Welcome to a BetaKit weekly series designed to help startups and entrepreneurs. Each week, investors Roger Chabra and Katherine Hague tackle the tough questions facing founders today. Have a question you would like answered? Tweet them with the #askaninvestor hashtag, or email them here.
As always, in this column we focus on seed and Series A stage companies. Much like your management team and employee base will change over time, so will your board and the functions they provide. For early stage companies, in particular, a board can be an incredible source of value-add for a founding team and their company.
I have sat on many early-stage boards over my venture capital career. I’ve seen boards with great chemistry and efficiency and I’ve seen some that are, well, not so great. Board members who are active contributors and board members who everyone winces at once they see the payoff table come exit time: “I can’t believe they are getting that payout for such little engagement and work!”
My experience is that putting in place a good board is one of the simplest ways a founding team can gain leverage and an advantage over competitors. If you have unfilled board seats in your company for an extended period of time, you are missing out on a significant value creation opportunity.
Just as you would take the time and care to put together your management team, your board members should face equal scrutiny and consideration. Let’s walk through some tips for composing your board and filling the actual seats themselves.
Just like in any meeting or team, too many people in a boardroom can be overkill and is usually counterproductive to working effectively.
First off, I’d like to discuss the topic of diversity on company boards. Diversity (meaning, the inclusion of people of different backgrounds, colours, and genders) is a major topic in the tech world these days — and thank goodness for that, it’s a long time coming and overdue. However, diversity isn’t just a buzzword, it’s simply good business practice. Companies that are more diverse perform better financially than those who are not as diverse. Don’t believe me? Check out this article from McKinsey & Co.
Adopt diversity in your mindset for building your team and board – and your business will have a better chance at succeeding. As you think about adding smart folks to your board be sure to include people with all types of viewpoints, backgrounds, and genders. Need some help finding diverse board members? Have a look at theBoardlist — a truly great initiative that helps companies find female board members.
Let’s now address how boards get outlined and how the seats themselves get allocated. The composition (meaning the actual number of seats and who has the right to fill them) of your board will change drastically from pre-funding startups through to Series A startups.
Pre-funding startup boards are usually populated by all (or a subset) of the founding team. Typically you will see two or three of the founders on the board of a company at this stage. There is very little separation between the governance team and operational executive team for this type of company. Typically the two or three founders with the largest equity stakes in the company will make up the composition of the board.
Board meeting are extremely informal and may not be physically held at all. Governance matters such as ESOP grants or approval of annual financial filings are usually done via email or a phone call with the company’s lawyers or accountants. As you think about raising funding it’s a good idea to start acting like a “real” board – having regular quarterly board meetings, keeping minutes of meetings, and so on. This will get you into a good habit for future governance and will show your professionalism to potential investors.
As companies raise funding, the terms of engagement with respect to board composition changes dramatically. In a “family and friends” round of financing, you may not be asked for board representation from investors, and that is usually just fine. These people, after all, are investing in you (not your specific company per se) and will typically trust your ability to govern the company, on top of managing it. Furthermore, funding amounts are usually small at this stage, and investors typically don’t feel the need to enact protection in the form of a formal board seat.
When you start thinking about bringing in money from people outside of friends and family, you will typically see term sheets that dictate the composition of a board. The composition of your board is a key term in a funding offer and should be negotiated as importantly as your valuation, ESOP size, protective provisions, and liquidation preference.
Your lead investor in a seed or series A round of financing will almost always ask for a board seat as a condition of investing in your company. This is a market term. In fact, you should want your lead investor to have a board seat and be actively involved in the governance and operations of your company. If they don’t, you usually have to question whether you have the right investor and whether said investor will be a true value-add. Your choice of lead investor should take into account that they will be an active — and perhaps the most active — board member in your company. Choose wisely!
I, personally, am a massive fan of smaller versus larger boards. In my view, you should minimize the size of your board at any stage of your company. You can always find ways to get valuable people involved with your company without giving them a formal board seat, such as advisors or consultants. However, the regular function of governing your company, from a high level, should be charged to as small a number of people as possible. Just like in any meeting or team within your company, too many people in a boardroom can be overkill and is usually counterproductive to a company working effectively. Importantly, note that this is also true for observer board seats (a less formal type of representation on a board which doesn’t carry voting rights, but has the right to sit in and participate in any board meetings).
Don’t just freely hand out observer seats; these are not benign. In my experience, observers regularly contribute and influence board discussions. In function, they have a tendency to turn into “full” board members overtime, even though legally they don’t have the same rights as formal board members. Trust me, you’ll wake up after a few meetings, look around the room, and see little functional difference between your legal board members and your board observers.
At the seed stage, post-funding, you will typically see boards of three to five people. The CEO of the company (who may or may not be a founder, but at the seed stage, they usually are) will be legally entitled to a board seat. The lead investor will have a board seat. The third through fifth seats are up for discussion and negotiation before you close your round of financing. These seats can either be filled with one or more founders (someone who has a large equity stake in the company), another incoming investor outside of your lead (again, someone who owns a material piece in the company), or what is referred to as an Independent.
An Independent is defined as someone who is not formally affiliated with the executives, founders, or investors of your company and have minimal or no business dealings with the company to avoid potential conflicts of interest. Seed stage companies may not have any Independent board members. The governance of the company can be handled by the CEO, another significant shareholder and a lead investor. This is just fine for smaller companies. Again, you can get the value of an Independent by setting up and advisory board or bringing in an executive consultant or two.
As companies mature beyond the seed stage, however, you will almost always start to see (and want) Independent board members involved. This is a good thing.
You shouldn’t be as focused about maintaining control of your board; you should be focused on building a functioning board with chemistry and true value-add potential.
An Independent board member should be chosen as carefully as your lead investor. However, recognize that you can change your Independent over time if they are not providing value. Rarely will you have the chance to change an investor board member! Independents should be people who have “been there and done that” within a company similar to yours or within your industry. These people can provide a very different view and value-add than a first or second-time founder and a VC board member who is usually a generalist and is not very deep within one specific industry.
Your Independent should have deep domain or industry knowledge and should be the go-to person for these type of matters. They can opine on industry happenings, they can comment on the readiness or applicability of your technology, they can open doors directly to potential customers, employees, or acquirers and so on.
Beyond industry or domain experience, good Independents have typically also been senior executives within a startup or large corporate. For this reason, they can be amazing mentors for a CEO or founding team, helping them navigate the issues associated with scaling and building out a fast-growing team and company.
A common mistake I see post-funding from early-stage founders is the tendency to believe important matters within their company will always come down to board votes. So, come term sheet time, they try at all costs to “stack” the board (with people they know will vote with them on important matters) in their favour in order to maintain “control” of their company. They put their fellow founders on the board or choose Independents that they know will “have their back.” This is a natural tendency; after all, it was you and your founding team that were on the ramen diet for two years before your friendly neighbourhood VC or Independent board member showed up! There is no way you are going to let a VC come in and take control of your company, right?!
I have been on the boards of upwards of 25 companies over my career. Add that up and it is many, many hundreds of board meetings. Ask me how many times an important corporate matter came down to a board vote, and I will tell you that I struggle to remember even more than a handful. This doesn’t make any sense though does it? Boards are supposed to have heated, power struggle votes on firing a CEO, or selling a company, or buying a competitor just like we see on TV or in the movies, right? Well, in actuality, no. Not for early stage, angel, or venture-backed companies.
First off, my experience is that boards will often work through important issues without anyone shoving the actual legal rights of the different people to vote on a given issue. Founders, CEOs and Investors usually don’t jump up and down in board meetings shouting “Well, the company legals say I have the right to do so and so and you can’t block me!” If your conversations are turning this way, as a seed or Series A startup, you have major problems my friend. Problems you need to fix pronto.
Your Chairperson provides leadership to the company’s board members. It goes without saying that this person should be chosen with extreme care.
Furthermore, particularly at the Series A stage and beyond, your investor(s) will typically have negotiated a set of preferred share terms known as protective provisions. These terms allow the investor to have approval over key corporate matters such as selling the company, the company issuing more shares by raising more equity, the company taking on debt beyond a certain amount, payment of dividends, changing the board composition, and so on.
In practice, these matters don’t technically need to come down to board votes. Good investors won’t waive these provisions in the face of a founding team or a company’s board, rather, they will talk through important items carefully and do what is best for the company. The point here is to recognize that key corporate matters very rarely come down to an actual board vote. For this reason, you shouldn’t be as focused about maintaining control of your board; you should be focused on building a functioning board with chemistry and true value-add potential.
As your company board gets to around four or five board members, you will usually appoint a Chairwoman or Chairman. This is also an important piece of leverage for you as a founder. Your Chairperson provides leadership to the company’s board members and act as the liaison between the board and the executive team. It goes without saying that this person should be chosen with extreme care. Your Chairperson will be charged with ensuring your board is functioning properly. They can be important enforcers if one or more of you board members is exhibiting bad behavior, and they can be constant sources of insight by founders to ensure that important matters are dealt with efficiently and with the buy-in of all board members.
Roger does an amazing and thorough job of describing how boards get formed and how they evolve over time. I’d like to dig a bit deeper into the topic of board control from the founder’s perspective. I disagree with Roger in that I think board control is very important for the founders of early-stage companies.
Negotiating how many board seats, if any, you give your investors is a very key part of any financing negotiation and I feel it should be taken just as seriously (if not more seriously) than valuation. While on the surface a board can seem like a helpful group of advisors, founders cannot lose sight of the real power board members yield. The board can make many decisions influencing the direction of the company including the ability to hire and fire all positions, including the CEO.
I’ve seen quite a few founders get pushed out of their operational roles in companies they founded due to conflicts with their board.
It is easy to think you’d never run into major problems with your board members at the time of financing; at that point everyone is getting along, and optimism is high. But it is very important that you understand the worst case scenario and protect your interests. Unfortunately, these worst case scenarios unfold more often than you think. When fired by the board, founders not only lose their ability to influence day-to-day operations through their role, but depending on their vesting schedule, they may also lose a large portion of their holdings in the company.
I agree that it is only natural that as companies raise financing and take on more shareholders the focus of control may shift, and this is often in the company’s best interest over time. But in the early stages of a startup, the makeup of the board should roughly reflect the cap table. In the case where founders still own a majority stake, founders should still control the board. If the company has sold a 30 percent stake to investors, they should control one of three board seats, not two. Independents are often viewed as neutral parties in a negotiation, however, who gets to appoint the independents to the board can be an important negotiating point. The allegiance of the independent is generally to the person that appointed them, but of course, that can change.
Over the years, I’ve seen quite a few founders get pushed out of their operational roles in companies they founded due to conflicts with their board. Replacing a founder with a professional CEO can sometimes be in the company’s interest. When this is the case, the best founders recognize that it is in their interest to do what is best for the company and transition to a new role in the company. But when a founder and other board members disagree fundamentally about what is in fact in the company’s best interest, that is when the conflicts arise.
Mark MacLeod put together a great post a couple of years ago on the topic of board control that I’d highly recommend, and very much agree with. MacLeod highlights Mark Zuckerberg as one of the more prominent examples of a situation where it was important that board control stayed with the founders. For many years, Zuckerberg ran Facebook with a focus on growing the community, putting off monetization. While it turned out to be the right decision for the company in the end, many investor controlled boards would have swiftly replaced him with a CEO focused on growing revenue.
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