Joining your first startup board as a VC or other investor representative is a big thrill.
You are joining a team you’ve invested in and you are excited to help them build something new and innovative!
But startups are known for being chaotic and turbulent.
And board members sometimes face personal liabilities.
Your VC fund's investors are also counting on you to help grow the company's value and shepherd it to a successful exit.
So how do you serve as a value-creating startup board member, balance conflicting interests as a representative of stockholders with rights superior to those of the common stockholders, and bring focus and discipline to the company but not stifle its agility and creativity - all without being sued?
Fortunately, effective board service comes fairly easily for many, as much of the role is about being a valuable colleague with a great attitude. But it helps to follow a few best practices that we'll explore in this article and to understand the answers to the questions below.
What’s a board and how do boards function
How are startup boards unique?
How do I ease myself into the role?
How can I add the most value?
What corporate governance principles govern board decision making?
How do I minimize conflicts in balancing my board and investor roles?
What’s a Board?
Under U.S. law, every corporation must have a board of directors, whether that is one person or many.
The board of a corporation is responsible for managing its business and affairs.
The Delaware General Corporate Law (DGCL) puts it this way – “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors….”
The size of the board is determined by a corporation’s bylaws, unless the certificate of incorporation dictates otherwise.
The certificate of incorporation, called articles of incorporation in some states, is the company's governing charter. Bylaws are formal but fairly standardized rules on meetings, notice and quorum requirements, adjournment, and other governance fundamentals.
Either the board or the shareholders can amend bylaws, but the board cannot change bylaw provisions that have already been amended by the shareholders.
Only shareholders can amend the certificate of incorporation, but all such amendments must first be recommended by the board.
The board’s primary levers for managing the business are hiring and firing the CEO and other key managers and approving and overseeing an annual plan and budget in cooperation with management.
Management is responsible for the day-to-day management of the business, making the board’s role primarily one of oversight.
Shareholders generally have no role other than voting on limited occasions to elect directors, voting on proposed transactions, and approving bylaw and certificate of incorporation amendments.
How are Startup Boards Unique?
The initial board of a startup is usually one or more of the founders.
If there’s a dominant founder, it often makes sense for that person to serve as the sole board member for ease of approving things like stock option grants.
In startups with two equal founders, they often both serve on the board. Early-stage startups rarely bring in other board members, unless they’ve made a significant investment.
Startups that want input and guidance from industry luminaries or other worthy mentors often just create non-fiduciary “advisory boards.”
It is rare and unnecessary for early-stage startups to create any board committees, while all public company boards have them.
In fact, early-stage startup boards often go their first two or three years without ever meeting! And that's perfectly fine and quite efficient.
Meetings versus Unanimous Written Consents. Instead of meeting, most startup boards take all necessary board actions in writing through what are called Unanimous Written Consents.
Boards meeting in person or via videoconference can take actions by majority vote, provided a “quorum” is present.
But they can also take action in writing without meeting, provided that all directors sign the unanimous written consent – hence the name UWC.
Investor Board Seats. A one to three-person board composed of founders often serves a company well until an investor requests a board seat in connection with an investment, which can occur as early as the first seed or pre-seed investment.
Once a startup raises a Series A round, it will then see its board expanded to include a “Series A Board Designee,” usually appointed by the lead investor in the round.
It is possible that the Series A Term Sheet will require other changes to the board composition. This might include requiring one or more board members to step down, especially if there’s an early investor deemed to not have particularly significant experience or expertise, or a founder not pulling their weight.
No doubt some lead investors in a Series A round occasionally suggest other board composition changes, but those are always a matter of negotiation.
Preferred Stock Rounds. Boards continue to evolve through Series, B, C, and D financing rounds. Earlier board designees might be asked to give up their seats. And by then, there are likely also to be several “board observers” from the various financing rounds. Observers receive materials and attend meetings but do not vote.
How Do I Ease Myself Into the Role?
Bring Your Best Self and Your Best Attitude. Serving on a board is a lot like joining any important team. Keep in mind, this is a position you could hold for years, so relationships within the board and with management are key to your success or failure. It is imperative to not lose anyone's trust and it is important to never be seen as a jerk.
Bad impressions and bad feelings last far too long and can escalate under pressure. Being argumentative, difficult, or aloof can quickly create ill will.
A CEO's trust in a board member can be irreparably lost if the CEO learns a board member is talking unkindly about them or other managers with other board members. Not to say that legitimate business and governance conversations shouldn't take place among board members and managers, but they should be constructive and respectful.
Over the years, I have seen two situations in which respected non-founder CEOs successfully demanded that a VC firm replace the sitting board designee - ouch!
Building trust and strong working relationships in an environment where you are expected to bring independent judgment to every meeting requires exceptional communication skills and a degree of humility.
Find your own favorite resources on how to state strongly held opinions in ways most likely to bring about the result you want, but here are a few tips for keeping your foot out of your mouth and not harming your relationships with founders, fellow board members, and management:
Avoid speaking strongly when you are angry.
Never attack the person, but disagree thoughtfully with the idea.
Couch potentially controversial opinions thoughtfully as questions.
Ask others with whom you disagree to further explain their position in an honest effort to understand their perspective.
Avoid any language or tone that can be interpreted or misinterpreted as disrespectful.
If you notice your words have landed badly, address it by quickly and publicly apologizing - "I'm sorry, that came out wrong Dave, I didn't mean to say it that way, please forgive me."
These tips apply not just to board colleagues, but also to every manager you interact with. Managers frequently talk about specific board members they deal with, and it's not always positive. You do not want to be the board member managers speak poorly of behind your back - you want them to express respect and admiration, feelings you earn by showing them to others.
We are mostly likely to err in our communication when things are going poorly, perhaps when a mistake or major problem has come to light. It is important to be at your best when things seem at their worst, staying cool, thoughtful, not stressed, not accusatory - but focused on solutions and silver linings.
Always keep in mind that people and organizations can learn great things from their mistakes. Leading with that in mind will help you help others.
You may feel strongly about your ideas about a particular topic, especially if it is important. But on a board, you also have to read the room and pick your battles carefully. As they say, "live to fight another day." Or at least to debate another day.
Some issues might also be better addressed in conversations with the founders or CEO outside the board room.
Listening and Asking Questions. Depending on the situation, a new, inexperienced board member joining a board might want to ease into the role, listening and asking relevant questions, and getting a feel for the dynamics of the board and its relationship with management. This can be harder if you are joining a board as a Series A designee and there are only two or three other board members, but avoid charging in too hard with strong, contrary opinions.
Immersion in the Industry and the Plan. New board members should immerse themselves in all available company materials and also educate themselves thoroughly about the industry if it’s new to them.
It probably makes sense in most cases to start with the higher-level materials and gradually get into more granular subjects.
First, review everything that is public-facing, including the company’s website, marketing materials, social media posts, and any publicly available videos of the CEO and other key leaders speaking about the company.
Second, review the company’s most recently adopted plan and budget, including any mid-year modifications that have been made to it.
Most well-run companies go through a methodical process each year of creating, approving, and measuring against a detailed annual plan and budget, and possibly also a less specific two or three-year plan.
As this is the process the board is likely using to manage and oversee the business, board members must be immersed in its details.
Third, it might be useful to explore the company’s recent past. This could include asking for and looking at the prior-year plan and budget, the last two years of board minutes and resolutions, and the closing documents from the most recent financing, assuming you were not integral to their creation.
Financing documents often include voting or shareholder agreements that provide additional information about the board’s composition and any relationships between and among the shareholders. Another interesting document usually goes by the name “Disclosure Schedule” or “Schedule of Exceptions.”
Disclosure Schedules contain lots of information about the company’s assets, leases, intellectual property, employees and contractors, and any pending, threatened, or resolved litigation or regulatory actions.
Requests for past minutes and other historical documents might raise founder eyebrows at some companies. Especially if mistakes have been made or plans missed.
But the past often reveals information to be learned from, so these are not unreasonable requests. Corporate directors should have full access to company records and information.
Nonetheless, some founders might resist or discourage such requests. Depending on the circumstances, it might be best to not push too hard, as board-management/founder relationships can be easily strained. Again, pick your battles thoughtfully.
Meeting Preparation and Attendance
Board members should prepare well for and attend every board meeting. We’ll talk later about fiduciary duties – but preparing for, attending, and contributing to meetings is job one.
Except for emergencies and long-scheduled vacations, it is unacceptable to miss board meetings. In general, board members who chronically miss more than 20 to 30 percent of a company’s board meetings should resign or be removed.
This goes to the importance of the board’s role in managing or overseeing the business and to the fiduciary duties of care and oversight owed by each board member. Corporate board service is not an honorific.
Adapting to Startup Board Admin Challenges. The biggest challenge for most board members relates to the fact that many companies are chronically late in distributing board meeting materials. Startup teams simply struggle to meet the somewhat heavy demands involved in preparing, organizing, and timely distributing board materials.
The bulk of the lifting usually falls to the CFO and the CEO, but COOs, CROs, CMOs, CTOs, GCs, and others generally have materials to prepare, review, and contribute, all the while staying focused on the key business drivers that are the subjects of said reports.
The result is that most boards are lucky to have one or two full days to review reams of materials before management team members talk through slides for half a day.
This fact of late-arriving materials is another incentive for studying historical materials. Older materials can provide context that helps you absorb the new materials - on the fly, when necessary.
Focus and Support of Key Strategic Initiatives
The best-run boards stay out of the administrative weeds as much as possible during their limited time together. Many board meetings will begin with a quick review and approval of minutes from the prior meeting. There may also be a raft of stock options to quickly approve. But the rest of the meeting should be focused on high-level strategic considerations and the company’s key business drivers, initiatives, and challenges.
Resist the urge to raise insignificant issues or delve too deeply into minutia during management’s presentations. Know the business plan going into each meeting, the challenges involved in hitting it, and stay focused on what the company needs to do to succeed with its key initiatives.
The best board members are optimistic and creative in offering strategic guidance and actionable ideas.
Good board members are also always alert for connections and introductions to offer up regarding strategic partners, business development opportunities, and even key hires for the company.
When meetings stray into unproductive or distracting areas, it is a valuable skill to gently get the conversation back on track to important goals and initiatives.
Basic Governance
As noted, startup boards evolve with time and financings, and they vary in their sophistication. Startups that have invested more in legal support and/or that have been through one or more rigorous VC-led financings are likely to have more sophisticated board processes.
Board functions at a newer Series A company might still be evolving, whereas most Series B or C boards should be fairly sophisticated, owing both to management’s greater experience and the increased number of experienced VC board designees.
Nonetheless, it is helpful to provide board development opportunities both for members of management and for most new board members. Major law firms offer solid governance and board effectiveness programs, and even group or individual training sessions by sophisticated corporate counsel can help managers and directors up their game.
Before getting into some deeper fiduciary duty concepts, let's cover some more basics so you can be alert to and guide your board away from common governance mistakes:
No board action can be taken at a meeting if no quorum is present, usually a majority of the board, and it's generally best for the board to only discuss unimportant administrative matters at any such failed meeting.
If a board member leaves a meeting and causes the number of members present to fall below the required quorum, no more action can be taken.
An action is called “ultra vires,” or “beyond the powers,” if it was taken at an improperly called meeting or at a meeting where quorum was not achieved or after quorum was lost.
Although shareholders can vote by proxy, i.e., written instructions to another person, board members cannot vote by proxy. So if a director has to leave a meeting, they cannot ask anyone else to vote for them.
If a board member resigns, most bylaws allow the remaining board members to appoint a successor, to serve until the next annual meeting, although in most startups it is just as easy to have the shareholders vote by written consent to fill the vacant seat.
The foregoing does not count if the resigning board member is a preferred stock class designee, in which case a vote of the class will be required to fill the vacant seat. This can be done by written consent of the requisite number of shares required under applicable bylaw or certificate of incorporation provisions.
There are certain things boards have to approve, including any grant of stock options or other equity awards, the incurrence of any debt, material asset purchases or sales, any other kind of financing, any plan of sale, merger or liquidation, and, depending on state law and organizational documents, long-term leases. Actions taken without board approval when board approval was required can be deemed invalid as ultra vires.
Board meeting minutes should be promptly drafted and approved for every board meeting. It is best to have experienced counsel draft them, as there is skill involved in drafting minutes with sufficient detail to record what was discussed and what decisions were made, but to not be so detailed as to later cause problems for the company. Board minutes are subject to discovery in litigation. They are not confidential or privileged. Greater detail is often required to document significant decisions.
Advanced Governance – Standards of Conduct and Standards of Review
An understanding of more advanced corporate governance principles is required for carefully balancing a VC board designee’s board member duties with their duties as an investor representative.
Duty of Care. All directors owe the fiduciary duty of care.
It requires directors to make decisions that pursue the corporation's interests with reasonable diligence and prudence, including informed, deliberative decision-making based on all material information reasonably available.
Exculpatory Clauses. Interestingly, under Delaware law, it is impossible for directors to be held personally liable financially for breaches of the duty of care. That is in part because most corporations have an “exculpatory clause” in their certificate of incorporation along these lines:
The liability of the directors for monetary damages for breach of fiduciary duty as a director shall be eliminated to the fullest extent under applicable law.
Under Delaware case law, such clauses cover all director negligence up to and including gross negligence.
Business Judgment Rule. And even without such a clause in a company’s certificate of incorporation, most states, with the exception of Georgia apparently, recognize the business judgment rule. Satisfying the requirements of the business judgment rule provides a rebuttable presumption that a board acted in accord with fiduciary duties.
To enjoy the protections of the business judgment rule in making a certain decision, the board must (i) have reasonable processes, (ii) consider all relevant facts, and (iii) act in good faith.
A reasonable process is one not unduly rushed, where documents and information have been distributed to the board timely, and where the board has been allowed ample time to make the decision.
Consideration of all relevant facts means considering the facts directly relevant to the proposed decision as well as all facts relevant to known alternatives to the decision. It is thus a mistake to quickly dismiss ideas or proposals about alternatives to a proposed decision.
Duty of Loyalty. The good faith requirement of the business judgment rule relates to the other key fiduciary duty – the duty of loyalty.
Failure to meet the duty of loyalty in a transaction or other decision can take a decision out from under the protections of both exculpatory clauses and the business judgment rule.
The duty of loyalty prohibits a director from engaging in self-dealing and it requires acting on a disinterested and independent basis in the best interests of the company and its shareholders.
Transactions that violate the duty of loyalty typically involve a director or officer engaging in self-dealing, where they personally benefit from a transaction at the expense of the company. Examples include usurping a corporate opportunity rightfully belonging to the company, entering into contracts with their own companies without full disclosure, or setting their own compensation without independent board review and approval.
Individual directors have personal liability for violating the duty of loyalty, so individual directors should avoid voting in favor of any transaction that could be characterized as self-dealing by them.
Self-dealing can also include approving special benefits for the share class a board member represents.
Always work with sophisticated counsel when contemplating transactions that potentially implicate the duty of loyalty.
Duty of Good Faith. The duty of good faith is a “subsidiary duty” of the duty of loyalty, and it has subsidiary duties of its own.
The duty of good faith requires directors to act honestly, in the best interest of the corporation, and in a manner not knowingly unlawful or contrary to public policy. Under the duty of good faith, directors cannot knowingly or recklessly allow their corporation to violate the law, applicable regulations, or “public policy.”
Duty of Oversight. The duty of oversight is a subsidiary duty of the duty of good faith and it was established by the Caremark case. The 1996 Caremark case is a landmark Court of Chancery decision that established a standard for board member liability based on a board or board member’s failure to ensure a reasonable system of reporting and information.
“Caremark” claims are often brought against regulated companies in order to impose personal liability on directors for alleged regulatory violations by the company.
Duty of Disclosure. The duty of disclosure is another subsidiary duty of the duty of good faith and can be used to impose personal liability on directors for violations of disclosure obligations, primarily under the federal securities laws.
Indemnification. As might be clear at this point, corporate directors have strong protections from personal liability under both exculpatory clauses and the business judgment rule, provided they have not violated the duty of loyalty and its subsidiary duties.
Additionally, most certificates of incorporation also contain broad indemnification clauses like the following, shielding directors from certain legal expenses if and when claims are made:
To the fullest extent permitted by applicable law, the corporation is authorized to provide indemnification of (and advancement of expenses to) directors, officers and agents of the corporation (and any other persons to which applicable law permits the Company to provide indemnification) through Bylaw provisions, agreements with such agents or other persons, vote of stockholders or disinterested directors or otherwise in excess of the indemnification and advancement otherwise permitted by such applicable law. If applicable law is amended after approval by the stockholders of this Article VI to authorize corporate action further eliminating or limiting the personal liability of directors, then the liability of a director to the corporation shall be eliminated or limited to the fullest extent permitted by applicable law as so amended.
But, as with exculpatory clauses and the business judgment rule, acts or decisions found to run afoul of the duty of loyalty, including the subsidiary duties of good faith, oversight, and disclosure, all fall outside of the concept “permitted by applicable law” when it comes to indemnification.
That is to say, while a company might be able to defend and indemnify board members against claims of fiduciary violations, once a violation of the duty of loyalty (including the duties of good faith, oversight, or disclosure) has been adjudicated against the board, indemnification must stop and any indemnification paid out by the corporation likely must be refunded by the directors involved.
Standards of Review - Recusal and Independent Committees
As if the multiple fiduciary duties weren’t complicated enough, Delaware case law has also evolved three “standards of review” for determining when conduct violates the duty of loyalty.
The business judgment rule is the standard of review when there are no conflicts of interest that would suggest a breach of the duty of loyalty.
The “enhanced scrutiny” standard applies to potential but relatively immaterial conflicts of interest.
And the “entire fairness” standard applies when there are actual and significant conflicts of interest.
For VC board designees, it’s this “entire fairness” standard that can rear its head in significant transactions – particularly the sale of a company where the common stockholders do not do very well relative to the preferred stockholders.
The most important Delaware case on these issues is In re Trados Inc. Shareholder Litigation. In Trados, the court held that:
“Entire fairness, Delaware's most onerous standard, applies when the board labors under actual conflicts of interest… Once entire fairness applies, the defendants must establish ‘to the court's satisfaction that the transaction was the product of both fair dealing and fair price….’
Not even an honest belief that the transaction was entirely fair will be sufficient to establish entire fairness. Rather, the transaction itself must be objectively fair, independent of the board's beliefs."
To obtain review under the entire fairness test, the stockholder plaintiff must prove that there were not enough independent and disinterested individuals among the directors making the challenged decision to comprise a board majority.”
The last line is most important for our purposes here. It highlights the need for having sufficient independent directors on a board by the time it needs to make difficult decisions that might raise conflicts of interest between holders of common stock and holders of preferred stock.
And those conflicts are likely to arise in any sale of a company where the common stockholders do not receive much financial compensation in the transaction.
Qualified counsel should be closely guiding the company and the board during any such transaction, but the Trados case highlights a key risk of personal liability for VC board designees who vote in favor of transactions that might later be held to violate the entire fairness test, resulting in a breach of the duty of loyalty for which indemnification cannot be provided.
The Trados case is actually known for a holding that is much more significant, but only tangentially relevant here - and that's the idea first espoused in Trados that preferred stock liquidation preferences are merely contractual rights that are subservient to the rights of a company's "residual claimants" - i.e., the common stockholders.
That somewhat unusual holding raises significant fiduciary duty risks for VC directors - again highlighting the need for very sophisticated corporate counsel when complex "interested transactions" are in front of a board. What you think of as obvious is not always nearly so obvious in corporate law.
Summary Takeaways
Board roles and relationships are generally long-term ones. Ease into them carefully, thoughtfully, diligently, and with humility.
Know the plan and stay focused on driving success in its key elements. Stay out of the weeds and keep your eyes and your brain on the bigger picture.
Exercise great care in expressing strong opinions and disagreeing with your colleagues and with members of management, always showing respect.
Remember that we all make mistakes and we can all learn from and benefit from mistakes.
Do not miss meetings and always show up prepared with your best self.
Keep the business judgment rule in mind when considering important decisions and recuse yourself from any vote involving a personal benefit to yourself.
Always make sure competent corporate counsel are guiding the board when a decision might be viewed as an interested transaction involving conflicts of interest between the preferred stockholders and the common stockholders.
Lastly, new bonus topic - periodically ask company counsel to give the board a full assessment of the company's director and officer liability insurance policies and any gaps or weaknesses in those coverages.
And, as always, have fun!