Board Games

Baldwin Louie — Mon, 22 Jan 2001 14:00:00 -0800

In an economic downturn, it's easy to blame poor stock performance and executive departures on the lackluster state of the markets. But the buck's got to stop somewhere - and ultimately, boards of directors must take the heat. Whether the company is ATT (T) or Peapod (PPOD), directors are there to protect and advance owners' interests, and for that, knowing how a company's management strategy is faring or failing is vital.

Effective guardianship has become all the more important in an era in which company investors have become more savvy, impatient and powerful. The California Public Employees' Retirement System (dossier), Fidelity and dozens of other financial institutions are increasingly telling directors to improve their governance or get out of the way. A recent survey of 400 investors by Wirthlin Worldwide for Russell Reynolds Associates (dossier) found a large majority think new-economy companies must follow the same good governance principles as blue-chip firms.

Lack of board independence is one of the thorniest issues Internet companies face, since board members are often officers of the organization. Consider the board of Razorfish (RAZF), a struggling Web design and e-commerce consulting company that was recently hit with a class-action investor lawsuit. Director Jeffrey Dachis is the co-founder, chairman and chief executive; Craig M. Kanarick is the co-founder, chairman and chief scientist; and Michael Simon is executive VP. Two outsiders also serve, but upper management controls three of the five board positions.

"We want aggressive bright people who 'get it' on our board, not representatives of corporate America who are interested in protecting the status quo," Dachis explained at a conference last year.

Still, insider control has become taboo within Fortune 500 companies - where only one in five directors is also a company executive. As a rule, board independence means that the chief executive is beholden to the directors, not the other way around. When directors don't work for the CEO, don't consult for the CEO and don't owe the CEO, that's a good sign.

But those are the minimum requirements. The equity market holds Internet firms to a higher standard since the risks are greater. As a result, Net boards should - and do - differ in three important ways:

Internet boards are smaller. Big-company boards average 12 to 13 directors, while Net boards contain half that. This "demi-board" makes good sense since the Internet world moves fast. Even the big players are moving in this direction. Sony (SNE) scaled back its board from 35 directors to nine in 1999, explaining that it faced more demanding capital and consumer markets, and needed to speed up decision-making.

Internet boards have more decision-making power. Blue-chip convention has been for governing boards to pick top management, approve strategy and then lay low. Not so for startup boards. Startups need all the help they can get, and their boards must function more like executive committees - providing input into business models, senior management performance and stock distribution. But directors beware: If you let strategic engagement become micromanagement, you'll turn your executives into pawns.

Internet boards have greater stakes in their companies. Rarely do directors of Fortune 500 companies collectively control more than 1 percent of company shares. But boards of Net companies often maintain a controlling interest.

Consider the board of Cyber Dialogue, a private company created in 1993 that assists companies with managing Internet customer databases. Five of its seven directors are venture partners jointly holding well over half the company. Expect to see even greater board stakes down the road.

A study last year of 350 old-economy companies by William M. Mercer Inc. and the Wall Street Journal found that a mere 1 percent paid their directors in equity alone. A parallel study of 32 new-economy companies revealed that more than 80 percent depended entirely on equity. In all companies, however, stock is making up an increasingly larger portion of board compensation, according to a recent report by the Conference Board.

For an example of an Internet board headed in the right direction, look at eBay (EBAY). Its size is right: seven directors. But its structure is not quite ideal: Directors serve staggered three-year terms. Only one-third of the directors can be voted out per year, effectively insulating the board against swift intervention by disgruntled investors if the company underperforms.

The five outsiders on the board outweigh the insiders, and they are beholden to neither the company nor its management. The outsiders comprise senior execs from Club Mediterranee, Intuit (dossier), Benchmark Capital (dossier) (an investor in eBay), Charles Schwab (SCH) and Starbucks (SBUX); the insiders include eBay's founder and chairman Pierre Omidyar and CEO Meg Whitman.

Three directors - Omidyar, Whitman, and Benchmark founder Robert Kagle - have huge personal holdings in the company. The others bring diverse experience in running other companies that have made a great deal of money for their investors. Ebay's board gets good marks on size, supervision and stakes. The capital market unequivocally demands great boards. It tolerates deviance from custom when a company's performance is stellar or its scale is modest. As Net companies prosper, they will inevitably feel the same demand. Better to create a great board now before the Street tells you to do it.

Michael Useem is professor of management at the Wharton School of the University of Pennsylvania (dossier) and director of the Wharton Center for Leadership.

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