In this bylined article, Michael Peregrine and David Nygren explain why governance is particularly important for health care subsidiaries dedicated to innovation-related activities and investments. They write, “Successful innovations-focused investment may require a specially designed board model that blends the attributes of traditional health system governance with those of entrepreneurial ventures.”
Originally published in Law360
Effective governance is a critical factor for health systems developing subsidiaries to pursue innovation-related activities and investments. This is in part due to the perception that the subsidiary’s success may be enhanced by including entrepreneurs on its board of directors. As a result, governance planning for the innovation subsidiary may require more attention than is typically required for other health system-controlled entities. This may particularly be the case for nonprofit systems, less familiar with entrepreneurial leadership styles.
Many leading health care systems are considering, or are in various stages of establishing, these types of subsidiaries. A common goal is to own or invest through the subsidiary in emerging technology, software devices, delivery platforms, pharmaceuticals, and other products and services complementary to the health care industry. The developmental premise is based on a “leaner” operational model with strategy, leadership, managerial and compensation/benefit structures resembling those of Silicon Valley companies, or SVCs, and successful venture capital-backed technology startups — and not traditional health systems.
However, such entrepreneurialism is not always a “clean fit” with traditional principles of corporate governance, particularly those in the nonprofit sector. Venture capitalists and other entrepreneurs often have particular views on organizational development and goal achievement that may differ in comparison to those of nonprofit health systems (e.g., the opportunity for equity growth) and in some circumstances, with large, mature for-profit health systems. In addition, there are often unique board oversight challenges associated with the development, testing and implementation of innovations.
For these and other reasons, the ultimate leadership structure for innovation subsidiaries should reflect a balance of necessary health system and subsidiary board oversight, with preservation of the subsidiary’s entrepreneurial orientation.
Achieving this balance may be aided by a proper understanding of the (1) the attributes of the “entrepreneurial director”; (2) the perceived governance practices of SVCs; and (3) the controls by which health systems might prudently apply to their innovation subsidiaries, given their commitment to entrepreneurialism.
Individuals with innovative, entrepreneurial expertise are in high demand for executive and board positions. In order to be successful in recruiting (and retaining) such individuals for their innovations subsidiaries, health systems will need to be informed about, and accommodate elements of, the entrepreneurial culture with which these candidates are familiar.
The Entrepreneurial Director
There is certainly no “one size fits all” model of the entrepreneurial officer or director. Nevertheless, health system board members should recognize that several attributes are most often associated with these successful leaders.
The corporate governance orientation of many seasoned entrepreneurial leaders may reflect their experience with venture capital-supported startup enterprises; e.g. a tendency to focus on venture performance and achieving liquidity for investors (i.e., converting to public company status in the shortest practical time). Recent analyses suggest that successful startup founders sometimes find it difficult to transition to a CEO role in a maturing enterprise, given resulting changes in the nature of the business challenge. In addition, a traditional corporate CEO position at a mature company rarely offers the substantial control and access to wealth offered to a “founder” in the startup model.
Venture capital firm representatives are often very “hands-on” as directors at emerging companies; e.g., participating in key operational decisions such as strategy, executive hiring decisions and technology/engineering monitoring. (This is often a matter of necessity, as the VC firm might be investing cash with a company run by more youthful leaders who possess great ideas, but lack experience running a business). The board is often small, prone to frequent meetings, and very engaged with management. This can pose challenges to the board/management dynamic — which challenges are often offset by the resulting financial performance.
As startups mature into public companies, some of these traits may prove problematic within a board focused not only on performance, but also on matters of corporate and social responsibility, and satisfaction of law and regulation. The extent to which matters of compliance necessarily occupy a corporate board agenda can be particularly frustrating for some who, by virtue of their venture capital background, are more focused on the importance of providing guidance to management.
Traits of SVC Boards
Recent surveys suggest that the corporate governance practices of SVCs in the technology or life sciences sectors are, in some respects, notably different than those of boards in other industry sectors. For example, these SVC boards tend to (1) reflect greater simple equity ownership by executives and directors; (2) be smaller in number; (3) meet, as a full board, with greater frequency; (4) more commonly include “insider” directors such as CEOs and CFOs; (5) eschew the combined chair/CEO position; (6) have notably different approaches to the size and meeting frequency of certain key committees (e.g., audit, executive compensation and nominating); and (7) pursue diversity at a somewhat slower rate (although that is trending upwards).
Venture-like boards expect speed and results. They invest wisely and are able to tolerate losses to a venture fund so long as capital is pouring in from other sources. The dilemma for the health system operating as a venture fund is that its core venture, the health system itself, cannot run an extreme risk to its corpus. Asset preservation is an inherent virtue of a health system. Innovation to such an expensive core business is slow. But, in order to fund the future left behind by federal system budget cuts, health systems of great size are making the turn to invest in their own futures.
This is noble but unnatural and requires a new way of operating and governing. The systems have taken to heart Willard Zangwill’s statement that “we either innovate or we die.” Large systems understand that the limitation to capital, and the demand to sustain inpatient, outpatient and home care delivery are expensive and unreimbursed in many cases.
Practical Lessons for Health Systems
Given these unique attributes, health systems should consider inserting the following types of controls into their innovation subsidiaries, regardless of whether they are operational- or investment-oriented in scope, and regardless of the organizational form the subsidiaries may take.
Loyalty: The innovations subsidiary is formed to support the organizational purposes of the health system, which is its ultimate financial sponsor. The strategic direction of the organization should be consistent with those purposes. There may be incentive goals and stock ownership opportunities (in investments directed by the subsidiary) for management and possibly the board. But unlike the typical venture capital-backed startup, the ultimate goal is not the financial gain of individual investors, but the mission gain of the member/owner.
Stewardship: The basic funding for the innovations subsidiary is likely to come from the operations of the health system, not from venture capital investors. (Funding, and ability to withhold the next round of funding, are what provide VC investors (and their board representatives) so much power and influence over the emerging company). While the innovations subsidiary must be free to take informed risks in its investments, its investment risk tolerance is likely to be more conservative (given the funding source), than that which is typically associated with venture-backed startups. Unique stewardship issues may arise when particular innovations investments threaten to conflict with mission-based tenets of the health system.
Conflicts of Interest: The innovation subsidiary’s conflict of interest policy should anticipate the potential for conflicts to arise from the usually diverse investment portfolio of entrepreneurial — grounded directors and officers, as well as the possibility that members of the board and leadership team (at both the parent and subsidiary level) may seek opportunities to invest along with the subsidiary. Conflicts may also arise in the context of the health system governance of the innovations subsidiary to the extent the subsidiary has minority shareholders (with minority shareholder legal protections).
Engagement: Venture capitalists and other entrepreneurs are in frequent demand for board service (and are often heavily involved in their own day-to-day investment activity). A health system should assure itself that the entrepreneurs they tap for board positions are capable of exercising the requisite level of engagement.
Compliance: The innovations subsidiary should not be exempted from the need to apply a vigorous compliance policy. It may contract with the health system for compliance program services, and the health system’s audit and compliance committee may support the compliance oversight efforts of the innovations subsidiary board. Yet, the scope of the compliance program itself is likely to be substantially different from that which applies to the health system.
Monitoring of Management: It is a necessary governance principle associated with innovations-based startups that its board may need to exercise a greater degree of oversight of management than would be necessary in an operationally mature enterprise. (Theranos is an obvious, yet extreme, example of the possible oversight challenges.) This board oversight should be supplemented by fulsome efforts of health system senior management to monitor subsidiary performance.
Reporting: A related lesson of Theranos is the importance of vertical and horizontal reporting by the management and board of the innovations subsidiary. In order for oversight at both the subsidiary and health system levels to work, there must be clear expectations on the degree of reporting by innovations leadership.
Practical Observations for Health Systems
Health system boards realize the risks of failing to innovate. They have watched many individual hospitals race to join them to support their infrastructure and capital needs while realizing that spreading the infrastructure cost only does so much to prop up existing operations. Health system boards are frightened of cannibalizing their core or endowments, but in the absence of meaningful alternative revenue sources some are stepping into significant investments in innovation.
As the health system innovation function accelerates these experiments, it is likely they will go deeper and deeper into innovation. Likewise, the funding to support this may be tight if expected to come from the parent. Challenges may arise as specific investments evolve. Examples include a technology platform that reveals the real value is in genomic science applications; that a supply chain is really monetized through pharmacy; or that home care is only cost effective with e-health or wearable technology. In these circumstances, boards get excited but may still wonder where the capital return on the initial investment to support the health system actually will be returned. That initial return on investment may look like venture capital, the return from which may have a longer-term horizon.
No model yet exists to balance the nonprofit and for-profit motives and incentives, but it will evolve of necessity either through venture partnerships and massive infusion by mega-health systems which can carefully consider the risks and returns. Significant consequences either way will require rethinking the competence to govern these businesses.
Health systems are increasingly recognizing the need to pursue investments in innovative programs, services and technology in order to support their commitment to quality and efficient care. This is particularly the case as such systems move away from the inpatient delivery system model and focus more on digital and ambulatory platforms. Successful innovations-focused investment may require a specially designed board model that blends the attributes of traditional health system governance with those of entrepreneurial ventures.
Michael W. Peregrine is a partner at McDermott Will & Emery LLP.
David Nygren, Ph.D., is an organizational psychologist and founder of Nygren Consulting, which specializes in organizational design, board dynamics, strategy, competency identification and board peer and CEO assessment.
The authors thank Mark J. Mihanovic, a partner at McDermott, for his contributions to the preparation of this article.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice. See, e.g., Mark Calvey, “Square, Facebook and other Silicon Valley executives are popular choice for nation’s boardrooms”, San Francisco Business Times, May 18, 2018.
 Tom Perkins, “The ‘Compliance’ Board,” The Wall Street Journal, March 2, 2007.
 Noam Wasserman, “The Founder’s Dilemma,” Harvard Business Review (February 2008).
 Perkins, supra.
 Fenwick & West, “Corporate Governance Practices and Trends: A Comparison of Large Public Companies and Silicon Valley Companies”; Orrick, “Public Company Corporate Governance Features in the Technology Sector”.
 Andrea Vittorio, :Silicon Valley’s Biggest Firms Buck Corporate Governance Trends”, Bloomberg Law, Dec.15, 2017.
 Willard I. Zangwill, Lightning Strategies for Innovation: How the Best Firms Create New Products, October 1993.
 Adam J. Epstein, “Silicon Valley’s Legendary Investors are Stuck in the Past”; The Business Insider, July 25, 2016; Edmund Andrews, “Who Runs Silicon Valley Boards?”, Stanford Graduate School of Business, Jan. 27, 2016.
 Epstein, supra.