· April 1st, 2007
“Good boards don’t create good companies, but a bad board will kill a company every time.”
– Old Silicon Valley Saying
Summary: Create a board of directors that reflects the ownership of the company and don’t let your investors control the board through an independent board seat.
The composition of the board of directors is the most important element of the Series A investment. It is more important than the valuation of your company.
The valuation of your company won’t matter to you if the board
- Terminates you and you lose your unvested stock.
- Forces the company to raise a low-valuation Series B from existing investors by rejecting offers until the company is almost out of cash.
- Merges the company with another private company and wipes out your common stock in the process.
If it isn’t obvious by now, a bad board can do lots of stupid or malicious things to make your stock or company worthless.
The board you create will be your new boss. But trying to please everyone on your board dooms you to managing board members and ignoring customers and employees. Great companies are rarely built by committee and a bad board will waste your time trying to run the company their way.
This hack will show you how to create a board of directors that you can trust even when you don’t agree with its decisions.
The board should reflect the ownership of the company.
The form of government in a company is dictatorship. The board represents the owners of the company and selects the dictator (CEO). The board then works to ensure the dictator is optimally benevolent towards the owners. Naturally, bad dictators get beheaded…
If the board represents the owners of the company, its composition should reflect the ownership of the company. Truly competitive and transparent markets, such as the public stock markets, have already reached this conclusion.
After the Series A investment has closed, the common stockholders are probably going to own most of the company. The common stockholders should therefore elect most of the board seats. Let’s assume the common stockholders own approximately 60% of the company after the Series A. If you’re taking money from two investors, the board should look like
3 common + 2 investors = 5 members.
And if you’re taking money from one investor, the board should look like
2 common + 1 investor = 3 members.
In either case, the common stock should elect its directors through plurality voting. Plurality voting enables the founders to elect all of the common seats if they control a majority of the common stock.
The sound bite you want to use in your negotiation is
“The common stock owns most of the company. Isn’t ownership the basis for determining the composition of the board? One share, one vote?”
Your investors may argue that this board structure leaves their preferred stock exposed to the machinations and malfeasance of the common board members. Your response should be
“Isn’t that why we’re giving you protective provisions?”
Early-stage companies with good leverage can negotiate this democratic board structure in a Series A. If your investors tell you that a democratic board is a deal-breaker and you want to move forward with them, use the fallback position: an investor-leaning board.
Don’t settle for anything less than an investor-leaning board. #
An investor-leaning board looks like this:
2 investors: 2 common + 2 investors + 1 independent = 5 seats
or
1 investor: 1 common + 1 investor + 1 independent = 3 seats.
An investor-leaning board gives an equal number of seats to every class of stock, no matter how many shares that class owns. This makes no sense, but, hey! that’s venture capital! There are many future scenarios where your investors can take over this board (e.g. a down round or hiring a new CEO), but there are no realistic scenarios where the common stockholders take over this board. Hence, this board is investor-leaning.
If you end up with an investor-leaning board, get your investors to agree to create a new common seat anytime the company creates a new investor seat (e.g. for the Series B investor). This prevents the investors from taking over the board in the Series B as long as this term isn’t renegotiated.
If you have a strong BATNA, you should reject anything less than an investor-leaning board. If your prospective investors suggest anything worse, they are probably trying to take advantage of you.
Fill the independent seat with an independent party. #
Don’t let the investors control the board through the independent seat. They may suggest a big shot for the independent seat whom you can’t decline without looking like a fool.
But the big shot does a lot more business with VCs than he is likely to do with you. VCs regularly refer the big shot to promising companies. The big shot invests in various venture funds and startups that the VCs send his way. Perhaps the big shot was an entrepreneur-in-residence at the investor’s firm. Where do you think the big shot’s loyalties lie?
Most likely, the big shot will be aligned with your investors.
The simplest solution to this dilemma is to fill the independent seat before the financing. At a minimum, select someone whom you trust and has the credibility to fill the seat. The investors will have a tough time replacing this independent director if your selection is a big shot himself or if he introduced the company to the venture firm in the first place.
If you can’t select the independent director until after the financing, the simplest solution is to
- Select the independent director by the unanimous consent of the board members. (Who could argue with this?)
- Tell the investors that you, like them, are going to be very picky about the independent director.
- Take control of the situation immediately by suggesting names for the independent director.