The argument goes something like this: Dot-coms and other emerging growth companies are different than the rest of corporate America and therefore the rules for accepted corporate governance practices don’t apply to them.
The counter argument is rather simple: these companies are exactly like everyone else, and sometime soon they are going to pay the price for failing to realize this.
The stark contrast between these two theories, and the gulf of reasoning that separates their proponents, was on prominent display at a recent Investor Responsibility Research Center (IRRC)-sponsored conference in New York. There, in front of a crowd of institutional investors, corporate governance wonks, and the press, Jeffrey Dachis, the 26-year-old CEO of Razorfish, unleashed a deafening multimedia presentation and a boisterous in-your-face speech that left a befuddled audience pondering the meteoric rise of a company whose mission is to ‘recontextualize’ how people think.
Razorfish is essentially an advertising consulting firm with an eye toward utilizing new technology and most people took issue with the composition of the company’s nine-person board. Pressed on board independence, Dachis conceded that three of the five outside directors had worked for the company in the last three years – a big no-no for most proponents of good governance.
Dachis may have only solidified the audience’s largely negative view of dot-com board practices, but Razorfish, which went public in April 1999 at $16 a share and now trades at a pre-split $92, is not atypical. According to an IRRC study of 39 dot-com companies, internet company boards have an average seven directors, compared to twelve at S&P 500 companies. As for independence, the study found that, 53 percent of directors serving on internet boards are considered independent, compared to 67 percent at S&P 500 companies. Overall, 13 of the 39 dot-coms failed to meet the minimum standard of majority independence.
Little room for consensus
While the answer might seem simple enough – the dot-coms and their fast-cap peers need bigger, more independent boards – the reality of the situation is different. For example, size is perhaps the least important issue for many critics of new economy governance. ‘Smaller boards can be just as good as larger boards, and they’re nimble and less expensive, which is important for these companies,’ says Gilbert Amelio, former Apple Computer CEO and a proponent of improved governance at dot-coms. On the issue of independence, however, Amelio adamantly argues that there is no substitute for independence. ‘Business is business, and these companies are just like everyone else, dot-coms or not. Independence is essential,’ he says.
But what is independence? The defenders of growth companies argue that their directors tend to be major shareholders, often venture capitalists who have been with the company since the beginning. Therefore, they offer strong if not stronger oversight than a typical director with less at stake in terms of company performance. Lawrence Begley, for example, outgoing CFO at Razorfish, says the directors are all investors and therefore their interests are aligned with those of shareholders. ‘My view is that we have a board that provides an independent view and oversight of management, so I’m comfortable with the components of our board.’
The board of Promotions.com, an internet promotions company, consists of four outside directors and two insiders. With the exception of one outsider, all are investors in the company. ‘Dot-coms haven’t been around long. So some of the board members are usually investors, either financial or strategic,’ explains Thomas Brophy, CFO at Promotions.com. ‘They are typically very smart individuals with industry experience and, therefore, can add significant value to the companies they represent.’
The ‘independence’ of venture capitalists is a bone of contention, but not all governance activists are as quick to dismiss the role of owner-directors. ‘Being a venture capitalist doesn’t preclude someone from being an outsider. If there are no other economic ties except for ownership of stock in the company, that’s possibly better than having an independent director with no ties and no stock at all,’ says activist Andrew Shapiro, president of Lawndale Capital Management in San Francisco.
William Crist, president of Calpers, notes that such individuals often have as much at stake as a normal insider, but they can also bring a different view. ‘In that sense, they’re outsiders and behave independently.’
But Crist also believes companies need to ensure their independent directors are in fact independent. They can’t be independent if, say, they have other companies in their portfolio (whose boards they may sit on) whose interests run counter to each other. ‘At some point, these companies will have to fall into traditional definitions of independence.’
Easier said than done, says Dachis, who pointed out at the conference that it is often difficult, if not impossible, to find qualified, independent directors for dot-coms. ‘We want aggressive bright people who ‘get it’, not representatives of corporate America who are interested in protecting the status quo.’
Raising the debate
Trying to pin down a definition of independence that appeases everyone seems as hopeful as finding lasting peace in the Balkans. But to Shapiro, what’s most critical is that companies focus on creating ‘process, transparency and permanence.’ He explains: ‘Having good governance processes sets forth the forum to enable an ‘independent’ board to act independently.’
Shapiro cautions that it’s not enough to simply adopt guidelines, which can be altered by a board. He points to Quality Systems, a California-based technology company that he successfully pressured to adopt corporate governance principles, where any changes must be disclosed. Not that Shapiro thinks governance needs to be forced everywhere. ‘In many instances, it’s simply educational – good governance enhances operating performance as well as investor perceptions on that performance.’
The problem is few emerging growth companies are focused on issues that they believe drain their focus away from running the business and surviving the fast-paced, cut-throat environment of the new economy. If guidelines for governance practices are on the back burner at many of these companies, the concept of cementing independence and independent activity for the future is still in a deep freeze.
‘Companies are going from $300,000 to $30 mn in revenue from one year to the next, and then to $300 mn the following year. They don’t have the management to keep up with that, on both management and board level. There has to be some structure, and right now you don’t have it in the traditional sense,’ says Greg Kyle, president of Pegasus Research International, a New York independent internet research firm.
To Kyle, the key is maturity, and he believes that as internet and other growth companies mature, they will put in place proper processes. ‘With maturity, you’ll see more maturity in their boards.’
A lack of will
But when will the maturity occur? The two obvious catalysts are a negative event that focuses attention on governance, or a push by investors for action. Unfortunately, it’s impossible to predict when a crisis will hit. As for the will of investors, it seems to flounder in direct proportion to the soaring valuations of emerging growth stocks.
‘Good governance isn’t at the forefront of people’s thoughts when things are going swimmingly,’ explains Crist, who believes institutions should worry about board independence in growth companies.
Jay Tracey, a fund manager at Oppenheimer Funds, is one of the few vocal managers when it comes to concern for governance practices at dot-coms and other emerging growth companies. ‘Management is key when you’re a small-cap investor, so I try to understand their experience and expertise. The truth is, nine out of ten IPOs that I see have less than two or three outside directors.’
Tracey says that there’s little time dedicated to governance on the part of the companies themselves and the investment bankers and analysts presenting them. ‘I tell bankers I want more information on the management and board. More of us need to communicate that. But most of us are trying to figure out what these companies do, and we have limited time for anything else,’ he concedes.
Act now
While emerging growth companies may be enjoying a catatonic investor base, there are rumblings of change. Crist, for example, says that although there is no formula to define when a company is mature, some of the dot-coms have reached a critical mass. ‘We’ve never had to consider dot-coms for our focus list of underperforming companies, but that’s changing as Yahoo comes up on the screen,’ he says.
There’s also the interesting case of eLot, the parent company of eLottery, which announced in late February that it is implementing Nasdaq’s recently revised independent director and audit committee standards. Shapiro believes eLot is the first dot-com or high-tech company to adopt ‘good, strong transparent governance’ proactively in advance of trouble. ‘eLot is doing this because it recognizes that it will aid it in attracting large institutional investors,’ he says.
‘As we’ve been going through the search for my replacement, we decided it’s important to embed in the culture of the business a strong and independent board in order to avoid becoming insider dominated. It may not be a danger now, but we felt it was important for the future,’ says eLot’s outgoing chairman and CEO Stanley Kabala.
Originally a bricks and mortar business (operating under the name Executone), eLot didn’t follow the traditional stages of financing that bring in venture capitalists (it also didn’t enjoy the attention of a splashy IPO). But as Kabala points out, nearly all of eLot’s directors are major shareholders. ‘We changed our board compensation to include minimal stipends. Directors receive the majority of compensation in the form of shares and options,’ he says.
Kabala notes that the company is going beyond the adoption of governance principles; it will specify a fixed date for the plan to be adopted to ensure transparency. ‘We think it needs to be put in the bylaws because boards can re-resolve a board resolution.’ As for finding directors who meet the criteria for independence, Kabala says, ‘There are plenty of qualified people out there, it’s just a matter of looking.’
