Introduction
We recently published a paper on SSRN, The First Outside Director, that examines the individual chosen by private and public companies as their first outside director.
Little is known about the process by which pre-IPO companies select independent, outside board members—directors unaffiliated with the founder or investor groups. Private companies are not required to disclose their selection criteria or process. They are also not subject to public listing requirements that stipulate independence standards or impose specific monitoring obligations through committees and executive sessions. Instead, board choices are driven largely by company insiders (such as the founder, management, and investors) in consultation with advisors and affiliates to address specific strategic, leadership, or operational issues facing the company. Even the timing of when to invite an external director to the board tends to be discretionary. The result is that a startup company goes from having a closely controlled board comprised entirely of shareholder representatives, to one with unaffiliated outside directors who have equal and independent voting rights, with no standard road map for making this transition.
Here, we look at when, why, and how private companies add their first independent, outside director to the board.
Why An Outside Director?
Companies recruit an outside director to supplement the knowledge and network of personal contacts that the company’s founders, investors, and managers have about managing a business in a specific industry. The challenge that companies and boards face is how to prioritize the issues requiring attention and identify an outside professional with the requisite skills. The list of potential criteria is vast. Directors are expected to help with strategy, oversee management, refocus managerial attention on critical items, advise on internal system development (IT, HR, finance and accounting, etc.), refine marketing and pricing strategies, mediate customer acquisition and business partner development, contribute to talent recruitment through personal and professional networks, provide access to additional financing, and prepare for a potential IPO or sale, while showing the proper levels of commitment, engagement, and professionalism and not overstepping management. All these tasks cannot be accomplished by any one person.
One manual for startups categorizes professional directors by the contribution they make to the firm. The first type are reputation directors, those who bring industry expertise and market credibility because of their name recognition. The second type are active directors, those engaged in the details of board work and ensuring fiduciary obligations are satisfied. The third type are supplemental directors, those who bring functional expertise in specific areas where the company needs development. Once the board is fully established, each of these should be represented on the board. But which type of director should be recruited first?
Research on public company boards offers only modest insight into outside director selection and impact. The most relevant finding is that directors with related-industry expertise contribute positively to performance. Dass, Kini, Nanda, Onal, and Wang (2014) find that companies whose directors have related-industry experience trade at higher valuations and have better operating results. Faleye, Hoitash, and Hoitash (2018) find that directors with industry expertise contribute to product innovation and firm value. Masulis, Ruzzier, Xiao and Zhao (2012) show that directors with industry experience contribute to performance, CEO oversight, earnings quality, and investment. Adams, Akyol, and Verwijmeren (2018) find that, even though companies recruit directors with a variety of skill sets, performance and decision making improve when director skill sets are less diverse and have more commonality.
At the same time, personal factors might contribute to director quality. Adams and Ferreira (2007) argue that it is optimal to recruit boards that are friendly to management: CEOs are more likely to share information with friendly boards and, in return, receive better advice; at the same time, an informed board provides more effective monitoring of management. Khanna, Jones, and Boivie (2014) argue that, while companies benefit from the prior experience and education of board members, the contribution of these directors is limited by their engagement and total workload across all directorships.
Research also shows that director quality can contribute to IPO pricing. Certo (2003) argues that investor perception of board prestige signals legitimacy for the entire organization and improves IPO performance. Bertoni, Meoli, and Vismara (2014) show that boards with value-creation skills are more important to IPO pricing when the company is relatively young; among more mature companies, board monitoring skills are more important to IPO pricing. Similarly, Baum (2017) provides a historical review of the evolution of boards and shows that their monitoring duties, including the independence requirements of public companies, are a relatively late emphasis; boards historically were relied on primarily for advice rather than oversight.
All of this is the 30,000-foot view. Each company faces its own set of managerial, commercial, and competitive challenges, with varying prospects for success. What do actual companies look for in their first outside director, and what does this person contribute to the company and its governance?
The First Director
In fall and winter of 2019, we surveyed 47 private and recently public companies to understand the reasons why they recruited their first outside director. Sample companies include a mix of technology, medical device, biotechnology, energy, real estate, and other service companies. Forty percent of the companies in the sample are publicly traded; the rest are privately held with majority ownership by venture capital (27 percent), private equity (18 percent), or other individual or institutional owners (11 percent). On average, the companies in our sample were founded in 2013 and recruited their first outside director two years later. Those that are public completed their IPO in 2016. Among those that are still private, 36 percent intend to go public, 28 percent do not, and 36 percent are undecided.
Skills and Experiences Requirements
Companies recruit an outside director primarily and clearly to add industry and leadership expertise to the board. The first director is almost always someone with senior-executive level experience within the industry. They are recruited to satisfy a specific advising need, and while governing skill and management oversight are sometimes desired attributes, they are almost never the primary reason for selecting a director.
Eighty-six percent of companies in our sample recruited a director whose primary profession was as an active or retired executive of another company. (These break down as: 36 percent active CEO, 25 percent active senior executive, and 25 percent retired CEO or executive.) By contrast, only 14 percent recruited a first director without executive experience (primarily an unaffiliated investor or other professional director).
Companies identify a laundry list of reasons for selecting their first outside director. The most frequently cited are industry expertise (71 percent), management experience (62 percent), relationships or professional connections (56 percent), experience growing a company (44 percent), and entrepreneurial background (38 percent). When asked to identify the primary reason for selecting this individual, industry, management, and growth-related reasons are almost always cited. Only 7 percent recruited their first outside director because of his or her prior governance experience (see Exhibit 1).