Determining Board Control Doesn't Have to Be Stressful. Here's What to Do.
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While securing capital to allow your startup dream to flourish is considered a stressful time in a startup's life, another very critical, and often angst-inducing element, of raising venture capital is determining board control.
At a high level, you, as the founder, have to come to terms with the notion that as you raise venture capital (and as you effectively sell a piece of your business to investors), you will be taking on partners who will want to have a voice in shaping the future of the business. So it is vital you create the appropriate structure and governance mechanisms that strike the right balance between the investor’s desire to participate in guiding the business and your ability to execute on your vision.
There are typically two areas in which control matters are implicated. The first one is the structure of your board of directors. The second one is voting rights and voting blocks that govern a variety of actions that affect the business. Let's discuss the former, structure.
As you probably know, the board has ultimate responsibility in directing the affairs of a corporation and is responsible for overseeing and supervising management. Therefore, all major decisions affecting the business remains subject to the approval of the board. Examples of such decisions include: hiring and firing members of management, raising additional capital, borrowing money, setting compensation levels, increasing the size of the option pool, granting options and determining vesting schedules, entering into strategic transactions or material agreements, buying complimentary businesses or selling the business. As you can see there is a lot of responsibilities for the board of directors and this is why control matters.
It is critical that you appreciate when it is appropriate to give an investor a board seat. Typically, the answer is relatively straightforward. When a venture investor makes a meaningful investment in a business, it will require that its representative have a designated board seat and a voice at the table. Ideally after your first round, you will have a board that is still controlled by the founders/common stockholders. The most pervasive configuration at this stage is a three-person board, with two seats for the founders/common stockholders and one seat for the investor. This structure assumes an investment that gives the investor an ownership stake that is in the 15 percent to 30 percent range, give or take. It’s also important to know that it is absolutely standard that one of the two board seats to be held by the founders/common stockholders be assigned to the CEO, because it would be highly unusual for the CEO to not be on the board.
As I said the answer is relatively straightforward in most instances, but there are a couple of situations that create some complexity around your board’s structure. The first is when a seed investor with a small ownership interest wants board representation. Typically, my advice is that small, seed and angel investors should be viewed as passive investors that are coming along for a ride, and therefore, shouldn’t be afforded board rights. The exception to this rule is in situations where an institutional venture investor is making an early-stage, seed investment. It is more common to see a board seat allocated to a seed-stage investor in these situations, but you should definitely think long and hard about whether the size of the check that is being written or the value that can be derived from having the investor join your board merits the possible structural imbalance that may be caused at the board level. Remember that you will inevitably have to give up additional board seats in subsequent rounds and you should assume that each new round of capital will demand a board seat, so it is important to maintain a board balance that roughly mirrors the ownership of the business at each stage to ensure the board isn’t controlled by the investors too early in your funding cycle.
The second situation that creates a little complexity is when two institutional investors are participating in a round on a relatively equal basis and both demand board seats. In these situations, assuming that the aggregate amount being raised is large enough, it’s not unusual to expand the size of the board to a five-person board to accommodate both investors and to allocate the three remaining seats to either the founders, or the founders and an independent board member. A five-person board which creates greater balance and parity between founders and investors is very common when you raise your second institutional round. Again, remember that your hold over the board should roughly correlate to your ownership of the business, and so you should be prepared to cede board control as you sell ever larger pieces of your business to investors.
Finally, remember not all investors are the same. There are good investors and there are bad investors. There are good board members and there are bad board members. Building a great board is a very, very important piece of identifying your sources of venture capital. A great board treats the CEO and the founders as peers and gives great weight to management’s visions, while bringing a fresh perspective to the discussion and pushing the management team beyond its comfort zone.