the credit for the sector's red-hot streak. Directors at tech companies, they point out, are more actively involved and hold more stock than typical board members. "There are more and stronger infused ties and [more] communications on these boards," says David B. Kixmiller, managing partner at Heidrick & Struggles Inc.'s international-technology practice in Menlo Park, Calif.DIFFERENT FEEL. But is trouble lurking in paradise? Some corporate-governance experts view the downplaying of board standards as a dangerous trend. Sure, many New Economy companies are producing amazing shareholder returns. But board watchers fret that they won't have structures in place to deal with a spectacular meltdown should things go terribly awry. "It's really not until something goes wrong that people focus on [governance]," says board expert Charles M. Elson, a professor at Stetson University College of Law. "You should have a decent structure in place so you can avert a disaster."
Starting with their size, Valley-style boardrooms look and feel different from those of their older peers. While mainstream boards tend to be large and diverse, those at high-tech and e-commerce outfits are often tiny. EBay Inc. has a board with just five members, compared with an average of 11 for most public companies, according to Korn/Ferry. The smaller board means insiders have relatively more power. And the absence of just one member can have a huge impact. "People leave, and if you've got a six-person board, you could be vulnerable to disruption," says Kixmiller.
Nonsense, says Koogle of Yahoo!, who argues that having a micro board has been an advantage for a company that has had to develop on Internet time. "When you're starting a business from scratch," he says, "speed is everything. Keeping the board small and concentrated really helps. You don't have to manage the interrelationships between board members."
Moreover, while putting a relatively high number of insiders on the board has become a no-no at most large public companies, it remains normal practice at many fast-growing Valley companies. In part, that's because many are startups. In many cases, the insiders are founding execs, and they often own huge stakes. Yet as startups have grown quickly to boast enormous market caps, the number of insiders often stays high. According to Spencer Stuart's Internet Board Index, 31% of board members are insiders, compared with 22% for companies in the S&P 500.
The outside directors themselves also sometimes have close business ties to the companies. On Valley-style boards, for example, it's viewed as a vote of confidence for a venture capitalist who provided key funding early in a company's life to remain deeply involved. Yet that raises another issue: While mainstream governance advocates argue that directors should limit themselves to just a few boards, venture capitalists tend to be on numerous boards at a time. And although venture capitalists are often forceful, active board members, not everyone thinks they provide a perspective totally independent of management. "We would consider a founding venture capitalist to be an insider," says TIAA-CREF's Bertsch, adding that a "substantial majority" of directors should be outsiders to avoid conflicts of interest.BACKFIRE. These issues aren't just related to startups--they're a factor at some of the tech industry's biggest players, too. Look at the board of Microsoft Corp. Its board had just seven members--and one of them, Mattel CEO Jill E. Barad, resigned in November after a year of poor attendance. Of the remaining six, three are current or former Microsoft execs, and one, David F. Marquardt of August Capital, was a founding venture capitalist, who himself missed half the audit- and finance-committee meetings last year.
Does the small size and heavy insider influence matter? Microsoft Chief Operating officer Bob Herbold defends the board as "having an appropriate but not unwieldy number of directors." He adds that Barad's poor attendance was one reason she quit and that Marquardt attended all regularly scheduled full board meetings. Yet in a year in which Microsoft fought off its antitrust suit in an aggressive manner, which appears to have backfired, there were very few voices from outside present in the boardroom. While it's impossible to know whether Microsoft's approach might have been different had there been more outsiders, it is certain that few, if any, investors complained. "These guys operate under a different set of rules," says John T.W. Hawkins, a managing partner at executive search firm Russell Reynolds Associates Inc. "How come no one cares? Because of the stock price."
The stock price, however, has as great an impact on Microsoft's board as it does on its investors--a key distinction that many traditional boards are now scrambling to emulate. Perhaps the biggest difference between high-tech board denizens and their peers at traditional companies is that tech directors are often far more highly invested in their companies. At Yahoo!, for example, the six board members together control 14.5% of the stock. And it's not just the founders and the venture capitalists who are in the money. According to Russell Reynolds, 80% of computer and electronics companies pay their directors in stock or stock options, compared with half of the companies in the S&P 500.SAME INTERESTS. For proponents of Valley-style boards, that high stock ownership is a big reason the traditional need for the board to act as a watchdog is diminished. The interests of insiders are identical to those of shareholders. As a result, such boards are far more willing to throw out poor performers or change direction if a strategy isn't panning out. "The traditional view that governs blue-ribbon governance panels is: `How do you fix the problems that occur when ownership is different from control?"' says David J. Berger, a lawyer at Wilson Sonsini Goodrich & Rosati in Palo Alto, Calif., the biggest law firm in Silicon Valley. "Here, typically the board owns the company. There's no concern about entrenchment. There's a concern about expertise."
All of this points to a strong difference of opinion on the appropriate role of directors. Should they participate actively in management or provide oversight? Many of today's high-tech board members see their job as actively setting the company's course. According to Korn/Ferry, 47% of respondents from high-tech companies said their boards helped develop strategy, vs. 34% of boards overall. "The board is not viewed as a governing mechanism," says Levitan. "It's viewed as a top-level strategy group."
Indeed, on many high-tech boards, outsiders are brought in for their connections or specific technical knowledge rather than their independent perspective. Their job might be to help facilitate business deals as much as it is to evaluate those deals independently. Venture capitalist Venetia Kontogouris, managing director of the $600 million venture fund Trident Capital and a member of 11 boards, including e-commerce consultant Viant Corp.'s, considers it a normal part of her job to use her connections. "I'm always willing to place a call to another CEO for the benefit of the business," she says.
What such boards gain in connections, however, they may lose in perspective. Women, for example, make up just 3% of all Internet-company board members, compared with 11.5% for S&P 500 companies, according to the Spencer Stuart Internet Board Index. "They have a lot of things to think about in terms of the composition of the board, and diversity is just one of those," says Julie H. Daum, co-managing director for U.S. board services at Spencer Stuart. "They need to have people who understand governance and business cycles."SCRAMBLING. The focus on active management also means that some traditional board functions, such as management succession, may get short shrift. At most big-company boards, grooming or choosing a new chief executive is now considered one of the most important responsibilities of all. But some in techland--where CEOs under 50 are relatively common--believe that replacing the CEO is the last thing the board should worry about when the company is scrambling for survival. "High-tech boards don't work on succession planning," says Novell Chairman and CEO Eric E. Schmidt, who is also on the board of Siebel Systems Inc. But isn't it the board's job to plan ahead in case of the unforeseen? "[CEOs] in this sector aren't leaving," Schmidt states flatly. "They aren't getting hit by a bus."
Moreover, critics argue that although certain benefits arise from having a board with lots of heavily invested insiders and closely linked outsiders, such links also raise conflict-of-interest questions. After all, as in the case with old-line companies, if a board member has long been close to the CEO, or his own firm gets a nice chunk of business from the company, he might not act independently when evaluating compensation schemes or other key issues.
Proponents of the new-style tech boards scoff at such notions. So what, Berger argues, if high-powered Silicon Valley lawyer Larry W. Sonsini performs legal services for a client such as Novell and also sits on its board? Given his close connections with hundreds of local companies, the notion that Sonsini might use his board ties to bring business to his firm is ludicrous. "Larry is asked on a daily basis to be on a board," adds Berger. "There's no concern that he would be on a board to get business."
Such arguments hold no water for governance traditionalists such as Elson, however. He thinks oversight and succession planning are the raisons d'etre of any board--no matter what the sector. "Succession planning does matter," he says, citing the case of Texas Instruments Inc., whose CEO died suddenly in 1996. "What if its board took the same casual attitude?" Stock ownership is a good thing, he argues, but it doesn't guarantee a board's independence and good judgment by itself. "The board should not be an extension of the management team," he says. "It's like a dog chasing its own tail."
Others question the startup model as well. At Internet-technology company Cisco Systems Inc., Chairman and CEO John T. Chambers is trying to create a middle ground. He wants a board that combines the greater involvement and high share ownership of tech companies with the larger size and diversity of traditional boards. His 10-person board boasts one venture capitalist and three current CEOs of other companies. But to avoid the problem big company boards are often attacked for--letting aging directors hang on too long--Chambers says he wants to rotate one or two regularly as different business skills become needed. "We have to invigorate the board and churn it every year," he says. "The speed at which change is evolving applies to the board makeup."
Could the roaring success of the likes of Yahoo! change the way corporate governance is perceived altogether? Certainly, the issue is picking up steam. In January, the nonprofit Investor Responsibility Research Center will hold a conference aimed in part at determining whether young high-tech companies should be governed differently from their traditional counterparts.
Whatever differences come to be accepted, you can bet that when the day comes that a high-profile tech company blows up, the question long asked of traditional companies--"Where was the board?"--is sure to be raised. Ideally, that question will be asked before, not after, poor management torpedoes some of the shareholder value this vibrant sector has created.By Jennifer Reingold in Palo Alto, Calif.Return to top