CORPORATE

GOVERNANCE
DURING VENTURE
CAPITAL

Theoretical and Empirical perspective

Lauri Tuomaala 376064

Jonaaron Välikangas 424518
Tommi Lindström 361956
Anni Kankaanranta 422277

18.5.2018
Content
Introduction 2

Part I: Literature Review 2

Corporate governance 2

Venture Capital 3

Corporate Governance setting of VC-backed firms 3

Ownership structure 3

Relevant parties in venture capital 4

Venture capital financing timeline 6

Stages of venture capital investments and corporate governance 7

First phase: Deal sourcing and investment decision 8

Second phase: Management of the investment 9

Third phase: Exit 11

Part II: Empirical Perspective 12

Interview introduction and results 12

Breakdown The first thing that we see from the interviews of both Eeva and Bill is the role
knowledge and education play in the board dynamics. The typical founder type often has no
formal financial background, unlike the financiers who jump in to the company after they’ve
proven their model’s worth in the real world. 18

Part III: Conclusion 19

References 20

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Introduction
Corporate governance during venture capital is an interesting topic as there is no extensive prior
research on the matter and, as Connelly et al. (2010) point out, ownership structures including venture
capital and thus the relationships on the top of the management evolve by time causing possible
conflicting interests even between the owners themselves. These aspects are not covered by
traditional corporate governance theories such as principal-agent theory where the owner base is
considered homogeneous with one aligning interest.

One concrete reason why we expect the roles of owners and managers to differ from the traditional
corporate governance setting, is the fact that venture capitalists are usually more active owners and
they aim to exit the company after certain period instead of continuous ownership. Thus, in this study
we will focus on venture capital during its lifecycle and investigate which type corporate governance
institutions are being highlighted and how the relationships on “the top of the company” are being
organized during the different phases. Some challenges that may face during the study is the limited
amount of information from the inside of venture capital companies as there are not many, if any,
public disclosures. We aim to mitigate this gap via interviews with venture capitalists in the empirical
part of the study. Our focus is on relationships and organization of the VC, the board, the management
and other shareholders.

We organize the study as follows. In part one “Theoretical Background”, we first go through basic
concepts related to corporate governance during venture capital and how we define or possibly narrow
them down in our article. After we introduce the governance setting specifically for venture capital,
and in the last part of literature review we go through specific phases of venture capital and typical
governance methods used during each.

In part two, we introduce our methods for the empirical analysis, semi-structured interviews with
venture capital experienced professionals and present our main findings from them. In part four, we
make our conclusions.

Part I: Literature Review

Corporate governance
Corporate governance studies relationships between different shareholders of a company and the
methods and mechanisms that aim to solve related issues by monitoring and distributing power

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between the relevant parties (Roe, 2004). Traditionally, relevant parties are the owners (shareholders)
and top managers of the company principal-agent theory being the pillar stone of most corporate
governance topics. Sometimes other stakeholders such as employees are included in consideration
when the aspect of corporate governance extends from top of the company to the whole company and
its business environment. As our scope is to investigate governance methods in venture capital, we
will narrow down the relevant parties to managers, the board and venture capitalist as the main type
of owners.

Venture Capital
Venture capital is a form of private equity funding unlisted small firms in their early phase and with
growth opportunities the aim of which is receiving capital gains by ultimately moving the firm to
public equity markets. Venture capitalists are usually professional investor(s) investing in risk equity
and whose goal is to realize their gains by exit, for example by IPO or trade sale. (Bartlett, 2006.)
Venture capitalists are considered outside owners, but still, in order to ensure the increase of firm’s
market value, they are usually actively involved in the management of the firm too. To minimize their
risk, venture capitalists may diversify and have several investments in different companies at once
that affects how engaged he or she can be in one company (Zider, 1998). Compared to so-called
business angles who practice similar activity to venture capitalists, venture capitalists traditionally
appear later on during the lifecycle of a firm’s financing during the growth-phase while business
angels give the very initial funding to start up a firm from a business idea.

Corporate Governance setting of VC-backed firms

Ownership structure
Corporate governance setting in a venture capital -backed firm differs from that of a traditional image
of a company’s governance mainly due to ownership structure. In publicly traded large companies
the ownership is dispersed with numerous owners with smaller stakes in the company. This setting is
called “diffused ownership” that leads to principal-agent problems between the owners and
management and that tries to be solved by vertical governance (Roe, 2004). However, as the
ownership and management are separated and venture capitalists have specific interests and
expectations from the company these principal-agent problems are present in venture capital too and
several article handling VC study the agency problmes (e.g. Broughman and Fried, 2013; Bartlett,
2006).

Alternatively, company may have a dominant shareholder, especially in a case of a private or small
company, there tends to be only few owners with larger stakes in the company, who can be for

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example entrepreneurs and founders. Having a major shareholder or owner in the company leads to
horizontal corporate governance and conflicting interest may occur between the owners themselves.
(Roe, 2004.) Because the venture capitalist usually is the major owner of a company (figure 1), one
could argue that the setting of horizontal governance with related challenges is the main theoretical
framework for VC-backed firms. Research has identified issues arising from conflicting interests of
owners in venture capital for example in the form of a resistance of possible IPO. (e.g. Broughman
and Fried, 2013; xxx). The presence of both type of recognized challenges are in line with Bartlett
(2006) who states that VC-backed firms face problems traditionally associated with private and issues
usually associated with publicly traded companies as companies are in their growth-phase in between
of being a start-up and going public.

Figure 1: Horizontal governance and relationships at the top of the management in a VC-backed company. Adapted from Roe, 2004.

Relevant parties in venture capital

Broughman (2013) calls the relevant parties as the “entrepreneurial team”. The entrepreneurial team
includes firm’s founder, other executives, common shareholders and the venture capitalist. Compared
to large companies, the “top pf the management” is more compact in a case of entrepreneurial team,
and most of the conflicts recognized and addressed in literature are between the VC and other
members of the team. VC may face resistance first when acquiring and restructuring the company to
meet his own targets and later upon IPO or trade sale as other members might be reluctant to give up
their holdings and power in their startup, possibly for sentimental reasons among others. However,
the company and its stakeholders - founder, managers and other shareholders - also benefit from the
VC. In addition to finance they reduce their own personal risk on the company and gain VC’s possible
experience and business relations in the industry (Zider, 1998).

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Traditionally, managers are feared to “shirk and steal” based on agency theory. As they are handling
owners’ assets instead of their own, theory suggests that rational managers wouldn’t work to their
utmost efficiency as they aren’t bearing the risk and it is hard for distant owners to monitor
performance. Consequently, they may make decisions beneficial for themselves but not for
shareholders or company’s value. In a case of venture capital, the managers also face risks of changes
in their positions and business as the firm grows and possibly becomes sold at some point. Thus, a
manager may want to retain the firm’s independence, stay in control and fear losing power in the
company when the VC first enters the company, and later they may fear future changes such as
dismissals resulting in a resistance towards VCs exit plans. (Broughman, 2013).

Based on our theoretical analysis the board’s attitude towards VC depends on its composition and
characteristics, mainly the independence of the board. Traditionally board members are classified
either as dependent (person having relevant connections to management) or as independent members
(an external member). Small companies without dispersed ownership tend to have insider board
including for example company’s founder(s). For reasons mentioned previously, insider board
members may resist VC and his or her goals. Also as a venture capitalist is likely to add external
members to the Board (Hermalin et al., 2003) the original members may lose their bargaining power
inside the Board room already during the beginning VC period, thus insider board increases the
conflicts between the venture capitalist and the board. Supporting this, Anokhin, Peck and Wincent
(2016) found a significant correlation between VC activites and a CEO duality that refers to the CEO
being also the chairman of the board that is one characteristic of an insider board.

Theory hasn’t found an unambiguous connection between and independent board and venture capital
favoring and both supporting and conflicting arguments can be drawn. Anokhin et al. (2016) did not
significant correlation between portion of outsider board members and VC activity in contrast to their
initial hypotheses and arguments. This might be due to fact that independent directors can be
suggested for board membership either by executives or the venture capitalists which may affect their
preferences. Also, because outsider directors may lack specific company knowledge they may heavily
rely on financial results and other “hard data” instead of choosing sides, and so support whatever
activity seems the most beneficial one. Usually this reliance is connected to venture capitalists as
Anokhin et al. (2016) did even if failing to find significant empirical evidence for it. However,
Anokhin et al. (2016) finds a positive correlation between multiple board mandates, a characteristic
associated with an outside board, and VC activities. Overall, assuming an efficient VC plan with
expected growth-possibilities and returns as associated with VC by definition, it can be determined
that an outside board is likelier to support venture capital instead of resisting it.

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Between common shareholders and the venture capitalist theory expects conflicts. Regarding
horizontal governance approach, venture capitalist usually demands and receives large stake in the
company, becomes a dominant owner and consequently he or she may be able to shift value from
smaller shareholders to themselves, as suggested by Roe (2004). Broughman and Fried (2013)
assumes incentives for common shareholder resistance for similar reasons. Upon exit venture
capitalists tend to have vantage over common shareholders in receiving payouts and consequently
common shareholders may not receive significant benefits from a trade sale for example. In addition,
venture capitalists try to exit their companies soon to realize the capital gains even if some “option
value”, potential to increase firm’s value even further and get even a higher price by waiting, still
remains in a case of which shareholders remaining in the company would prefer to delay going public.

Venture capital financing timeline

As discussed in previous chapter, various challenges arise during different phases during the venture
capital financing in the company. For example, Broughman and Fried (2013) focuses on challenges
during exit while Anokhin et al. (2016) discusses VC relationships with the board and CEO during
running the firm. Investopedia too, a practical aite about finance, recognizes different phases for
venture capital financing calling it “a supply chain starting with “seed financing” and “early stage”
esing with finding exits (Lamb, Investopedia). We’ve assume that consequently different corporate
governance goals, challenges and methods have a different weight in different phases, and they may
even change significantly over time. One concrete example is a governance institution of sharing
information. As a stated by for example a visiting lecturer, Eero Suomela, in Aalto University (2018),
there is conflict with the sharing of information itself – with full disclosures and detailed information
the company can share relevant information about the firm performance and attract current and
potential investors but at the same time a company does not want to reveal sensitive information such
as business plans to competitors.

These aspects are highlighted in different phases of venture capital too. During the management of
the investment when growing up the business company’s best interest is probably to keep information
to itself to gain advantage, but when approaching the phase of going public venture capitalist’s
interest is to attract new buyers, achieve the best possible price and so sharing of information becomes
crucial. In IPOs extensive public disclosures are required by law too. Being so, the mix of governance
bundle may vary significantly over the period of venture capital. Out of the corporate governance
institutions we will focus on previously stated board, management and other owners.

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 Figure 2: Timing of Venture Capital and its phases. Adapted from Zider, 1998.

Inspired by the research (e.g. Bourghman and Fried, 2013, and Investopedia) we break down the cycle
of venture capital to three phases. Figure 2 shows the timeline of venture capital phases and the period
of venture capital in the company’s growth phase. First phase is the investment decision when the
venture capitalist evaluates which company to invest in. Second phase management of the investment
when the capitalists drives the growth of the business to increase its market value. Third phase is the
exit when the venture capitalist finally sales his or her own share of the company, for example by a
trade sale of by going public through IPO. In the next chapter we will go through each of these phase
and related governance challenges and best-practices in greater detail.

Stages of venture capital investments and corporate governance

In each of the venture capital investment phases, venture capitalist can use different corporate
governance institutions to protect their investments. From agency theory perspective, corporate
governance is especially important in growth companies because of high business and agency risks.
The level of control exercised by the venture capitalist is based on likelihood of the risk materializing.
For example, if the managements action is hard to monitor, then venture capital takes corporate
governance safeguards to prevent managerial misbehavior (Barney et al., 1994)

In analyzing the methods venture capitalists use, we are assuming that the venture capitalist is private
venture capital fund with the sole goal of financial gain. In this regard it is important to highlight that
there are venture capital funds that can have different goals from private venture capital, which can

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have an effect on the corporate governance of the portfolio companies. Corporate venture capital
refers to companies investing in growth companies like startups. In corporate venture capital financial
return is not the only goal of the investment and often it can be considered as a strategic business
decision similar to research and development done inside the investing company. The goal of
corporate venture capital is not usually pure financial gain from the investment, but the possibility of
developing business around for example a new technological innovation (Anokhin et al., 2016).
Public venture capital is another form, where public authorities take part in investing in startups.
Public venture capital is typical in developing countries where it is thought that government
intervention is necessary to provide capital for startups. In public venture capital one of main goals is
that the investment benefit society as a hole which separates it from private venture capital (Chen et
al., 2012).

We also assume that venture capitalist are active investors and do not consider venture capital
investment strategies that do not try to actively develop the business of the portfolio companies. It is
important to note thought that even though in general venture capitalist are considered active
investors, academic literature has identified that there is variance in venture capitalist roles in
company management including in-active, active-advice giving or hands on investors (Elango et al.,
1995).

First phase: Deal sourcing and investment decision

Venture capitalist are experts in reducing agency risks. This is demonstrated by the fact that venture
capital has a high impact on the level of corporate governance in growth companies. Because of this
specialization, agency risk doesn’t play a big role in sourcing possible investment possibilities and
making the final investment decision. For example, according to a study conducted by Gompers et.
al 2016 based-on survey of the answer of 889 institutional venture capitalist, the most important factor
in investment decisions was the quality of the management team followed by business related factors.

In the investment decision phase, the venture capitalist influence the corporate governance of the
portfolio company even before the investment is made. In the investment phase the major corporate
governance institution is the contractual agreement that venture capitalist makes with the
management of the company. The purpose of the contractual agreement is to reduce agency risk in
the venture capitalist investment. For a venture capitalist the agency risk can be divided to
management risk and competitive risk. Management risk refers to the managers ability to adopt
decisions that are detrimental to the venture capitalist investment. Management risk can be considered
as the most important agency risk factor. In empirical studies managerial competence is seen by
venture capitalist as the most important factor in the success of the investment (Gompers et al. 2016).
8
Similarly, Kaplan & Strömberg (2003) found that venture capitalist see management as the most
important internal risk factor for their investment.

In the contractual agreement venture capitalist limit management risk especially by provision
enabling venture capitalist to remove the management team. According to study by Fiet et al. (1995)
venture capitalist use extensive boilerplate contractual provision which enables them to replace the
entrepreneur in the case of under-performance, incompetence and malfeasance. The contractual
agreement also includes provision on the board representation and voting rights which enables the
venture capitalist to reduce management risk by enabling the venture capitalist to better monitor the
management and make corporate decisions (Kaplan & Strömberg 2003).

Usually new rounds a financing follow a new contractual agreement with the managers and venture
capitalist. New rounds of financing typically lead to increase in venture capitalist control rights
(Kaplan & Strömberg 2013). The staging of financing can also be considered to be a method of agency
risk reduction, since new funding is locked behind the company achieving economic milestones
aligning the interest of venture capitalist and the managers of the company.

Competitive risk refers to the danger of the managers leaving the company and starting a competing
business. In venture capital competitive risk is important, because growth companies are usually
based on innovation which represents a high information asymmetry between investors and managers.
The managers ability might also be a vital part of the value of the firm which would decrease
dramatically in the event of the managers departure. Venture capitalist can limit competitive risk by
contractual provision which makes departure costlier for managers. According to Kaplan &
Strömberg (2013) venture capitalist often use contractual provisions that limit the value of the
managers share’s in the event of early departure or non-compete clauses which prevent the
management from starting a competing business within a certain timeframe of the departure. The
above-mentioned provisions can also be seen as method of bonding the managers to the company,
since the value of the managers shares increase the longer he stays in the company and the more
valuable the company becomes while the non-compete clauses effective narrow the management
options in the case of departure.

Second phase: Management of the investment

Once the investment decision is made, the goal of the venture capitalist is to unlock the value potential
in the firm in preparation for the future exit. A key method venture capitalist use to develop the
company in the desired direction is through their representation in the board of directors. In academic
studies venture capital has shown to have an effect in both the composition and the working of the

9
board of directors. According to Broughman & Fried 2013 venture capitalist secure their
representation in the board of directors by aggressive negotiation which typically leads to deviation
from the default rule of “one share one vote”. According to a study by Gombers et al. (2016) the
control of the board of directors is also one of the contractual provision that venture capitalist are the
least flexible. Kaplan & Strömberg (2003) also found that the representation in the board of directors
of venture capitalist typically increases with new funding rounds.

In academic research venture capital financing is generally associated with increased board
independence. Broughman & Fried 2013 found that in the U.S the most typical composition of the
board was such that neither the venture capitalist or other owners held the majority, but that
independent directors held the swing vote. According to Baker & Gombers (2003) venture capital
involvement is associated with fewer inside and instrumental directors and more independent outside
directors. Similarly, Gabrielsson & Huse (2002) found that venture capital funding was associated
with decrease in the dual role of CEO as both the CEO and board chairman. Although academic
research has found a link between independence of the directors from the company, some authors
have questioned whether this independence extends also to the venture capitalist. Broughman & Fried
(2013) suggested that the even though on paper neither venture capitalist or other owners have a
majority in the board of directors, in U.S venture capitalist have de facto control of the board because
the independent directors or the CEO are not independent from the venture capitalist. Similarly, Van
den Berghe & Levrau (2002) found that venture capitalist often controls the board and do not actively
try to attract directors that are also independent from the venture capitalist.

The control venture capitalists are able to exert is clearly shown in the tendency of venture capitalist
to replace the founder CEO. It has been empirically shown that venture capital financing leads to a
replacement of the founder CEO more often than in the case with no venture capital financing
(Broughman & Fried, 2013 and Baker & Gompers, 2003). For example, in Broughman & Fried
(2013) study of 50 venture capital backed startups in Silicon Valley found that after 6 years of
operation 63 % of the firms had replaced their founder CEO.

The effect venture capitalists have on the working of the board of directors can mainly be seen by the
increased role the board has in strategic decision making. According to Rosenstein et al. (1993)
compared to similar sized firms with no venture capital involvement, the board of directors in venture
capital backed firms are more active in formulating the company’s strategy. Gombers et al.(2016)
also found that venture capitalist are active in strategic formulation. Venture capitalist use the board
of directors also a method to advise the management team. Gombers et al (2016) found that venture
capitalists provide the portfolio companies help in customer introduction, operation guidance and
10
hiring decisions. Although academic research has generally shown that venture capitalist participation
in strategic decisions and the advisory function bring value to the portfolio companies, Rosentein et
al (1993) also found that the ability of venture capitalist have an important impact on how company
management perceives the value of venture capitalist involvement. According to the study by
Rosenstein et al. (1993) management didn’t place higher value higher value on the advice of the
venture capitalist compared to other advisors unless the venture capital fund belongs in the “top-20”
venture capital firms.

Third phase: Exit

At the end of the investment period, the goal of the venture capitalist is to sell the company at a profit.
To sell the equity stake in the company, the venture capitalist can sell the shares back to the
entrepreneurs (buy back), sell the company to another company interested in the assets (trade sale),
selling the shares to financial investors (secondary purchase) and taking the company public (IPO).
In the case the company can’t be sold the only option is liquidation which usually results in total loss
of the invested capital (Cumming & MachIntosh, 2003). The research on venture capital is focused
on IPO exit, because IPO requires information disclosure and is thus easier to research. Trade sale on
the other hand does not require public disclosure of information, which makes it a harder research
subject. Despite the emphasis of academic research on IPO exit, trade sales are a more common form
of exit than an IPO and financially at as important as IPO: s (Broughman & Fried, 2013). For example
in Gombers et al. (2016) study the venture capitalist interviewed reported that IPO:s represented only
15 % of the exits while 53 % are through trade sales.

Cash flow rights of venture capitalist are especially important in the exit phase of the investment. In
the United States venture capitalist are almost exclusively issued preferred shares for their
investments in startups. Preferred shares are convertible to common shares and they carry a
liquidation preference over common shareholders. The preferred shares give the venture capitalist an
upside and downside protection meaning that as preferred shareholders they have priority over the
common shareholders to the company’s cash flows up to the liquidation preference while giving the
venture capitalist the option to convert the preferred shares to common shares when their share of the
company’s cash flows as common shareholder would exceed the liquidation preference. In IPO exit
the liquidation preference of preferred shares is not as important, since listing a company in the stock
market typically requires that the preferred stocks are converted to common before the listing and the
venture capitalist exits the investment as a common shareholder (Broughman & Fried, 2013).

In an IPO exit venture capitalist are often assumed to make changes to corporate governance to attract
investor interest in the newly listed company. Kleinschmidt (2007) found that in exit preparations
11
venture capitalists often add members to the board of directors who already have experience in board
work from listed companies. He also found that venture capitalist backed companies preparing for an
IPO follow corporate governance codes significantly more often than other portfolio companies. The
author highlights that the possible reasons why venture capitalist initiate changes to corporate
governance in IPO preparation might not be to strengthen the monitoring, bonding or advisory
function of corporate governance, but to try to maximize the likelihood of a successful IPO.

Control rights are important in the exit phase, because the initiation of an IPO or a trade sale usually
requires the approval of the board of directors and the approval of the common shareholders. As was
stated before, venture capitalist typically has a high representation in the board of directors which
enables them in the exit phase which enables them to initiate an IPO or a trade sale. Typically,
corporate law always requires some level the approval of the common shareholders to initiate an IPO
or a trade sale. The required level of common shareholder approval on the other hand can be different
in different jurisdictions. In a trade sale the acquiring company can also require high level of common
shareholder approval than the applicable corporate law requires (Broughman & Fried, 2013).

The venture capitalist has numerous ways to get the required approval from both the board of directors
and common shareholders. Broughman & Fried 2013 classified these methods as either “carrots” or
“sticks” in the context of trade sales. Carrots refer to methods such management bonuses and common
shareholder carveouts, that motivate managers and common shareholder to support the exit
transaction. Sticks refer to coercive methods that venture capitalist can use to pressure managers and
common shareholders to participate in the exit transaction. They found that venture capitalist typically
offer benefit to managers and common shareholders to get the required approval for the exit
transaction. Coercive methods are less commonly used to convince managers and common
shareholders to support the transaction.

Part II: Empirical Perspective

Our methods for the empirical analysis them being semi-structured interviews with venture capitalist
professionals. In part three of the study, we introduce and analyze the interviews and present our main
findings compared to theoretical background. In part four, we make our conclusions. The interviews
have been made via phone.

Interview introduction and results

In addition to providing the class with theoretical framework, it is our belief that the fundamental
issues are best understood if the theory is accompanied by practical examples. We chose to do this

12
by approaching two professionals with the intention of gaining wisdom and knowledge about the
fundamentals of this area of research. Both of them are extremely intelligent, dedicated and
successful individuals – and they work on the opposite sides of the negotiation table and on the
opposite sides of the Atlantic Ocean.
The first interviewee is Eeva Ahdekivi, a former investment banker and currently a manager at
Hartwall Capital Oy Ab, located in Helsinki, Finland. The second, is William ‘’Bill’’ Baker, a
technologist and a start-up founder, former CEO of HireRight Inc. and currently the CEO of Ocean
Group LLC and the President of Netforce Inc. the first located in Los Angeles and the second in
San Francisco, in the state of California in the USA.

Both Eeva and Bill were excellent interviewees, and we wish to express our thanks to them for
giving us their time and their expertise. On behalf of the group and the class we thank you.

Interview I: Eeva Ahdekivi

The discussions with Eeva were restricted to the dynamics between the owners, the board and the
company management and how the different mixtures of this ecosystem produce alternating
corporate governance results. Much of the input was from Eeva reflecting on her experiences in the
financial world and as the manager at Hartwall Capital Oy Ab.

Hartwall Capital Oy Ab is the investment company of the Hartwall family that was created in its
current form by the families of Hartwall, Tallqvist and Therman after selling the Finnish beverage
giant to Scottish & Newcastle in 2002. Today, the company has ownership stakes in multiple
companies, including Arnolds, Inkerman, Polarica, Kährs and Remeo. The fund is sized at 840
millions and they have a staff of ten people.

‘’In the family company there are about 80 persons as owners. The family is relatively close, but is
of course easy to understand, that this amount of people cannot be at the manger’s side all the time.
Hence, we meet once every quarter of the year.’’

‘’How do we ensure that moral hazard doesn’t become a problem in a company like this? We have
ten people working in the company and with that amount of personnel, everyone knows the doing
and goings of everyone else. This means we constantly see each other, and whether someone is tired
or having a difficult time and this is important because if that happens the performance will suffer.
In this respect, we’re an organization of highly trained professionals, which is relatively good at

13
ensuring no moral hazard problems are born.’’

‘’In the company we buy stocks [both the owners and the managers] and then we sit with the
owners, owning the same shares, in the same ownership situations and thus attempt to avoid any
possible risks [that the separation of ownership and management might bring]. That serves as a
downside protection on the part of the owners.’’

‘’We have a very independent board from all externalities. This is by coincidence. People in
Finland are now realizing that finance is an area of business. Trade and service are areas of
business.’’

‘’When in Finland one establishes a reputable board, then often the membership comes from
industrial fields. Thus people have very strong views and at times you’ll have to explain why some
issue doesn’t behave in an identical way it does in industrial fields. Meaning a situation has been
created where every now and then the management is teaching the board. If you look at our board at
this moment, then you’ll see that there are no finance professionals there. Meaning the conditions
for potential information asymmetry are there. Sometimes I, in the role of the manager, will remind
the board that you may not know this, here’s how it is, you may check this from other sources, but
this is the way we should look at it.’’

‘’It’s important that the board gets a full mandate to act from the shareholders. You wouldn’t have
the professionals working here that you do, if the shareholders were constantly attempting to assert
themselves in everyday affairs. In private companies, it’s worth asking how many people there are
as owners. If the number is 70, they do understand that you can’t always go in between. For
example, we have a council of owners, which every now and then asks questions from the board.’’

‘’When we, on the other hand, invest in some company, we’ll often analyse the actions of the
management. You can always change the board but good management is always in demand. There’s
a surplus of willing board members, everyone wants to be one.’’

‘’When you become an investor in a company, you’re not going to see the managerial behaviour at
its fullest beforehand. That’s always the risk you’re going to have to take.’’

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Interview II: Bill Baker
In 1995, Bill founded HireRight, an American human resource technology company specializing in
background checks. In 2005 he left the position of the CEO after first moving to the position of
Chairman and then later being voted out of the board and the company altogether. Today Bill is a
professional investor, managing his two companies in California. HireRight today is valued at
several billions and it is still the leading company for background checks in North-America.

‘’I founded HireRight in 1995. I did just one round as a CEO, because the venture guys put the
money in with the premise that the guy that I hired and trained for a year would become the CEO
and I would become the Chairman.’’

‘’They used him [the CEO] to control the board of directors’’

‘’Yes, the VCs had two seats on the board as well. They wouldn’t have done the deal if they
wouldn’t have been able to control the board. They got one seat each for each one of the two
venture capitalists. So the board was me the Chairman, the new CEO, the two venture guys. So in
theory as they controlled the purse strings, well not in theory, actually in reality. They had three
seats to my one. And they used it. They ran the company out of money, so that we had to go back
and raise more money. They did that by granting bonuses to the management, even when the
management did not make their milestones.’’

‘’You need to remember that at this point in company history I was controlling more than 50% of
the company.’’

‘’You have to understand that usually these venture capitalists are very arduous. They would not
invest in a company if they wouldn’t control it. They weren’t worried about not having more stock
at that point because they knew that ultimately they’d own more. Before any deal gets done with
these venture guys, the founders, if they’re lucky, would be able to keep around ten percent of the
company.’’

‘’My understanding is that in business schools there are classes which advice how to get rid of the
founders. It’s kind of an unstated thing, but the first thing the financial people want to do is to
organize the management with the people who will be loyal to them. It’s like when a new president
takes over, he wants all the generals in his military and all his advisors to be loyal to him. You’ll

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have to consolidate your power, it’s all game theory stuff.’’

‘’They demanded the board seats, they demanded the CEO position. They also demanded liquidity
preferences. So they had preferred stock and their preferred stock had to give them returns double.
Sometimes they even demand triple the money they put in. So if they put in ten millions dollars
they would get thirty million dollars out first. And then the common shareholders. At that point they
would be converted to common shareholders. That’s to prevent the management from selling the
company when they don’t want to sell. So they can control management. Because management
could make money for themselves as individuals but it wouldn’t be great for the company so they
insist on preferences.’’

‘’I don’t know about these days. I haven’t done a deal like that in a long time. I’d be surprised if it’s
too much different. I think they still want and require the preference items. There’s a whole lot of
other things like pari passu, it’s a latin term for, you know, future filings that they may have. They
get their right to participate at the same basic level at the future prices. There’s a lot of terms and
conditions you have to sign to get the deal done. It’s incredible.’’

‘’If I had to do it over again. And by the way, I’m doing it over again. I’m planning another
company as we speak. I would take their money very early. Realizing that I’m going to lose control
and not keep the company under my domain for very long. I would take their money, realizing I
would own maybe ten percent of the company at the end. And get them early, because then they’re
on the hook. And there’s no other place for them to go, they’ll have to continue funding the
company. And if they want my participation, of course, they’ll have to remunerate me, keep my
stock options. Like with any CEO. They’ll have to issue more stock options and give them to you.
What they love to do, is to have you prove your model, and come to them right before you go
public, at the very end, put in their money and proclaim their greatness. Then their return on
investment to their investors is incredible.’’

‘’Something less than 15% of the venture capital companies in the world can return any money to
their limited partners. Most of them lose money.’’

‘’Of course, the venture guys all have money, but what you want to when you’re interviewing them,
is to find out what else they would be bringing to the company besides the money. In our case, the
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venture capitalist we let in opened us a lot of doors. They brought in the best guys at the time on
human resource space business, who had invested in the human resources companies, supported
them and in terms of investments knew how to get the company public. So what the venture
capitalists contribution was, was to make sure the company got public. And it did. And then I think
they were also instrumental in having a rollup of the industry, so after they went public they merged
with the largest company in the industry and those two companies together, then, were able to buy
the second-largest company in the industry. The venture capitalists work is how it became a 3.2
billion dollar a year business.’’

‘’What the challenge of the board meetings is, is that they have the resources to come in fully
prepared. So you’ll have to be on your game at board meetings. They have the analysts who have
come through all the data working for them, they know the law, they bring proposals to the table.
They’re on their game and ready to move. They don’t mess around. With the intent of driving the
company into one of two directions. It either goes into the stars as fast as possible, or down the
toilet because they don’t want to think about it anymore. If the company turns out to be a loser,
they’ll just want to take it bankrupt and move on to other things, because they got a lot going on.
Which is not in the best interest of the managers or the founders, because we want to make the
company successful no matter what. They don’t have that ambition. They want it to the stars or to
the toilet as fast as possible.’’

‘’I think in the venture circles they call it failing quickly, there’s some buzzword on it.’’

‘’In their minds they are in control and they pull the strings. When they put the money in they don’t
want to run it day to day by they insist on telling the day to day people what to do. They are very
strategic.’’

‘’If there is a good CEO then he also knows how to control the VCs well. It’s a big dance. If you
think marriage is a dance, get a VC into your company! LOL’’

‘’Almost every founder is muscled out. Like I said, they teach classes in the university on how to do
it.’

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Breakdown
The first thing that we see from the interviews of both Eeva and Bill is the role knowledge and
education play in the board dynamics. The typical founder type often has no formal financial
background, unlike the financiers who jump in to the company after they’ve proven their model’s
worth in the real world. This dynamic then plays out in both the decision-making process of the
board and in the stakeholder behaviour outside and inside the board. As proper financing is the
lifeblood of a company, the financial knowhow of the institutional investors gives them a universal
edge when it comes to running companies.

This expertise then creates a situation where the investors often have experience from the
machinations of multiple large companies. They excel at the company politics due to them
‘’controlling the purse strings’’, as Bill said. The founder may be running his/her first major
company as the CEO, often with an engineer / technology background that doesn’t prepare one to
the politics and the power plays that come to any company as the size and the scale grow.
Another thing of note is the fact that the CEO has to put in the hours to focus on running the
company itself, while the VCs can pour all their resources into estimating the flaws in the system
the CEO has built. The Founder/CEO has the biggest incentives out of everyone to steer the
company into profits. The VCs of course want to see the project succeed, but they might think it’s
more probable through following their own, inter-company instincts and experience than the more
contextual factors on which the management builds their case.

Time is also a significant factor in how the decision-making process plays out. The institutional
investors like the VCs always have another case to move on to, but the company managers have all
their eggs in this particular basket. Factoring this in, the VCs might favour a more pressing, middle-
of-the-road approach than the management who is in a sink-or-swim situation.

Still, while the institutional investors might present the company board and its management with
additional risks, some of the economic and political. They clearly do offer an important utility for
the management and earlier, less institutional investors. They bring in expertise from multiple
industries, deals and firms. They have vital knowledge of economics, strategy, finance and law.
Without them, or even with less assertive investors, the company management might have their
vision not challenged at all in the board room, or even worse, cheered on as a rule by the early
investors (friends, fools, family or angels) who see the management strike early success and become
convinced they can do no wrong.

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The VCs bring in meta-knowledge that can be gathered only from running multiple companies in
similar situations. For example, at the end of his interview, Bill did admit that even though his
personal power was minimized by the VCs, the company probably would not have become the
juggernaut it is today, in their particular field.

Thus, it can be said that VCs present the company, its preceding board, the founders and the
management with the good and the bad, depending on the perspective. While they might hinder
individual manager/founder power, they’re invested in making the company big in as little time as
possible. The company also gets a powerful countering weight to the founders in the board
meetings. The VCs are educated in business schools and they have the knowledge of the worst
human risks related to the company, like information asymmetry and moral hazard.

Part III: Conclusion

We identified relevant parties in venture capital based on Broughman’s (2013) entrepreneurial
team. The entrepreneurial team includes firm’s founder, other executives, common shareholders and
the venture capitalist. Based on our theoretical analysis the board’s attitude towards VC depends on
its composition and characteristics. Main part is the independence of the board. Theory hasn’t found
an unambiguous connection between independent board and venture capital favoring, but there are
some signs that an outside board is likelier to support venture capital instead of resisting it. The
empirical observation was that the target company has a very independent board, but it is a
coincidence. Also, another notion was that it is important that the board gets a full mandate to act
from the shareholders. This is crucial to get professional board members.

Between common shareholders and the venture capitalist theory expects conflicts. Regarding
horizontal governance approach, venture capitalist usually demands and receives large stake in the
company, becomes a dominant owner and consequently he or she may be able to shift value from
smaller shareholders to themselves. Our empirical findings supported this view, especially that
venture capitals want to take control of board. Other methods are demanding the CEO position and
liquidity preferences.

The mix of governance bundle may vary significantly over the period of venture capital. We
identified three phases (investment decision, development, exit) in venture capital investment, using
venture capital investment model. In each of these phases, venture capitalist uses different corporate
governance institutions to protect their investments. Various forms of venture capital have different
investment goals and this can have a high impact on the form of corporate governance in growth
companies.
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In the investment phase, the major corporate governance institution is the contractual agreement
that venture capitalist makes with the management of the company. Because of venture capitalists’
high impact on the level of governance, agency risk does not play a big role in sourcing possible
investment possibilities and making the final investment decision. Research have found that the
management is the most important internal risk factor for their investment. This fact came up in our
empirical findings that good management is always in demand when evaluating investment
opportunities.

The development phase’s goal of the venture capitalist is to unlock the value potential in the firm in
preparation for the future exit. Strategic dimension plays a major role in board work when venture
capitalists is involved. In the exit phases’ transactions always require approval of the board of
directors and shareholders. Venture capitalist can use motivating and coercive methods to get the
required approval for exit transactions. Venture capitalists’ ultimate target is grow the business as
fast as they can. Company owners and managers may prefer to hold on the company.

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