How Venture Capital Influences An IPO's Board Composition

Friday, October 22, 2004

Profs. Malcolm Baker and Paul Gompers, Harvard University Journal of Law & Economics, http://

Abstracted from:
The Determinants Of Board Structure At The Initial Public Offering
Journal of Law & Economics - Vol. 46, No. 2, Pgs. 569-598

Impact of venture capital.
Effective corporate governance depends on an effective board. Setting the board structure at the time of the initial public offering is therefore critical to corporate success and shareholder value. Does venture-capital backing influence board structure? If so, how does this affect the company over time? Harvard Business School professors Malcolm Baker and Paul Gompers wondered if the presence of venture capital influences the number of outsiders on the board at the time of an initial public offering. Using the VC firm's reputation as a proxy for the influence and control of outside investors in determining the board's composition, they considered the relationship between the CEO's influence and authority (measured by tenure and voting control) and the number of insider board seats. Their sample consists of 1,116 firms that went public between 1978 and 1987, one-third of which had venture-capital backing. Most of the boards studied have between four and seven members, with insiders holding roughly half of the seats. Venture capitalists represent the largest category of outsiders, holding an average of 0.66 seats. Each company was followed for 10 years after its IPO, tracking events such as merger offers, merger completions, and other firm outcomes.

Insiders versus outsiders.
The authors found that those companies with venture-capital backing have fewer insiders on their boards. They average 2.4 insiders, compared with 3.2 insiders for companies lacking VC support. This finding is consistent with the notion that VC partners have access to the outside expertise necessary to fill a board seat and that they take an active role in monitoring and managing their portfolio companies. It also suggests that VC-backed boards are characterized by greater independence and oversight. Venture capitalists held over one-quarter of the board seats at companies with VC backing, while they accounted for only 0.1 of the board seats at companies without such support.

Power to the CEO.
The CEO's tenure and authority also plays a major role in determining the board's composition. The proportion of insiders rises as the CEO's tenure and voting control increases, while the number of seats held by venture capitalists decreases. On the other hand, venture capitalists hold more board seats at companies backed by VC firms with strong reputations, and those boards have fewer insiders. VC firms with less experience have lower board representation than the firms with strong reputations. The founder's ability to remain in the role of CEO decreases as the venture firm's reputation strengthens, which, the authors posit, indicates the VC firm's enhanced bargaining power and its ability to find a replacement. CEOs at companies with strong cashflow also stay longer, perhaps because they have less need for external funds.
Longer-term outcomes. No strong link exists between venture-capital backing and long-term performance, although companies with VC backing do show a 7% lower rate of failure over time. The authors' long-term tracking also reveals a slightly higher likelihood that the company with more outside directors and VC backing will receive a takeover offer or be acquired, although such an outcome does not necessarily reflect corporate success or any influence by board members.

Abstracted from Journal of Law & Economics, published for University of Chicago Law School by University of Chicago Press, Journals Division, PO Box 37005, Chicago, IL 60637.

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