Whether at founding, prior to a financing, or as part of negotiating a financing term sheet with an outside investor, a common question founders have is around how to structure a start-up company’s Board of Directors, including the size of the Board and who should serve as a Director.
While there are no hard and fast rules or answers with respect to the structuring of the Board of a start-up company, there are some common considerations that founders should think about when thinking about how to set up their Board.
1. Do I have to have a Board of Directors? What is the Purpose of a Board?
If you are a venture backed company (or intend to raise outside venture financing), then typically investors will expect you to incorporate as a Delaware C-corp, and a requirement of being a Delaware C-corp is having a Board of Directors (“Board”).
While the officers or managers of a company (usually the President or CEO along with other officers such as the CFO or CTO) are responsible day to day operations of a company, the Board is in charge of “managing” or overseeing the officers. Ultimately the shareholders of a company are the actual “owners” of the company, and therefore the Directors are appointed on behalf of the shareholders to hire and provide oversight of the officers and ensure that the interests of the company (as a corporation and separate legal entity) and the company’s shareholders in general are taken into account in important decisions.
2. What are the responsibilities of a Director? What are fiduciary duties?
Directors are responsible for ensuring that the interests of the company and its shareholders are represented. They do this by providing oversight of the officers and their management of the company. In carrying out these responsibilities, Directors of Delaware corporations are subject to certain duties, generally referred to as “fiduciary duties,” that govern their actions and decision making. These fiduciary duties are varied and are governed by both Delaware corporate statutes as well as past Delaware case law, but include duties such as the duty of care (which requires Directors make informed decisions based on all material information reasonably available), and the duty of loyalty (which requires Directors to act on a disinterested and independent basis, in good faith, with the honest belief that the actions being taken are in the best interest of the company and its stockholders).
Generally speaking, Delaware courts are loath to second guess the decisions of the Board, and will view whether Directors are meeting their fiduciary duties under the lens of the “business judgment rule,” in which the courts will give wide discretion and deference to the decisions of the Board, provided they are not acting grossly negligent or and there is no conflict of interest.
3. What is a Preferred Director? What is the difference between a Preferred Director and a Common Director?
Typically, investors receive preferred stock in exchange for investment in a corporation (whether pursuant to a direct cash investment, or after the conversion of a SAFE or convertible note from a prior cash investment). Preferred stock provides the holder certain rights and privileges, one of which may include the right of the holders of such preferred stock to appoint one or more directors.
Investors usually ask for the right to appoint a director as part of a financing round, as it gives the investor both visibility (via attendance at Board meetings) and control (via the right to vote on certain actions subject to Board approval).
Directors appointed in connection with a financing are typically referred to informally by the name of the financing round, e.g. the director appointed by the Series A Preferred shareholders is often referred to as the “Series A Director” (and is appointed pursuant to a process specified in a voting agreement or the Certificate of Incorporation of the company, or both). Likewise, each new series of preferred stock often also have a right to appoint their own director, resulting in multiple outside directors (the “Series A Director”, the “Series B Director”, etc.), each of whom is appointed by the respective holders of each series of preferred stock.
These directors are generally referred to as the “preferred directors”, as opposed to the directors appointed separately by the holders of common stock (typically referred to as the “common directors”), or by the holders of all stockholders voting together. It is typical that common directors are the founders and/or the CEO of the company.
Other than differences in who (or how) the directors are appointed, voted on or removed, the rights of each director are the same (generally each director has one vote each). However, depending on the terms of a financing, there may be actions that specifically require the approval of one or more of the preferred directors.
4. What is an Independent Director?
In some instances, whether as a result of a financing requirement or upon agreement of the directors of the Board or the shareholders of the company, an “independent director” seat may be created.
An independent director seat is a director seat that is created to be filled by someone who is NOT otherwise an employee or founder, and who is NOT a representative of a particular investor or class of shares. There may be multiple reasons for creating such a seat – the Board may want someone with specific industry experience, skills or background to help the Board and the company, or they may want to add an independent voice to help balance the Board between the inside founders/management and investors.
Depending on the provisions of a voting agreement or the company’s Certificate of Incorporation, the independent director seat may be selected and filled by some combination of the CEO, founders, common/preferred directors, or common/preferred shareholders. Given how important it is for founders and/or the CEO to have a good rapport and working relationship with all directors, including the independent director, it’s generally good practice to require that the Common directors, the CEO or common shareholders have approval rights with respect to the appointment of the independent director.
5. How Big Should the Board Be?
For early stage companies, smaller is generally better. Prior to a priced round external financing, usually the Board is comprised of just the founder (or founders). There are a few reasons for keeping a Board smaller (at least initially):
a) Smaller Boards will make it more likely that founders retain control of the Board and decision making;
b) Managing and coordinating meetings can be difficult, especially with outside directors who are not involved in the day to day operation of a company;
c) It’s easier to act quickly and decisively on major decisions (such as raising a financing, agreeing to acquire a company or be acquired) with a smaller Board;
d) Lots of “voices” in a Board meeting can make such meetings less efficient, with meetings getting bogged down by questions or explanations to directors who are less involved (this can also be true of having multiple Board observers).
For those reasons, it’s not uncommon to see a one, two or three person Board (typically just one or more of the founders), and after the initial priced round external financing, a three person Board (with one seat occupied by the Preferred Director, and the other two seats occupied by the internal founders/management).
In addition, typically companies try to create a Board with an odd-number of directors, to avoid potential “ties” in voting, thus you often see Boards constituting 3 or 5 members or seats for early stage private companies.
6. Who SHOULD be on the Board? Who Should NOT be on the Board?
It is typical for an early stage company that has NOT yet raised an external, priced round financing to have a Board made up of just one or more of the founders. For most companies, this will mean a Board of up to three. Whether or not some or all of the founders are actually on the Board is a discussion as between the founders, although it is customary for the CEO of the Company (whether or not the CEO is a founder) to occupy at least one seat on the Board.
In addition it is typical for investors to have the right to appoint a director. Although investors typically have a legal or contractual right to appoint a Preferred Director, the company (including management of the Company) will still often have a great deal of informal “say” in the decision of which particular individual is appointed. Investors want to ensure a good relationship between the Board and management, and typically will not want to appoint a director that may not get along with the CEO or other founders. Therefore, company founders should discuss with potential investors who they may appoint as director, especially at the term sheet negotiation phase as that is when the company has the greatest leverage.
Companies with only a single founder have sometimes asked whether it is OK to appoint a spouse or relative to a seat (who is not otherwise an employee with the company), as a trusted person to fill a seat in order to “control” more than one seat and outvote any preferred directors that might be added. While there is no specific rule against doing so, generally this would be frowned upon by potential investors, who would rather see someone who is either operationally involved with the company or can offer industry experience or connections. Rather than taking this approach, a simpler approach is to leave one or more seats empty, and allow the founder the right to fill and/or vote the seat, which is discussed further below.
Finally, some founders have important advisors or prominent individuals involved with the company (whether or not they are an employee or investor) and wish to offer such prominent individuals a Board seat to insure they stay involved. Generally speaking, at least initially, Board seats should be reserved for just the founder or management (e.g. the CEO) and major investors. Advisors, spokespersons, and other influential persons could instead be engaged as members of an “advisory board.” That said, as noted above, to the extent the investors and/or the company decide an Independent Director seat should be created, then such individual may make sense to fill such a seat.
7. Do Investors Always Get a Board Seat?
Not all investors get a Board seat – especially given Boards typically only have one outside Preferred Director for each preferred round financing (e.g. one Series A Preferred Director after a Series A Preferred financing round). In addition, to keep board sizes manageable, after there are multiple preferred financing rounds, it is common for groups of preferred stock to be combined, so that a single director may be elected by holders of several rounds of preferred stock, all voting together.
Typically, the Preferred Director is appointed by the “lead” investor of a particular round – usually the investor that both (a) invests the largest amount in the round; and (b) negotiates and sets the terms of the financing round, usually by issuing the term sheet for that financing round and negotiating the financing deal documents for the round.
That said, it is not always the case that the lead investor appoints the Preferred Director – in some cases the lead investor does NOT wish to appoint a director (sometimes for liability reasons), and a co-lead or other investor participating in the round will have the right to appoint the director. In other cases, if a company already has gone through multiple preferred financings where it may already have more than one outside Preferred Directors on its board, the new investors will not require a new Preferred Director to be added. Also, Directors that were appointed by early investors may come off the board as larger rounds follow.
That said, as a base line, companies and founders should plan for adding a new Preferred Director for EACH financing round (Series Seed, Series A, Series B) it closes, and therefore should game plan for the size of the Board and the number of seats to be held by the common/founders/management accordingly.
8. Is it OK to have an Empty Board Seat?
Not all Board seats always have to be filled. While there are certain quorum rules that may need to be paid attention to for smaller board, generally speaking, there is no need to fill a board seat right away, and it’s not unusual for a seat to be left open after a financing in order to be filled in the future.
In addition, in some cases it may make sense for founders to specify that one or more seats remain empty, and further provide that the founders or CEO retain the right to fill such seats. This could allow such founders to retain control over the Board, especially if there aren’t any other trusted founders or officers that can fill such seat, and where the founders or CEO doesn’t want to go to the trouble of finding a trusted independent Board member.
9. What is the Difference between Board Observers vs Directors?
A board observer is someone who is allowed to attend a Board meeting but does not have any formal voting or approval rights. While arguably anyone who attends a Board meeting who isn’t a “director” is a “board observer”, a board observer as referenced by investors is usually a specific request for a contractual right that requires that the company allow a specific person appointed by the investor to attend any and all board meetings (and receive the same board materials as what directors would receive both before, during and after a meeting). This might be addressed as a contractual right in a separate side letter between the investor and the company, or drafted into the financing documents pursuant to the typical investor rights agreement that is entered into in a preferred financing round.
In many cases investors, knowing there is already a Preferred Director, or where they know a lead investor will fill a Preferred Director seat, will ask for this right – while they won’t get approval rights on the board, they will still get information and visibility that is greater than what most investors would get just from “normal” investor information rights provided in a usual investor rights agreement or side letter. Such rights should also specify when an observer can be excluded from a meeting, for confidentiality or other reasons.
Founders often view this is an “easy give” – after all, the observer can’t vote, so what is the big deal? However, founders should still be careful about not granting observer rights to too many investors, and being careful about who to provide that observer right to, for the following reasons:
a) Similar to the rationale for why companies should have smaller boards, managing and coordinating meetings with multiple directors AND observers can be difficult;
b) As noted previously, having lots of “voices” in a Board meeting (whether as observers or formal directors) can make such meetings less efficient and bogged down;
c) While observers don’t have formal approval rights, human nature being what it is, it is hard to get items passed or approved if one person vehemently is against a particular action or approach, even if that person doesn’t have a formal legal right to block or approve.
10. Are Board Members paid? Do I need to cover their Expenses?
Board members of private, venture-backed companies typically do NOT receive any compensation for being on the Board. For earlier stage private companies, usually the directors are made up of founders, existing management, and/or investors, and therefore it is not customary to provide compensation as the directors either are direct shareholders of the company, are being paid by the company in an operational role, or indirectly will benefit via investment in the company. In addition, it is also typically rare for independent directors of private venture-backed companies to receive cash compensation for attending board meetings, although in some cases companies will provide equity grants to outside, independent board members, similar to a grant that might be provided to an important outside advisor to the company.
As for expenses, while covering expenses for directors who are founders or who are in management would not customary, some companies do reimburse for expenses incurred by outside directors (whether Preferred Directors or Independent Directors) for attending board meetings, although there is no general rule, and in some cases companies do not reimburse Preferred Directors (as the rationale is, again, as investors, they are already incentivized to attend, and attending board meetings as an institutional investor or venture capitalist is an expected “cost of doing business” for the investor).
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