HOW TO CONSTRUCT A GOOD SEARCH FUND BOARD OF DIRECTORS
Historically, search fund boards have been filled with search fund mafia members supplemented with a sprinkling of industry veterans. Board members either receive no compensation or a $1k per meeting stipend.
There are many issues with this model. The most pressing is that it does not scale given the rapid expansion of the search fund asset class. Board structures need to mature with the sector. It would be wise for searchers and investors alike to think deeply on some historical issues of boards that have limited effectiveness: investors who might have operating experience that is many years in the past, a wide spectrum in terms of members’ time commitment, the need for increased board expertise as search funds increasingly enter more technical industries, and the lack of any standard compensation program to fairly reward investors who step up and to attract and retain high value-adding board members from the outside.
If the promise of the search fund model is to surround young, smart, inexperienced CEOs with board members who can guide them to success, nothing could be more important than getting this piece of the puzzle right.
I have no magic bullet on this topic and my exposure to board dynamics across the entire sector is admittedly limited. My goal here is simply to make some observations based on what I have seen and hopefully foster continued discussion among investors—and a thoughtful approach by searchers themselves when the time comes to assemble their board.
Here are a few things to consider:
Number of directors. Small is beautiful. The purpose of every board is to be a cohesive and effective group where everyone is focused on the same goal. That doesn’t mean all board members will always agree; by design, different board members should bring different perspectives and expertise. The larger the group, the higher the chance that communication will break down and effectiveness will become hampered by sheer size. In most cases, three outside directors is a good starting size for search fund acquisitions, with the flexibility to expand over time. This keeps the group small and focused on the task at hand.
Where They Come From. Finding the right board members is unique to each deal. Here are a few sources to consider:
· The largest investors in the deal will want to be represented on the board (as they have every right). The fund of funds increasingly taps experienced LPs who are senior or retired executives, since they personally can only serve on a fraction of their portfolio company boards. As a searcher, it’s okay to ask to meet the proposed board member and openly discuss how that individual fits into the overall mix of board members you are assembling.
· There are a growing number of search fund CEOs who have either exited their businesses or have been in their roles long enough to be able to add real value as board members. This is a great pool of talent to consider.
· During your search, you as the searcher have had the opportunity to interact with your investor group and get to know each of them on a fairly intimate basis. Don’t ignore your gut instincts telling you how that experience went—they can help you figure out which of your investors, large or small, might make a good board member. If the search lasts a year or two, you are going to work with your board for five to seven years, or potentially even longer. Personal chemistry and an investor’s demonstrated willingness to go out of their way to be helpful are certainly important factors to consider when building your board.
· You may want to draw from outside your investor base to bring on board members who have particular knowledge of the industry or geography in which you operate.
Mix of Expertise. Drawing from outside your investor base is only one way to foster a good mix of people. It’s important to think about the skill sets that will be most helpful to your board. Different board members should bring different experiences to the project of helping you build your business. Having all search fund investors on your board who might have once had operating experience in the distant past is probably the worst answer.
Think about the critical success factors in creating shareholder value in your business. Usually it’s a mixture of functional areas (sales/marketing, product/tech, human resources, operations, finance, etc.) with an overlay of experience in that functional area in the context of a particular industry area: building a sales and marketing team for a SaaS company, finance/capital raising in a specialty finance company, or human resources in a call center environment.
The right mixture is generally board members with complementary, relatively broad areas of expertise and at least one board member who has a depth of experience in some aspect of your industry.
CEO Coach. Every search funder becomes CEO of his or her acquisition company having never done the job. This is a situation rife with peril. By design, the recurring revenue businesses targeted in search are intended to be able to withstand an inexperienced CEO. But, particularly in those first couple of years, you are going to need help beyond even what even an active and supportive board can give you. You need someone you can talk to on an extremely regular basis about the most mundane to the most strategic issues—someone you trust enough to ask those things you don’t want to air out in front of the full board.
This position is what I would generically call your coach. You can certainly go outside the board to hire a coach. There are a bunch of good ones. But preferably, there’s one board member who you feel particularly comfortable with that has proven themselves willing to take your panicked calls in the middle of the night, if necessary.
If you develop that kind of mentor relationship during the search process, ideally that person would serve on the board no matter what their industry or functional background and you can continue the relationship both on the board and between meetings.
Personality Match. Search investors are always talking about finding searchers who are “teachable.” I do think it’s okay for you as a searcher to consider personality when constructing a board, with a preference for humility over arrogance—no matter the qualifications of potential board members. When successful, this process is marked by collaboration in both directions. Dysfunctional boards are generally the result of ego getting in the way of progress.
Compensation. Search fund boards have historically suffered from an acute freeloader problem. The idea has been that the reward for serving on the board is the investment return. But in any given deal, most investors will not be on the board. And those that do serve are left with only non-economic incentives to go the extra mile when working with the search fund CEO.
As mentioned above, the simple math means that the most active search fund investors increasingly have to nominate surrogates to represent them. And constructing truly professional boards requires going outside the search ecosystem to recruit the right expertise and temperament.
The whole reason I’m writing this post is because I think the board is where the promise of the search fund model—taking a talented, young, but inexperienced CEO and surrounding him or her with the right people to encourage growth and success—works or fails. Implicit in that statement is that attracting the right people and motivating them to dedicate real time on a regular basis will not happen unless there is a change in the practice of board compensation.
The most straightforward way to do that, in my opinion, is to award board members a fixed $25k fee in equity each year. This is to emphasize that attendance at meetings is required but not sufficient to make progress. A lot of important work happens by working with the CEO between meetings. And this makes it clear that when a board member does a really good job, the reward will be non-trivial--money worth spending if the central challenge in generating search fund returns is molding a first-rate CEO out of a recent MBA graduate.
Again, none of the above is meant to be gospel. It’s an attempt to open the topic to further conversation amongst search fund investors and search fund CEOs as we work together to build the best possible boards.