Nivi · April 1st, 2007
“Because we weren’t having success finding a CEO, [our investors] insisted that we hire these managers [a temporary CEO and CFO]. That didn’t go great.”
Summary: Create a new board seat for a new CEO. Don’t give him one of the common seats.
Whether you negotiate a proportional or investor-leaning board, your term sheet will probably state that the CEO of the company must fill one of the common board seats. This may seem reasonable. One of the founders is probably the CEO and you were going to elect him to the board anyway.
Don’t accept this term. The investors are looking several moves ahead of you.
If you accept this term and hire a new CEO, he will take one of the common seats. The common shareholders will not have the right to elect that seat. If the new CEO turns out to be aligned with the investors, the new coalition of CEO + investors will control the board of directors.
A new CEO may be aligned with the investors.
A new CEO will probably be a professional manager who does a lot more business with VCs than he is likely to do with you.
VCs regularly refer the CEO to promising companies. They let him co-invest in their startups. They let him invest in their venture funds. They determine his compensation in your company. Where do you think the CEO’s loyalties lie?
Most likely, a new CEO will be aligned with the investors.
A coalition of CEO + investors can hurt the company.
A coalition of a new CEO + investors can hurt the company, founders, and employees. Consider this scenario:
The company needs to raise a Series B. Your investors discourage the new CEO from shopping around for cash because they want to invest more money in the business at a low valuation. Your investors tell you not to spend time raising cash because they will put in more money: “You should focus on building the business.” You want to shop around and raise money at a high valuation but the CEO does a half-arsed job because he knows this game.
The company ends up doing the Series B with its existing investors because that is the best offer on the table. A few months later, the CEO’s shares are “right-sized” and he is happy (“We have to pay the CEO market rate, right?”). The investors have put in more money at a low valuation and they are happy. The founders and employees have been diluted and they are wondering what just happened.
This story is not unheard of in Silicon Valley.
A new CEO may be naturally inclined to dilute you.
A new CEO can develop an antagonistic relationship with the company’s founders. Founders, like everyone else, have inadequacies as leaders and managers. Their inadequacies are usually worse than the ones the company portrayed while it was recruiting and selling the new CEO.
The new CEO joins the company and naturally blames the founders for all of the existing problems in the business. Who else is there to blame? Like any new leader, he continues to blame his predecessor for the next 12 months and loses any sympathy he had for the founders. He convinces himself that he deserves more equity for his contributions even if it dilutes the founders and employees.
“These fucking founders,” he tells the investors.
“Yes, these fucking founders,” say the investors.
And on they go to find to find a mutually beneficial opportunity to right-size the CEO.
Create a new board seat for a new CEO.
These two tales of CEO-investor intrigue illustrate why a new CEO is not necessarily your friend on the board of directors. If and when you hire a new CEO, create a new board seat for him. The common board seats should always be elected by the common shareholders.
For example, adding a CEO seat to an investor-leaning board with two investors yields
2 common + 2 investors + 1 independent + 1 CEO = 6 seats
The same scenario with one investor yields
1 common + 1 investor + 1 independent + 1 CEO = 4 seats
If you want to keep an odd number of people on the board, add another independent seat too.
If you have a good BATNA, you should reject any proposal where the CEO takes one of the common board seats.
The new CEO seat maintains the board’s structure (if you’re lucky).
Your investors may argue that the new CEO seat tips the board in favor of the common stockholders since the CEO holds common stock.
If only you were so lucky.
If your investors accept the premise that the new CEO is probably aligned with them, the new seat actually tips the board in their favor. If they don’t accept this premise, they are still wrong.
First, the independent director holds common stock, but the investors do not consider his seat to tip the board in favor of the common stockholders. You should ask your investors to consistently apply the same reasoning to the new CEO seat.
Second, the CEO does not represent the common stockholders on the board; his job is to create value for all classes of stock. In fact, all of the board members have a duty to serve the interests of the company, not a duty to “serve their class of stock”.
You learn a lot about an investor’s attitude toward directorship if they imply that they represent their class of stock on the board. Investors should protect their class of stock through protective provisions, not through their board seat.