Key Questions Directors Should Ask Before Joining a Troubled Company

It takes a special kind of director to join the board of a struggling company. While some directors love a good turnaround—and some even specialize in it—it's not for everyone. Thrill-seekers aside, joining the board of a troubled company can be a tough decision.

It's one thing to jump out of a plane knowingly, and quite a different thing to fall out by accident. In the former case, you will have made adequate preparations including checking the wind speed and strapping on a parachute. In the latter situation, you are freefalling and unlikely to get away unscathed.

To prepare, here are questions to ask before joining a troubled company.

How Troubled Is the Company, Really?

The company has disclosed that they need help. They want you to join the board to help them. But sometimes companies may underplay the problems they have in order to bring a director on board.

Potential questions to ask:

What got the company into financial trouble, and is that issue close to being resolved?

Companies get into financial trouble for a variety of reasons, not all of which are equally susceptible to a quick resolution. If the company is in trouble due to a bloated cost structure, a swift reorganization may be all that is required.

On the other hand, if the company is in trouble because it has no revenue due to a global pandemic, the fix may be much harder, if not impossible. In some cases, the company is already dead; it just doesn't know it yet.

There are myriad other ways in which an embattled CEO and board may have bought into a set of assumptions that are no longer valid or that rely on an unlikely series of events. For example, the company may be relying on a single big order from a buyer who is no longer interested in the company's product.

As a board candidate, you will want to ramp up your diligence so that you have a clear understanding of what these assumptions may be, and whether there is time to correct them.

Does the company have any serious legal issues?

Some types of litigation may not be that serious. For example, many shareholder suits are entirely frivolous and will be settled for relatively low dollar amounts. On the other hand, any compliance issues involving government regulators are always serious. A conversation with counsel may be clarifying here, but this will be delicate due to attorney-client privilege issues.

In addition to finding out what is going on, you will want to understand the potential exposure of a company. Is the issue an unfortunate distraction or truly catastrophic?

Would the company be using my reputation to repair its reputation?

If you are brought in to help resolve an unfortunate situation, there are likely to be reputational issues at play. It's fine for a company to recruit you as part of their effort to demonstrate to the world that the company is turning over a new leaf, but only if they are really planning to take your advice and turn over that leaf.

It is difficult to discern where a company's management and board are on a question like this, since it is not a question you will be asking directly. You might consider whether the board and management spend more time railing about how unfair the situation is versus looking for ways to improve, even if these methods cost money and inconvenience.

How close is the company to filing for either Chapter 7 or Chapter 11 bankruptcy?

This is a question about the company's cash runway. You need to know if you have time to turn things around, or if the situation is already a lost cause. Companies can prematurely use up their runway in two ways: (1) they are further down the runway than they think, or (2) the runway will end before they realize.

A classic case of being further down the runway than the company thinks happens when a company needs short-term financing. The company may believe that if financing happens in the next 30 days, they will be all set, but they do not yet have a term sheet in hand. This makes a 30-day funded close extremely unlikely. In other words, this company has used up more of its remaining runway than it realizes.

The other side of the coin is not realizing where the runway actually ends. As I've written elsewhere, filing for a good Chapter 11 or even a good Chapter 7 bankruptcy takes more money than most people realize. All too often, no one has done the diligence required to realize how short the runway actually is.

Finally, remember that if you are on the board of a company that goes into bankruptcy, you'll need to disclose this in the future if you're up for a public company board seat.

Can I sign an NDA so that I can better evaluate the company?

If it's a public company board you are considering, public documents may be available to help you understand the situation well, including reports by investors who have shorted the stock. For both public and private boards, consider signing an NDA so that you can dig deeper and better assess the situation.

And if the company refuses to give you this kind of additional information, perhaps bogusly citing Regulation FD or the like? Run away. (There is no Reg FD violation if you sign an NDA and agree not to tip or trade in the stock.)

For clarity, your diligence is not just a result of being distrustful of the CEO and board that is recruiting you. Sometimes when people are in the middle of a tough business situation, they don't realize how bad it actually is.

In these cases, your perspective as an outsider can be very helpful. Of course, you can provide this perspective as an unpaid or even paid advisor; you do not necessarily have to join the board to be helpful.

Is It a Well-Functioning Board?

It may not be management's fault alone that things are going poorly. Before you get involved with the board, understand its overall dynamics by taking the time to meet and talk with fellow board members.

You might be OK with stepping into a toxic situation, but it's important to get a sense of what that is ahead of time. Keep in mind that the company may or may not have an onboarding process. If they do not, you may have to fashion the onboarding process yourself.

Potential questions to ask:

Is the board factionalized?

Any group of people will have its share of politics. The question you are trying to answer is whether these politics have divided the board, or whether the board is still able to debate issues thoroughly and respectfully. It will be hard to be influential in the boardroom if half the board is against you before you have even walked in.

Is there a good balance between the board and the CEO?

Getting the balance between the board and its CEO can be challenging; some boards are too passive and others are micromanagers. Both extremes will cause problems. If this is an issue, you will want to know this ahead of time so that you can plan the focus of your efforts accordingly.

Is the company giving corporate governance the right amount of attention?

Corporate governance for its own sake can kill a company with too much process at the expense of making decisions and taking actions swiftly and efficiently. Conversely, without good corporate governance, a company can easily careen out of control and over a cliff.

Are you being recruited to institute more corporate governance, and if so, is the organization ready for this? Conversely, has the board elevated corporate governance over the needs of the business?

This is another place where knowing the landscape will go a long way to helping you plan your approach should you decide to join the board.

Will They Protect You Financially?

Joining the board of a troubled company without ensuring personal protection is like jumping out of an airplane without a parachute. Personal Indemnification agreements and directors and officers (D&O) liability insurance are designed to offer the protection needed should you be sued by private plaintiffs or pursued by government regulators.

Potential questions to ask:

Does the company offer a state-of-the-art personal indemnification agreement?

Assuming the company is solvent, your first line of defense will come from this agreement. When you join the board of a troubled company, sometimes things get worse before they get better. You will want to ensure that your personal indemnification agreement has all possible bells and whistles.

Does the company currently have good insurance and what are its prospects for the renewal of this insurance?

If a company is in bankruptcy, the personal indemnification agreement it issued to you will be worthless. D&O insurance, on the other hand, is typically designed to respond on behalf of directors who are sued while the company is in bankruptcy.

However, when a company is financially troubled, it can be difficult to secure a good renewal. Carriers may even attempt to put bankruptcy exclusions on the D&O insurance policy of a company that has to renew its insurance when the company is on the verge of filing bankruptcy.

It could even be the case that the company is so far gone that it does not have the cash to pay for the renewal. You can choose to go on the board of a company that has poor prospects for its D&O insurance, but when you do so you are exposing your personal assets if you are sued.

Is this a situation where it makes sense for the company to provide separate D&O insurance for new directors?

The troubled company's D&O insurance may already be impaired, meaning that there is existing litigation that may use up the entire coverage available. In such a situation, it may be prudent for a new director to ask for a separate insurance policy for all new directors, a policy that would not respond to any of the existing litigation.

This is an expensive and difficult type of insurance to place, but it can be done if you have a sophisticated broker.

In summary, all directors understand that if their companies hit turbulence, they are expected to stay on board and help fix the problem. It's another thing altogether to voluntarily jump onto a plane that is headed for a crash landing. Saving the plane can be extremely rewarding, but asking the questions outlined here will help you assess if you can land the plane safely and how to protect yourself if you cannot.