This is an ongoing Research Series from GoingVC on The Term Sheet


The Board

When it comes to the term sheet, the first considerations for most investors involve deal economics: What is the company valued at? How much do you invest? And how do you protect your investment with a nice liquidation preference?  

But after those critical details are hammered out, you might be wondering what else you can do to help your portfolio company progress, particularly if you are interested in being an active investor.

The answer is to join the Board of Directors, which is the next term in our term sheet series.  The Board of Directors is often dealt with further down on the term sheet.

But make no mistake, your position on the Board of Directors, and the configuration of the board, will determine how much of a say you have in that company’s direction.

What Is The Board Of Directors?

The Board of Directors is an appointed group of key stakeholders that makes decisions for a startup including whether to raise money, whether to be acquired or enter into a strategic partnership.

Every corporation by law has to have a Board of Directors, even if it’s only a one-person board. The board also plays a crucial role in hiring and firing senior management such as a CEO or CFO. The individuals on a board may even play a part in making operational decisions for the company such as setting company policies, budgeting, choosing an accounting firm, moving the company’s headquarters and approving the vesting schedules.

Lastly, boards have “fiduciary duties,” meaning they have to act responsibly and in the best interests of their company’s stockholders. While in most instances the Board and founders will agree, there may be instances where this is not the case so the fiduciary responsibility plays an important role to ensure the incentives are correctly aligned within company management and decisions are made that benefit stockholders and not just management, for example.

Are Investors On Boards?

“…when an investor says that they’re committed to partnering with you for the long-term – or that they’re betting everything on you – but then tells you something else with the terms that they insist on, believe the terms.”

jason kwon

The short answer is yes.  If you have made a sizable investment in a company  – in the realm of 15 to 25 percent – then it is not unreasonable for you as an investor to request a seat on the board. After all, you do want a say in your portfolio company’s decision making, and could prove to be a valuable resource for the company.

That said, how hard you push when it comes to the overall composition of a board will say a lot to others in the company about your motives and thought process.

As we mentioned, the Board of Directors wields a lot of power – they can fire the CEO – so it’s unlikely a founder or team of founders is going to want investors to have complete control over a board with more than one member representing the investor or firm’s interest.

“When boards are set up to take power away from founders, the investor’s outward justification will frequently be reasons of governance or accountability,” writes Jason Kwon and Aaron Harris on Y Combinator’s blog. “But the more power that’s taken away, the more it’s undeniable that the investor is attempting to structure away a perceived risk. So when an investor says that they’re committed to partnering with you for the long-term – or that they’re betting everything on you – but then tells you something else with the terms that they insist on, believe the terms.”

In Y Combinator’s standard version of a Series A term sheet, representing what the world famous accelerator typically sees on most term sheets, the investor designates one board member and the common majority gets to designate two board members.

Both the Upcounsel and VC Experts blogs suggest startup boards should appoint independent directors, at least in some capacity. 

Independent directors are people on boards who have no personal financial or related interest in the company. At inception, it is not uncommon for startups to create Boards that are composed of the founders (see below). Independents can offer a less biased lens through which to view strategic company decisions, and is a standard of strong governance practices in every well-run company.

“They are not investors in the company, nor are they involved in its day-to-day management,” Laviva Mazhar, a venture capitalist at Luge Capital, writes in her Medium post. “An independent director is often brought in to add specific expertise or ensure that ‘control’ of the board is not swayed in either the direction of the founders or investors.”

Let’s say you have a small, three-person board. A common configuration might be to give one seat to a founder, one seat to a major investor and the remaining seat to an independent director.

Mazhar also says the following scenarios are common for startups with a three or five-person board:

  • Two co-founder directors (common shareholders), one investor director (preferred shareholder)
  • Two co-founder directors, one investor director, one investor observer (not a voting member)
  • Two co-founder directors, two investor directors, one independent director

Veto Rights Are Not Uncommon

Although your requests as it pertains to the makeup of a board tells the founders a lot about what kind of partner you want to be, that doesn’t mean you shouldn’t protect yourself – you do have your own fiduciary duties to your limited partners.

That’s why it is not uncommon for investors to seek veto rights.

Veto rights enable a specific investor, or group of investors, to block a big decision if they – and they alone – vote against it. So, if one board member or group of board members with veto rights opposes a decision, it would not pass despite the majority of board members voting in favor.

Typical provisions investors will request veto rights on, as stated on Forbes by Richard Harroch, the managing director and global head of M&A at VantagePoint Capital Partners, include:

  • Amendment of the company’s charter or bylaws to change the rights of the preferred, or to increase or decrease the authorized number of shares of preferred or common stock.
  • Creation of any new series or class of shares senior to, or on parity with, the preferred.
  • Redeeming or acquiring any shares of common, except from employees, consultants, or other service providers of the company, on terms approved by the board.
  • The sale or liquidation of the company.
  • Incurring debt over a specified dollar amount.
  • Payment of dividends.
  • Increasing the size of the company’s Board of Directors.

Always keep in mind that actions speak louder than words.

Founders might think you have ulterior motives if you request veto rights that reach too far, and that can lead to tension on a board, which needs to be a well-oiled machine if a company is to succeed. The Israeli-based venture capital firm TLV Capital has an interesting approach to veto rights, which you may want to take note of. The firm said it never will allow a single investor to take their own veto rights, but rather push for veto rights to go to a group.

“When conflicts arise, investors with veto rights are less likely to compromise. Giving veto rights to single investors will increase forceful interactions,” TLV wrote on its Medium page. “We take veto rights seriously. For us, it can become a show stopper when doing a deal. We insist on sharing veto rights even if we are the largest investor. If previous investors are not willing to share their veto rights, we may pass on the deal. We also cut veto rights as much as possible and reserve it only for the most crucial of matters.”

This is a great way to show founders that your intentions are sincere.

Ultimately, while we have tried to show you all the angles, Harroch says that good investors rarely abuse veto rights.

“Word spreads quickly in the venture world,” he wrote in Forbes. “And VCs know that if they are arbitrary in blocking sensible deals, it will adversely affect their reputation with future entrepreneurs.” 

Conclusions

While the Board of Directors may seem like something handled down the road for most ventures, intelligent Board composition decisions made early in the lifecycle of a company can pay dividends down the road.

Influences from Independents and trusting the Board with strategic decisions may not create a strong competitive advantage, but that won’t matter if the Term Sheets doesn’t get signed! Stay tuned for more on GoingVC’s Term Sheets and Research Series.


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