Outside Directors at Early-Stage Startups

There is substantial debate about the role of outside (i.e., non-employee) directors in enhancing corporate governance. Most of the research on this topic has focused on public corporations, which are required by law to have adequate representation of outside directors on their boards. Yet we have a limited understanding of how firms build their boards over time before they become public. In our paper, Outside Directors at Early-Stage Startups, we examine startup firms at the series A stage (“early-stage” startups) to answer some fundamental questions about outside directors: Why and when do startups hire outside directors? What type of outside directors do they hire, and what skills do they seek in them? How do outside directors affect startups’ future performance and exit strategy?

Startups in the Series A stage begin focusing on establishing a viable business model to scale up their operations, which may also involve making the company’s board of directors more professional. Importantly, unlike public corporations, startups do not have to hire outside directors to satisfy regulatory mandates and will do so only in response to specific governance needs. In our data, we observe board formation from scratch and can conduct analysis at the startup-director level in the year the director is hired. These features enable us to understand the factors that lead to a match between startups and directors, with a specific focus on the skills that startups seek from outside directors, and to examine how the choice of early-stage outside directors correlates with future performance of the startups.

We obtain information on startups, their investors, and director appointments from CrunchBase (www.crunchbase.com), which is the largest crowd-sourced database on startups, and AngelList (angel.co), which is the leading on-line fund-raising platform for startups. We collect additional biographical information on directors from BoardEx and LinkedIn (linkedin.com). Our sample comprises 44,815 startups at the series A stage, whose future progress we are able to track.

We find that the propensity to appoint early-stage outside directors correlates positively with measures of startup quality and the degree of coordination between founders and investors. Specifically, early-stage startups that raised more funds in the seed and series A stages, especially from venture capital (VC) firms and well-connected lead investors, and those in which the founder shares a past professional or educational connection with one of the early-stage investors are both more likely to appoint outside directors and to have one of their early-stage investors serve as an outside director. These findings suggest that the primary role of outside directors at early-stage startups is to advise the management team and help in setting strategy, rather than to ameliorate agency conflicts between managers and investors.

The local labor market for directors plays an important role in director appointments. Early-stage startups are less likely to appoint outside directors, and those that do are more likely to appoint their early-stage investors as outside directors, when the local supply of directors (in their city and product market category) is low or the local demand for directors is high. These findings suggest that outside directors are a scarce resource.

Our analysis uncovers some interesting patterns about the matching of startups with directors. First, an individual is more likely to be appointed as outside director if he is an investor in the startup or has a past professional connection with the startup’s founder or investors. Interestingly, the appointment of growth-stage directors and late-stage directors seem to depend on their past professional connections with the early-stage directors, which suggests that early-stage directors play an important role in attracting future directors.

Second, expertise plays a crucial role in the appointment of directors. Formally, we measure the expertise of individuals along five dimensions: past entrepreneurial experience, past board experience at either a public or a private firm, past professional experience as a C-suite executive at a public or private firm, past professional experience in finance or law in a non-C-suite role, and past patenting experience. We find that board experience and entrepreneurial experience matter the most for outside director appointments at all stages. Public board experience is much more important for the choice of later-stage directors, whereas private board experience is marginally more important for the choice of early-stage outside directors. Patenting experience matters only for the choice of early-stage directors, whereas C-suite experience matters only for the choice of late-stage directors.

Third, an individual is more likely to be hired as an early-stage or growth-stage director when the vector difference (along the above five dimensions) between his expertise and that of the startup’s founder is high. In other words, startups hire those individuals as early-stage and growth-stage outside directors whose expertise complements those of the founders. When we deconstruct the vector difference into its individual components, we find that founders seek early-stage directors who are dissimilar to them in terms of board, entrepreneurial, and professional experiences, while in sharp contrast they seek early-stage directors who are similar to them in terms of patenting experience.

We perform a two-stage analysis to identify the effect of early-stage outside directors on the startup’s future performance and exit strategies. We find that early-stage startups that appoint outside directors raise larger amounts in later stages, are more likely to attract VC funding, progress quicker to the series B (i.e., “growth”) stage, have higher patenting activity, and are more likely to exit successfully, especially through IPOs, compared with otherwise similar early-stage startups that did not appoint outside directors. Among the subset of early-stage startups that appointed outside directors, those startups whose early-stage investors serve as directors obtain larger amounts in later stages and are more likely to attract VC funding compared with otherwise similar startups with non-investor outside directors. Interestingly, however, startups whose early-stage investors serve as directors file fewer patents, take longer to exit, and are more likely to exit via acquisitions rather than IPOs compared with similar startups with non-investor-directors.

Finally, we show that one of the ways that early-stage outside directors affect future outcomes of startups is by leveraging their network connections to attract new investors to invest in the later-stage funding rounds. All else being equal, an investor is more likely to participate in later-stage funding rounds of a startup if he is connected to the early-stage director, especially if the connections were formed by working together on a previous startup (e.g., as co-investors, co-directors, or as investor and director). Our results suggest that startups benefit from having well-connected directors serve on their boards.

This post comes to us from professors Buvaneshwaran Venugopal at the University of Central Florida and Vijay Yerramilli at the University of Houston. It is based on their recent paper, “Outside Directors at Early-Stage Startups,” available here.