Upon a startup’s incorporation, their attorney usually helps establish a board of directors (aka – the “board”), even if a solo founder is the only board member. The company’s bylaws call for the formation of a board and grants them certain authorities. But when does the board actually start taking action and how should it be composed? That’s the purpose of this article.
Setting the Stage
Until institutional investors enter the picture, many startups barely even notice they have a board. They’re reminded of it when their attorney presents them with various consents and authorizations that need to be officially approved by the board, but that’s about it. If they reach the point of raising a Series A round of funding, all of a sudden there’s a flurry of discussion and debate about board composition. Waiting until a Series A term sheet negotiation to get serious about your board of directors is too late and will involve way more investor “help” than a startup wants.
The purpose of the board of directors involves a combination of governance, oversight and fiduciary responsibilities. You can think of the collective body as a guardian of sorts for the company and their key stakeholders, but with big emphasis on the company’s shareholders.
Some founders think the board of directors control all important decisions for business-related matters. That’s definitely not true. The company’s bylaws define the composition of the board and grants it specific authorities. But most founders never read their bylaws or ask questions related to this. Matters such as approving stock option grants to employees, setting the fair market value for the company’s stock, approving executive compensation, and certain matters related to raising funding, taking on debt, or selling the company are usually decided by a vote of the board.
Sometimes the board’s approval for a given matter must also be supported by a successful vote of the shareholders voting their shares. And there are plenty of other matters that are mostly or solely decided based on a vote of the shareholders. In fact, often times a board member can be removed based on a vote of the shareholders, especially in the early days before institutional investors gain a locked-in seat. Startup founders that assume their authority is locked in as a result of holding a board seat are sometimes shocked when a co-founder dispute results in them losing both their board seat and their job.
Always an Odd Number
Since certain matters are decided by board members voting their seat rather than the number of shares they hold, you would never want an even number of board members. That introduces the risk of a tie vote and deadlock. The same risk exists if two co-founders split the company’s equity 50-50. If they are also the only two board members, they could be in real trouble if they disagree on a matter that requires a board vote, a shareholder vote, or both. By adding a third person, perhaps a trusted advisor, to the board and granting them any small amount of equity, the needed tie breaker exists in both cases (board vote and shareholder vote).
Managing the Board
The CEO has responsibility for keeping the board updated on various matters and serves as the host for the regular meetings of the board. The more board members there are and the more divergent their interests and philosophies are, the more effort the CEO will need to put into managing the board. It can actually get quite distracting at times.
Because of this, careful thought should be put into the size and composition of the board. Both will likely change over time as the company enters new stages of growth. But making a mistake related to board size and composition in the early days will continue to cause downstream issues later.
If a startup is on a venture funding track, I strongly recommend they start having board meetings during their seed stage, at least six months before they expect to raise a Series A and a year before is even better. This provides penalty-free practice time.
At the seed stage, a three-person board is ideal. That probably means two founders plus an advisor or supportive angel investor. Having a non-employee on the board has an added benefit while negotiating your Series A term sheet. Assuming this third board member has solid credentials and has been helpful to the company thus far, they can become the de facto independent board member that will likely be called for in the Series A term sheet.
If you don’t already have an independent board member identified, guess who is going to present you with a list of recommended candidates? That’s right, your Series A lead investor will try to secure an independent board member that they have a relationship with. But in that way, they aren’t really independent, are they? It’s true that you insisting on your trusted advisor or friendly angel investor creates the same issue, only in your favor. Sounds good to me. Having your independent board member already identified and serving on the board during the seed stage forces your Series A lead to have to justify why they won’t make for a good independent board member going forward.
During the seed stage, try to follow a typical board meeting format. For more on that, read my article titled “Your First Board Meeting”. This means taking official meeting minutes that get approved later by the board members and archived for future due diligence. It also means conducting other official board business (stock option grants, etc) as well as reviewing company performance, strategy and significant opportunities. During the seed stage, a portion of each board meeting can be reserved for planning and strategy.
Series A Boards
Since increasing the size of the board translates to more effort and more risk of divergent interests and philosophies, I typically try to keep a three-person board following a Series A round of funding rather than increase to five. This usually means a co-founder has to give up their board seat to the Series A lead investor. But if it also means keeping the prior independent representative, who is hopefully aligned with the founders’ strategy and vision, the overall balance of power at the board level is maintained favorably. The suggested three-person board would be comprised of one representative of the common shareholders (usually the CEO), one representative of the preferred shareholders (usually a partner from the lead investor), and one independent.
After a Series A round of funding, the company will have a new preferred class of shares that is held by the investors. All board members have an overall fiduciary responsibility to the company and, more specifically, to the common class shareholders. But it’s also impractical to expect your lead investor to not be influenced by the special class of shares they hold.
Your independent board director might also hold preferred stock, especially if they were an angel investor in one of your early rounds of funding and their convertible security converted to preferred equity during the Series A. That independent director possibly holds both common stock for their board role and preferred stock for their investment. As long as their amount of preferred equity is in the low single digit percentages, I don’t typically worry about it. But it is something to consider when trying to decide on a good independent director, hopefully well before the Series A.
A Series A round of funding is also when the topic of board observers might first come up. Observers are supposed to be just that. They get to attend the board meetings but aren’t really intended to be an active participant. A good example is when your Series A lead investor brings an analyst or associate from their firm for note taking and action item capture. Another example is converting a co-founder’s board seat into an observer seat following the Series A board transition. Yet another example is a non-lead investor in the Series A round that insists on an observer seat as a condition of their significant investment.
There are no set rules for the allowed actions of an observer, but I find that they quickly forget they hold an observer seat and not a full-fledged voting seat. Their comments and voiced concerns can change the dynamic during the board meeting, which might also influence some important votes in a way that you don’t want. I recommend that you be very careful and selective on the inclusion of board observer seats. And I strongly recommend that you set expectations with them before they attend their first board meeting with regards to their amount and type of interactions during the meeting. They mostly should just observe. Maybe that also means they dial into the meeting via conference call versus in-person attendance.
Compensating Board Members
This article is mostly about the composition of an early stage board, but it’s worth touching on which board members are compensated and what that compensation typically looks like.
Founders don’t get extra compensation for serving on their own board. Neither do investors that secure their board seat during a negotiated equity round of funding or board observers. For the most part, that leaves the independent board directors as the ones that deserve compensation. Even if they also hold some preferred stock as a result of an early angel investment, they usually get some extra compensation for their board role.
For the early stages of a startup’s evolution, likely through a Series B, the deserving board members are compensated with common class equity. After a Series B, it’s possible that some cash compensation also enters the picture. If a board member must incur meaningful travel expenses (ie – plane flight or hotel room), they usually can submit that for reimbursement by the company.
As for an appropriate amount of equity, it varies based on the stage of the company and the amount of effort expected by the board member. Some independent board members are only expected to show up at quarterly board meetings while others might be expected to provide some advisory assistance in between meetings. The frequency and intensity of that advisory assistance can make a big difference in the amount of equity that is appropriate.
To determine the amount of equity that’s appropriate for a given board director, first read my article titled “Compensating an Advisor”. The same basic principles apply, and I typically recommend two-year terms with monthly vesting.
I also recommend taking into consideration the extra legal liability risk the board members are assuming with their role. Disgruntled shareholders don’t just file lawsuits against the company or the company’s CEO, they also go after the board of directors. After all, a primary role of the board is governance, oversight and fiduciary responsibility on behalf of the shareholders. So, if you have both an advisor and a board member that are equally skilled and are expected to be equally active over an identical term of assignment, the board member should get a little extra equity. How much extra is subjective, but if the advisor earned 0.75%, the board member might be granted something like 0.85%. You should also provide all board members some form of indemnification agreement during the seed stage and directors and officers insurance (D&O) following a Series A.
For more information on board compensation considerations, read the article I wrote for prospective board members titled “Startup Advisor & Board Compensation Guidelines“.
Assembling a high-performance board of directors can be a real difference maker to a startups success. It can also create distraction and chaos. Careful thought and intentional actions during the early days can help set things in a positive direction. I hope this article provided some helpful advice in that regard.