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Startups need mediators for VC-founder rift

Independent directors fulfil that role, and many startups have them even though they are not legally mandated to, finds a study

Startups backed by venture capitalists (VC) are not legally obliged to have independent directors on their boards. But many such firms do so, and they benefit from the mediation role played by independent directors, shows a working paper by Michael Ewens and Nadya Malenko for the US National Bureau of Economic Research.

Studying a sample of 7,200 VC-backed startups in the US, the researchers report that at the first financing, a startup board has three members, with most of the power vested in the entrepreneurs. The power and control shift from the entrepreneur to the VC in successive rounds of financing as the VCs’ share in capital increases.

The board composition further evolves as independent directors come in. Around 49% firms had at least one independent director, and this grew to 63% by the fourth round of funding.

The board of an average startup has two seats held by VCs, 1.7 by entrepreneurs or executives, and 0.8 by independent directors, the authors find. As the investors themselves largely take up the role of monitoring and advisory in startups, independent directors’ role becomes more of a tie-breaker in case of disagreement.

However, this mediating role might not always produce the most optimal outcome—for example, in situations when one party’s participation is more important for the firm, the paper says.

The paper further observes that the bargaining power of VCs vis-à-vis entrepreneurs in startups has reduced over time due to the deregulation of private equity markets and the entry of non-traditional investors such as sovereign wealth and hedge funds.

Technological development has made it cheaper to start a new business, overall diminishing the role of VCs in early stage funding. This larger entrepreneur control in startups has expectedly led to a decreased role of independent directors, the authors say.

Also read: Board Dynamics Over the Startup Life Cycle

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