Nivi · April 1st, 2007
“Good boards don’t create good companies, but a bad board will kill a company every time.”
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.
Topics Board of Directors
One of the biggest challenges facing entrepreneurs is being “fundable” also known as being “in network” or “known” by the venture firm. Unless your product is complete or has an existing following or is profitable, it is very hard to get in cold…
Here is a version of a conversation repeated many times around the world…
BootStrapper: Hi, I’m John Smith with SaveTheCrack.com.
VC: Hi John, pleased to meet you (looks at his watch)
BootStrapper: Well, I noticed you invest in early stage startups in technology.
VC: Uh yea, we are proud to be one of the most savvy venture firms out there and are very in tune with entrepreneurs and current trends. (glances around the room for somoene he knows)
BootStrapper: Well perfect, then i’m sure you’ve heard of social crack. It’s the latest trend and we are set to take advantage of it.
VC: Yes, we invested in a social crack company last week, we see a lot of good things happening in that space.
BootStrapper: Perfect, well my company kicks the space for yadayada reason. This is my third start-up unfortunately the last one failed and I’m broke but I have these great sketches and almost an alpha.
VC: Great, that sounds exciting (thinks “When is lunch?”)
BootStrapper: Look here on my treo (demo’s product). What do you think?
VC: Very cool, it has some potential but I’m sorry I have to go, I have a meeting in the conference room down the hall (free buffet)
BootStrapper: (following on heels of the VC) So do you think maybe, uh, well, you may want to, ehh invest?
VC: If you want you can send me a business plan (hands card) but I don’t think this is really for us. (only 3 feet from the door to the buffet now)
BootStrapper: But why?
VC: You have no track record of a real exit and we don’t know you so why would we give you money. (as he walks into the buffet and away from groveling entrepreneur)
BootStrapper: But I thought you take unsolicited business plans and I paid $400 for this conference….(no one hears this as he sulks off to the next VC)
Now, I’m sure this has happened to many of you out there if you are reading this site. A version of this even happened to me and I’ve founded two successful companies. Never fear though….there is always a hack!
So without further ado…how to hack your way in the door…
There are 2 ways to do this. The first is the easy one, pester that VC (after all he did readily give you his card) until he responds and gives you a references to someone else. Keep following the chain of referrals, eventually someone who likes your idea will think the person who referred you actually likes your plan and will take you seriously and wala! you have an investor really looking at your business and possibly investing.
Now, that is not always going to work and takes the right type of pestering networker to do it right. The other way to do this is tough but easier then raising capital.
REMOVE YOURSELF AS CEO. Go out and find a CEO (or at least a Chairman or President) to come on board as an equity level founder who has been there and done that. Someone who has taken a company public before.
Now, you say, why would someone of that calibur want to work with me? Well, if you are saying that, forget about investors, your company will fail, try again next year. If you don’t have the confidence and guile to make someone on that level believe in you, go back to the drawing board and try again.
There are hundreds of executives out there frustrated with their $250,000/year corporate jobs. There are also many hundreds of executives that sold a company and are now bored. For an entrepreneurially minded person boredom is worse than bankruptcy. If your pitch is right and you write the proper job postings and put them in the right places (like executive job boards, linkedin, soflow, offline networking group boards etc…) you will be able to find a bored exec looking to take another company to the promised land and interested in coming on board as a founder. Sure, it’ll cost you equity but wouldn’t it better to have an experienced CEO that knows the investors on a first name basis or at least has a track record to get in door than be left broke with your pants down? If you are really sharp, you can recruit people to come on board AFTER they raise the capital for you but that is an advanced topic for later.
Hope this helps.
Richie “The BootStrapper” Hecker
http://www.BootStrapper.com
http://www.RichHecker.com
I disagree with the fundamental idea of an “investor-leaning” board: one vote one share, for sure. And everything is equal as long as the investor can walk away just as easily as the founder. You comment that the board can fire the founder, and he will lose his unvested shares. You don’t also observe that that only happens when the founder messes up and the company isn’t doing well.
But the founder’s then free to start another company. After the founder moves on, what happens to the investor? They have to supply more money, dilute their original investment and keep trying to get an outcome. So boards are “investor leaning” because the investor is supposed to stick around after the company gets in trouble. I’d be willing to sign up for a deal where everybody goes home — equally — if the company doesn’t work. In fact, that’s the deal we offer our companies and we believe that’s democratic! No performance, no more money.
Your comments presume that the investor is taking advantage of the entrepreneur. I hope I never start an investment with that low a level of trust amongst the group around the board table.
I have a startup about to be funded via a convertible note, and it’s time to build my board. I own 90% of the shares issued.
I’ve already agreed to put my part-time CFO on the board — right now it’s only me. I already know his interests are more aligned to outside investors than me. I’m also considering adding 3 of the angels to the board. I don’t believe they have any interest in getting rid of me and taking over the company — they just don’t have the time/resources to do that.
So net net I feel really good about the calibre and quality of these people, but I’m interested in the risks I’m creating with a board of 1 founder, 1 CFO and 3 angels.
Love your site BTW. Really pertinent stuff.
Anonymous Startup,
A Board of 5 people is very large for an angel-round company. When you go for VC funding, you’ll have a bit of a mess when you have to remove most of those Board members to make room for the VCs while keeping your meetings manageable.
Also, keep in mind that Boards are like any committee – the larger the group, the slower the decisions and the greater the overhead. At your stage, I would suggest a two, maximum three person Board.
Finally, don’t put anyone on there whom you don’t trust 100%. These people are going to be your bosses. From your description, that doesn’t sound like your part-time CFO.
Hello. I run a profitable start-up and have only raised a small angel round a while back. I am about to raise VC because the market is forming very quickly. I am the sole director and have some great non-investor advisors. I’m looking to bring on potentially one VC for a $5M Series A. How would you recommend setting up the board prior to this investment? And does it make sense to bring on any of the high-quality non-investor advisors I have?
Thank you!!!
Nattybumpo,
What are you wondering about that’s not covered in the article? Let me know. My suggestion would be to follow the article’s advice on selecting an independent director prior to the financing.
Hey Nivi – The article is very helpful and clear about setting up a board in a Series A. As the Sole Director, I’d bring on one other director that reflects the current ownership, and allocate one board seat for the new investor. My confusion is: I have several really strong advisors now that represent a range of strengths – therefore, I was envisioning a larger board to be able to provide me with optimal guidance – not just oversight. Maybe I would do the three seats and establish other seats for the advisors. Does that make sense?
Nattybumpo,
You don’t need to put your strong advisors on the board.
The board provides governance for the company.
You can get the same great advice from your advisors if they’re not on the board. Why do they need to be on the board to help? You can still spend time with them, you can still give them equity. In fact, you might get more from them if they don’t have to spend time on other board matters and don’t have to worry about their fiduciary right to the shareholders of the company.
You could also make them board observers. But in my experience, my great advisors have wanted to not be on the board. They just want to give good advice.
What is standard compensation for a board member?
Can be high (2%+ for a very early company) to low (1/3 of 1% for a very late stage company). Average is 1%. Note that you don’t need to compensate Preferred (i.e., VC) Directors separately – they’re already covered through their investment.
What is the standard vesting schedule for options for board members? Is it two years like employees or something shorter? Thanks…
I just founded a new airline, which with regard to funding is hard work but we’re nearly there in terms of raising the funding. I have one investor who is putting in the seed finance of $500K, and then institutional investors who are putting in $20M, what I want to know is, I being CEO, how much of the company do me and my team get and also the seed investor’s entitlement, and how much do the institutional investors keep, and what’s to stop someone from kicking me out and taking control afterwards? I know everything about running an airline, but not to much about ownership and shares I’m afraid… anybody have an answer?
How much you get is determined by the competition you create.
Avoid getting kicked out by maintaining board control and accelerating your vesting upon termination.
Thanks for the very useful advice. What happens if you only have 1 investor (wanting 33% of the company and leaving the founders 66%) and they are proposing to have 5 board seats: 2 common, 2 investors and 1 independent as selected by both parties? According to your investor-leaning board makeup, if there’s only 1 investor, they should only get 1 seat? In your opinion, is this a fair setup? Thanks!
I think you’re asking two questions.
The first question is whether a democratic or investor-leaning board is more fair. Your leverage is more relevant than what is “fair”. The more competition you create for your deal, the more likely you can get a democratic board.
The second question is what are the pros and cons of a 5-man investor-leaning board vs. a 3-man investor-leaning board.
A 1/1/1 Board gives more power to the outside Director. It also increases the odds of a deadlock situation, which is then resolved by the Outside Director. In reality, deadlocks rarely come up. 1/1/1 Boards are much easier to run and manage and take less of a toll on the budding entrepreneur. I’d go with the smaller, simpler Board.
Term Sheet Hacks: Get a Great Deal | Point Nexus Consulting // May 24, 2010 at 12:37 pm
[…] first two hacks show you how to create a board that reflects the ownership of the company and why you should make a new board seat for a new CEO. We also maintain a list of all the term […]
Great advice. Thank you very much.
In my situation, we are a new startup with myself, my trusted partner and another trusted developer.
We aren’t looking for investors yet. But this is great advice for when we do. Thank you