I very much enjoyed Brian Broughman’s “The Role of Independent Directors in VC-Backed Firms.” There is much law and economics in this work—a well-articulated theory and then some empirical work aimed at testing the theory. So, there is a little bit that I can add to the commentary on this paper. However, I should say that I know as much about the corporate governance literature and the literature on venture capital investing as a pig knows about Sunday. Probably less.
So, with that disclaimer, let me make just a few remarks and then look forward to the day’s commentary. Private firms, organized with venture capital financing, are under no legal obligation—as I understand it—to appoint independent directors. So, to the extent that VC-financed firms have independent directors, they have them for reasons that are probably functional. Brian’s hypothesis is that VC-financed firms appoint independent directors to serve as mediators between directors loyal to the founding entrepreneur and those loyal to the venture capitalists. Without the “ID-arbitrators,” as Brian styles them, there is the chance that the board will end up in one of three undesirable states—domination by the entrepreneur, domination by the venture capitalists, or deadlocked into inaction.
Brian elaborates a model that results in a variant of the old method of appointing an arbitral panel—each side nominates an arbitrator and then the two nominees agree on a third.
He then identified 141 VC-financed firms in Silicon Valley and sought to interview their founders and officers to test his hypothesis. He received 57 positive responses but had to eliminate three from that sample. His interviews with the 54 firms confirmed his model of the ID-arbitrator in VC-financed start-up firms.
I had just a few quibbles with the paper. First, I very much wish that Brian had included some comparative statistics early in the paper so as to give me a sense of how much this is an issue that is particular to private firms financed by venture capitalists. I realize that this may be asking too much—after all, he had to develop his own descriptive statistics regarding independent directors in VC-financed Silicon Valley firms. But I would like to know if IDs are common in privately financed firms without venture capital financing (such as those private firms financed by bank consortia or family money or private investors).
Second, and related, I would like to know if Brian’s findings are unique to the high-tech VC-financed firms that form his empirical sample. Are there VC-financed firms in other sectors besides high tech? And if so, do they exhibit the same tripartite board structure? My suspicion is that they do.
Third, what about VC-financed high-tech firms in other parts of the U.S.—say, in Austin or Naperville or Seattle or—for that matter—Champaign? Brian’s model would seem to suggest that he would find exactly the same factors at work anywhere private firms are financed by venture capitalists who may be at odds with the founding entrepreneur. So, one would expect his findings for Silicon Valley to be replicated throughout the U.S. and, indeed, in other parts of the world where VC-financing is common.
The mark of a terrific paper, like this one, is that it makes one think, “What’s next?” And there are plenty of follow-on studies that Brian’s paper suggests. Here are a few.
It would be fascinating to know the extent to which those VC-backed firms that have successfully incorporated the ID-arbitrator into their boards exhibit systematically different outcomes from those firms that are entrepreneur-dominated, venture capitalist-dominated, or deadlocked. I read Brian’s paper to suggest that VC-backed firms that appoint IDs to arbitrate or mediate between the founding entrepreneur and the venture capitalists should be more efficient than those similarly situated firms that do not do so. Will the empirical work support that view? Are those VC-backed firms that have added IDs more successful? Do they grow faster and with greater stability? Are they eventually capitalized in the market at higher values than those firms that do not appoint IDs? Do they take less or more risk than entrepreneur-dominated firms? And so on.
Well done, Brian. I very much look forward to today’s discussion.
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1. Posted by Brian Broughman on July 29, 2008 @ 1:22 | Permalink
Dear Prof. Ulen,
Thank you for your very helpful comments. I suspect independent directors are more common in VC-backed firms than in other types of privately-held firms; however, I don’t have reliable data on this. There are very few studies of board composition in privately-held firms (particularly outside VC where two regularly used databases – VentureOne and VentureXpert - exist). The few studies that I am aware of involve data from outside the U.S. and it is difficult to make reliable comparisons across studies.
On your second and third points, I don’t think my results are unique to high-tech firms or to Silicon Valley. Kaplan and Stromberg, for example, find similar board composition using a broader study of VC-backed firms from across the U.S. (http://www.nber.org/papers/w7660).
Finally, I would love to know what effect independent directors have on outcomes. This is difficult to show empirically because outcome data is hard to come by for privately-held firms, and because the use of independent directors is not exogenous. Hopefully, future research can address this in various ways.
2. Posted by Larry Ribstein on July 29, 2008 @ 9:30 | Permalink
I'm skeptical about exploring the effect of independent directors as Tom Ulen suggests, for the reason Brian gives -- the use of independent directors is endogenous. In other words, if results differ I'd have to wonder if it was because of differences between the firms unrelated to the use of independent directors.
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