Dear reader,

Welcome to the September 2013 edition of The Director’s Dilemma. To read this email in your browser, go to www.mclellan.com.au/newsletter.html and click on ‘read the current issue’. 

This month our real life case study concerns the special circumstances surrounding a board of an entrepreneurial company which is still heavily influenced by its founder but contemplating a major change.

Consider: What would you advise a friend to do under these circumstances?

Zander has joined the board of a privately owned company that is growing rapidly and has plans to list within the next year or two. He is excited by the prospect of the IPO and determined to do a good job as a director, even though he has no prior board experience.

He is finding the role unexpectedly difficult as the CEO, who is also the founding entrepreneur and chairman, is very independent and views the board as a nice think tank - but not as an authority over him. On a few occasions the board has met without seeing up to date financial reports because the CEO was, by his own admission, “too busy building the business to worry about administration”. Whilst the business does appear to be going well Zander is worried that he is not discharging his duty.

Zander had a coffee with the CEO to discuss his concerns. At that meeting the CEO let slip that he had set up a board because the company had reached a growth threshold where a board was required rather than because he felt any need for guidance or control. At the latest meeting it became apparent that the capital structure of the company was changing and that new investors were being invited to take up shares. The board had not approved a prospectus or information memorandum or any valuation of the company. The meeting became quite disorderly as the two professional non-executives expressed their concerns and the CEO refused to divulge information because it was ‘his company’ and he didn’t think they should know how much he got from the sale.

Directors’ fees were due for payment a week after the meeting but have not been paid. The CEO is not returning calls or replying to emails and Zander is wondering what he should do.

How would you advise him to proceed?

My first thought for Zander is to get out while he can! This is a board of directors that is heading for trouble and a business that is heading for failure.

Zander is unable to perform his duties as a director, he does not know the financial position of the company. If the directors have not been paid - are there other long term creditors. Is the business insolvent?

My advice to Zander is let the Corporations Act be your guide.

The CEO and founder is a strong willed individual reluctant to let go. The business will die with him (if not before!) unless he changes his view on the role and value of the board. He needs help, but will not accept it.

However all is not lost just yet, and if Zander feels the business has potential (based on a closer understanding of the business than is known to the reader), the company can still be saved...if there is sufficient will all round.

The point of leverage here for Zanda is the potential IPO. Zander should try (again) to discuss with the CEO in terms of offering sound ideas to make the IPO and business successful in the long term: "Zanda wants to be part of a successful company and he thinks the business has a sound base, and he admires the CEO for his vision etc etc."

If this approach does get the interest of the CEO, then suggest that IPO advisors be brought in to advise the board and discuss governance and other requirements to ensure a successful IPO.

If the CEO accepts this and takes advice, implements improved practices and good governance requirements, ie. An independent chair, and the financial position of the company is sound, then Zander can make a rational decision if he wishes to stay as a director.

If this does not work then Zander should resign and put in writing why he has resigned, keeping a certified and dated copy himself.

Murray McIntyre is a Director of Tradelink Asia Pty Ltd. He is based in Kampangphet, Thailand

Zander must talk with his fellow NEDs. They should unite in opposition to this behaviour.

What basis do directors have for believing the company is ‘going well’ without regular reports?

With an expected IPO in a couple of years it is not unusual for a founder to sell some equity; many investors do not like to see founders ‘taking money off the table’ during an IPO and there will be escrow periods after.

If the new shareholders add value, as well as cash, this will help the company. The board should know who is investing and how they may be perceived by subsequent investors. Do the new investors have a track record of successful floats or are they usually private company stock-holders? Will they support an IPO strategy or prefer a trade sale to a larger company? Will they join the board? How will the answers to these questions impact strategy?

The price of stock at this point is germane; the last traded price is of interest to the next buyers and will influence their price expectations. The CEO should expect scrutiny - there are now very few exchanges in the world where CEO salary details aren’t subject to disclosure rules. Everyone will know what he gets, when, why and how!

Disclosure is not the only change upon listing. The power balance between the NEDs and the CEO will change as new parties join the register. Private equity and institutions may take stock and insist, even after IPO, on a governance role. The CEO must be ready to cede power and must understand choosing to whom he cedes as yet another strategic decision.

The withholding of director fees is another example of not thinking issues through; if the NEDs send letters of demand these will be disclosed in pre-IPO due diligence and could impede IPO success. The sad fact is: most companies that think they will list in a couple of years fail to do so. Many cease to exist. Often that is the result of immature management teams that can’t handle the transition to a new model.

Zander can have one last try to get the CEO on side and, if that fails, he should walk. I would warn that the CEO may vote all the NEDs off and replace them with mates or the new investors. Zander is naïve to expect the agreements when he joined the board to be honoured by a bully when there is a major disagreement. He should have got some director experience on a better run board before attempting one that is under-supported, heading for major transition and possibly about to start infighting.

Julie Garland McLellan is a practising non-executive director and board consultant based in Sydney, Australia.

This is not unfamiliar territory for many private businesses that get to the scale and complexity that warrant independent Board members. Murray's take is pretty close to the approach I would recommend.

If I were in Zander’s shoes, my #1 priority (regardless of the perceived success or future prospects of the company) would be to demand from the CEO sufficient information about the financial position to ensure the company isn't trading whilst insolvent. If this were not forthcoming, I’d resign immediately. The non-payment of Directors Fees might be a red flag regarding solvency (it might also just be because the last meeting didn’t end well), but I’d be looking at others (e.g., is the CEO trying to raise funds quickly to plug a liquidity hole).

Directors will need to consent to the lodgement of any future prospectus if the company goes down the IPO path, so Zander will need to ensure that requirements of ASIC regarding raising funds and the disclosure requirements in the Corps Act are being complied with in that respect. If he suspects that might not be able to be achieved, then it’s another strong factor that might support exiting the Board.

The NED’s duty is to the company and managing the CEO (no matter how difficult or brilliant) is a core responsibility of the Board. Sometimes the relationship between the Board and the CEO is problematic, but if there isn’t trust and respect there with a culture of no-surprises, then it is likely to end in tears.

Michael Rich is a director of Blackhall and Pearl. He is based in Melbourne, Australia.

The opinions expressed above are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling. Names and some circumstances in the case study have been changed to ensure anonymity. Contributors to this newsletter comment in the context of their own jurisdiction; readers should check their local laws and regulations as they may be very different.

What drives Good Board Performance: I was invited to speak on this topic at a lunch in August. The host later made an excellent summary of my points and those raised in the ensuing discussion. Read full report.

Book review - Executive Appointments and Disappointments by John Colvin, Justine Turnbull and Mark Blair. There are few things that impact a company as profoundly as the appointment of a new CEO; it is without doubt the single most important decision a board makes. So why do so many boards get it wrong and end up in costly, distracting and embarrassing litigation with the person they believed was going to be their strongest ally? This new book from the team at the Australian Institute of Company Directors doesn’t answer that question but it does set out some clear ideas that might, if implemented, make it moot.

Inspirational quote -

I have subscribed to a service that delivers an inspirational quote every day. It is a good way to get into a positive frame of mind for the work day ahead. I thought I would share my favourite quote each month. This month my favourite quote was:

"Sometimes the questions are complicated
and the answers are simple."
~Dr Seuss

I have just re-read Malcolm Gladwell’s excellent book “Blink” and agree that, as directors, we often instinctively know the answer yet go through extensive due diligence to prove that we discharged our duty to the required standard. Knowing when to back your judgement and when to rely on analysis is a major skill shared by all the good directors I know.

I also love Dr Seuss books!

If you would like to subscribe the service is run by Darren La Croix at: https://365inspirationalquotes.com/.

This newsletter - If you have any ideas for improving the newsletter please let me know. If you are reading a forwarded copy please visit my website and sign up for your own subscription.

Suggestions for dilemmas - Thank you to all the readers who have suggested dilemmas. I will answer them all eventually.

Farewell until the next issue (due 1 October 2013). Enjoy governing your corporations; we are privileged to do what we do!

Best regards,
Julie