VC Term Sheets – Board Controlby Scott Edward Walker on March 24th, 2011
This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat. Below is a longer, more comprehensive version, which is part of my ongoing series on venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
Today’s post relates to the composition of the Board of Directors and specifically addresses the issue of who should control the Board following a Series A financing.
The Board of Directors
What is the Board of Directors? The Board of Directors is a corporation’s governing body, and its role is to oversee, monitor and authorize all of the corporation’s significant activities, including the appointment of its CEO. Accordingly, control of the Board means, in effect, control of the corporation.
The composition of the Board is thus an important and indeed sensitive issue to founders. Sadly, we’ve all heard the horror stories of founders being “fired” from the company they founded.
Traditional Board Composition. It has traditionally been rare for the founders to control the Board following a Series A financing (despite the fact that Series A investors generally acquire a 20-40% stake in the venture). Sometimes the investors push to control the Board; however, usually there is a “compromise” in which neither the investors nor the founders technically control the Board.
Thus, in a five-member Board, two directors would be appointed by the investors, two would be appointed by the founders and one director would be independent (jointly appointed by the other directors). Similarly, in a three-member Board (which is more common these days), one director would be appointed by the investors, one would be appointed by the founders and one would be independent.
Today’s Frothy Environment. The pendulum has recently swung dramatically in the founders’ favor (particularly in Silicon Valley), giving the founders extraordinary negotiating leverage with investors if they have a “hot” startup. One area where founders have exercised such leverage is in connection with Board composition.
As Paul Graham, co-founder of Y Combinator, recently wrote:
“Founders retaining control after a series A is clearly heard-of. And barring financial catastrophe, I think in the coming year it will become the norm.”
Accordingly, if you have the leverage, founders should push hard to maintain control of the Board post-closing. The founder-friendly VC’s obviously know what’s happening in the marketplace and are likely to capitulate and agree to a provision in the term sheet akin to the following:
“Immediately following the Closing, the Board shall consist of three members. Holders of a majority of the Series A Preferred shall be entitled to elect one member, which member shall be designated by [Investor A], who initially shall be __________. Holders of a majority of the Common Stock shall be entitled to elect two members, which members shall initially be __________ and ___________ [the Company’s Founders].”
Another alternative for the third director (which is still founder-friendly) is the following: “Holders of the Preferred Stock and the Common Stock, voting as a single class on an as-converted basis, shall elect the third director.”
Note: It would prudent for the founders to require the investors to actually name their representative on the Board in the term sheet – to avoid a situation where some unknown junior staffer takes the seat (as opposed to the heavyweight partner who can clearly add value).
Founders should push to control the Board following a Series A financing. Indeed, any concerns the investors raise are minimized by their protective provisions (i.e., veto rights), which I will discuss next week. And remember: all terms are negotiable – no matter what anyone tells you. Cheers, Scott