One thing entrepreneurs learn early (or should) is that controlling a business – having the final authority on matters big and small – is about more than owning a majority of the stock. Various parties - including creditors, investors, minority owners, etc. - can have contractual rights that limit the freedom of action of even a 100% owner of a business. And then there is the Board of Directors, a body that appoints (and can dismiss) the management team, and makes (or at least ratifies) most major corporate actions.
The Board of Directors of VC-backed startups typically include two, and often three, categories of directors: folks appointed by insiders (founders/entrepreneurs); folks appointed by investors; and independents (variously appointed by either the insiders or the investors, often subject to the approval of the other group). The balance between these groups is usually carefully negotiated each time significant new investors come into a deal. By the time of a second or third round of venture investment, investor-appointed directors often constitute a majority of the Board of Directors, even if the entrepreneurial team still owns a majority of the voting stock.
Now, who controls the Board – the insiders, the investors, or now and again an independent via a tie-breaking vote – is no small matter. The size and structure of the Board is in fact something worth thinking through with care. That said, it’s maybe not quite as big a deal as entrepreneurs sometimes think, for a couple of reasons.
First, Board decisions are most often unanimous. While reaching an agreement on matters brought to the Board may take some time, the agreement is usually reached before any recorded vote is taken. It’s typically in no party’s interests for the Board minutes to reflect serious disagreements among the directors. A close recorded vote on a matter worthy of serious Board attention is usually a warning flag of team tensions.
The second reason why understanding the Board’s role is more than just asking who the various members work for is that whatever sub-group of the shareholders appoints them, every director has a fiduciary, legally enforceable obligation to represent all the shareholders. So, a director appointed by investors is bound to represent all the shareholders, even those that have no say in the particular director’s appointment.
Most of the time, this legal principle has little practical import. Directors elected by investors will tend to see issues brought to the Board the way the people who elected them view those issues: presumably, that was why they were elected. Ditto, of course, for insider directors. True as that is, there is more to the story. Boards indeed take many actions to the effect of which is to favor one group of shareholders over another: it’s in fact inevitable. But a director who casts a vote the purpose of which is to favor one group of shareholders over another is treading on dangerous ground.
Let’s look at an example of how the difference between a director’s perspective as an investor and her responsibility to shareholders generally might play out. ane Doe, a general partner of Acme Ventures, is appointed to Newco’s Board by Acme and the other venture investors. Newco is running low on cash, and Beta Ventures has offered to lead a new $1 million round of financing at $2.00 per share, a healthy premium over the previous financing at $1.25 per share. Director Doe votes against taking Beta’s offer. The following week, Newco’s board of directors, at director Doe’s suggestion, accepts Acme’s offer for a $1 million investment on substantially the same terms as the Beta offer except the price is $1.00 per share.
Has director Doe done anything unlawful?
Probably. On these facts, a jury would likely conclude (you can never be certain with juries, and perhaps there are other pertinent facts) that director Doe violated her fiduciary duty of loyalty to all Newco shareholders – not just those who appointed her - when she cast her votes against accepting Beta’s financing offer and for accepting Acme’s offer.
If those facts seem extreme, that’s because they are. It’s an illustration of a principal, after all. But while they may be extreme, they are of a kind that has embroiled many entrepreneurs in many disputes with venture investors. Those disputes are often in the context of cram-down (aka “washout/recap”) financing rounds. Indeed, that’s one of the reasons investors often shy away from such financings: they don’t want the washed-out shareholders coming back – with the benefit of hindsight – to question the motives of the investor directors if the deal ultimately works for everyone but the washed out shareholders.
None of this means that “who controls the Board?” is not an important question for founders and investors alike. In most situations, policy differences between investor and insider directors don’t rise to the level of compromising – at least obviously so - the fiduciary position of directors. But at crunch time, when decisions are being made that will impact different ownership groups very differently, every director should remember that her actions should reflect her view of what is best for the collective owners of the company, not just those that appointed her. Now and again, entrepreneurs can be well-served by reminding the directors that while they may have many perspectives, at the end of the day they all have the same constituency.
One thing entrepreneurs learn early (or should) is that controlling a business – having the final authority on matters big and small – is about more than owning a majority of the stock.