15 min read
Boards of Directors
- A board is a group of individuals elected to represent the interests of the broader shareholder-base of any legally established business entity.
- Its mandate is termed corporate governance—defined as the rules, processes, and procedures designed to guide the way corporates make decisions and operate.
- In their roles as shareholder fiduciaries, boards have three levers through which they exert influence: (1) the internal rules, processes, and policies they designate to guide management's behavior; (2) their choice of management and especially the CEO; and (3) the major capital allocation decisions they approve/veto.
- Irrespective of one's motivations for starting a company, it would be wise for every entrepreneur to acknowledge that proactively designed boards truly do represent some of the most transformative assets for an early-stage company, capable of dramatically accelerating growth and business success even in the immediate term.
Effective Board Compositions
- According to Fred Wilson, partner at Union Square Ventures, "a perfect startup board is comprised of the startup's CEO (which may or may not be its founder), one financial investor (e.g., an influential Angel or VC), and two to three fellow CEOs (peers) who have built or are in the process of building successful companies."
- Brad Feld, renowned serial entrepreneur, author, venture capitalist, and thought leader upon whom I lean heavily in this piece, takes this a step further in recommending that every startup board should also include at least one independent director and preferably also its legal counsel.
- The ideal board size for early-stage companies ranges from three to five seats, with five being the the more optimal as recommended by veterans.
- For early stage companies, board members are typically compensated with non-qualified incentive stock option grants, ranging from 0.5% to 2.0% of the startup's equity, profile of board member, and stage of company dependent.
Building Effective Startup Boards
- Founders and/or startup CEOs should approach building their boards the same way they would in building their management team.
- First, decide how many seats are needed/wanted; as mentioned, the recommended number of seats for young companies is three to five, with five being optimal.
- Next, identify the skill gaps or skill requirements that are lacking but needed at the company, and source directors with experience in these arenas. The most common areas where board members supplement management are as follows: (1) product development, (2) customer/market development, (3) business model development, (4) team, and (5) fundraising.
- Third, map these skills to your broader network's available pool of potential directors.
- And finally, dimension the personality/character traits of each shortlisted director, diligence them, and ensure that they align with the values of your company and the personalities of your other prospective board members.
What’s Your Perspective?
Depending on your perspective, type, ambitions, and reasons for starting your company, the idea of establishing a board of directors (“board”) may either excite or intimidate you. And depending on whether you are a first-time founder or veteran, you may be one of the many with a slightly elevated view of what boardrooms look like.
To the question about personality types, if you are a king—an entrepreneurial persona coined by Noam Wasserstein of Harvard Business School which characterizes an entrepreneur that is principally motivated by control and independence—the idea of voluntarily establishing a group of wise-men responsible for managing, governing, and potentially firing you may seem ludicrous. If you are on the rich side of the spectrum, however, whose psychology is driven more by the opportunity for extreme financial gain than by the need for control, then you probably don’t need much convincing of the value of a board.
Given the lack of tangible, referenceable information on startup-stage boards out there, this article seeks to shed light on boards as a construct, their workings and nuances, and strategies for building effective ones. It will begin with board basics and legal definitions before transitioning into a practical guide of do’s and don’ts of building effective boards.
My own control biases aside for the moment, boards truly do represent some of the most effective arrows in every entrepreneur’s quiver, capable of dramatically accelerating growth and business success, even in the immediate term.
Board of Directors: Abstract to Basics
What Is a Board?
A board is a group of individuals elected to represent the interests of the broader shareholder-base of any type of legally established business entity. These range from traditional limited liability, for-profit, and nonprofit organizations to agencies, government parastatals, and limited partnerships. A board’s strict mandate is termed corporate governance, defined as the rules, processes, and procedures required to guide the way corporates behave/operate, all the while balancing the interests of all stakeholders (i.e., shareholders, management, employees, customers, suppliers, financiers, government, community, and others).
Beyond the definition detailed above, corporate governance is guided by four legal principles:
- Duty of Care: A tort law concept that mandates a minimum standard of care that must be maintained while directors perform their duties. This involves remaining prudent in decision-making, acting in good faith, and conducting demonstrable logic/data-driven diligence ahead of any decision where negligence could result in foreseeable harm to stakeholders.
- Duty of Loyalty: Referred to as the cardinal principle of fiduciary responsibility, this concept encapsulates the legal obligation of each director to operate solely in the interest of the party to whom they are obligated (i.e., the shareholder). Duty of loyalty prohibits even the appearance of conflict-of-interest, self-dealing, or even slight biases toward personal interests. The most common example of duty of loyalty infringements occurs with VC investors. VCs who sit on startup boards are principally fiduciaries to the startup’s shareholders. They do, however, have a conflicting fiduciary responsibility; that is, to their limited partners, which often serves as powerful temptation/distraction. Their motivations and biases thus have to be carefully understood, closely observed, and managed attentively during the course of their board tenures.
- Duty of Confidentiality: This is a sub-principle of duty of loyalty, requiring directors to maintain in the strictest confidence all and any nonpublic information about the organization.
- Duty of Disclosure: This is the legal requirement of all directors to take every reasonable step to provide the company’s shareholders with any material information that they may require to effect any company-related action for which they may be required.
Control Levers of Boards
As mentioned, the primary responsibility of a board is to serve as fiduciaries for the broader shareholder-base of a given company. Boards around the world perform this duty by focusing on three main control levers for exerting influence upon their companies:
- Internal rules, processes, and policies: The controls that boards put in place and by which the company and management team must operate are the first of the three major levers. On the one hand, these policies and procedures protect the company by unifying and creating congruent frameworks for decision making—support the CEO in their daily execution capacity by simplifying what is permissible, when, and under what circumstances.
- Choice in leadership: Management reports to the board, but management is responsible for the day-to-day resource allocations and strategy execution around everything from product and sales to marketing and HR. As such, who, and in what capacity, boards chooses to hire, fire and empower C-level executives, especially CEOs, are materially of consequence.
- Capital allocation and fundraising decisions: Annual OpEx and CapEx budgets, special approvals, management, compensation and incentive plans, financings (debt, equity, hybrid securities), the creation of new classes of stock, dividend policies, and others—these are just a few of the capital allocation and fundraising decisions that come down to board approvals as they guide their companies into prosperity.
And while the above three reflect the more technical of every board’s responsibilities, they also have softer duties equally critical to the success of their organization. These include:
- Establishing and maintaining trust: Specifically, trust between and amongst fellow directors, the founders, the CEO, and broader management. Without the maturity and experience to maintain trust and congruence, even in spite of different temperaments, views, work-styles, and expectations, even the most experienced boards and talented teams will yield poor outcomes.
- Judgement and emotional support for the CEO: Beyond evaluating the CEO and management team’s performance, the best boards also serve as coaches and stabilizing factors during periods of tumult. Great boards have been there before and are thus able to strike a balance between the latitude required to let their younger, less experienced founder-teams try new things and learn, and a tight enough leach where no existential threats come of that learning process.
- Transparency and driving alignment: Transparency and openness both represent the cornerstones that keep all issues, interest, and disputes open to discussion, which in turn goes a long way toward maintaining alignment between all stakeholders.
Founder-CEOs and Boards
Worthy of a quick aside is the unique relationship between founder-CEOs and boards. As you may have picked up, once established, the CEO—even if a founder-CEO—functionally works for the board. This is especially true once outside external/institutional capital is brought in. In such circumstances and irrespective of pre-money share allocations, the founder-CEO may lose control by: (1) either being diluted down to a minority shareholder (usually after multiple rounds of financing), or (2) through protective, restrictive, or other special control provisions agreed to and detailed in the company’s shareholder agreement.
Given this reality, it would be wise for every entrepreneur to truly wrestle with whether they lie on the rich vs. king side of the spectrum and raise capital or expand their board accordingly. If you lean heavily toward control, bootstrap your company and keep your board lean or to an advisory board, thus avoiding the ideological warfare that will inevitably come with the alternative.
Board Structures and Governing Documents
By law, when a company is incorporated, it is statutorily required to establish a board of directors even if with just one director. This initial director is usually the founder/founders, but early boards do sometimes include initial angels or invested friends and family—a highly inadvisable practice that will be revisited later in this piece. Over time, the composition of most early boards change, either at the election of the founder(s) or upon the infusion of external capital, and come to include external investors, independent directors, board observers, and potentially even your legal counsel.
At founding, the state laws of the incorporation jurisdiction and the company’s charter documents represent the totality of the company’s governing guidelines, defining how the said company and board should conduct itself. Founding charter documents include:
- Articles/Certificate of Incorporation: This is the charter document filed with the secretary of state confirming the legal establishment of your entity. It formalizes the corporation’s name and address, the authorized outstanding share count, the terms of each class and/or series of capital stock, the baseline rights of all participating shareholders, and other opt-in or opt-out options for various matters relating to governance.
- Bylaws/Constitution: This document outlines the rules and procedures that govern the internal management of your startup, such as how directors are elected, how board and shareholder meetings are to be conducted, what officers the organization will have, descriptions of their duties, how disputes are to be settled, and much more. Take the time to read the document carefully.
Upon the company’s first external financing round, the startup’s articles of Incorporation and bylaws are typically amended. This is done because, (1) the new investors typically receive preferred stock as opposed to common, the issuance of which requires an amendment; and (2) because the new investors will want their new economic and control rights legally reflected. As such, two more governing documents are typically added:
- Shareholder Purchase Agreement (SPA): A legal document binding the relationship between the investor and company, which details the terms and conditions of the purchase/sale of shares in the business. SPAs set forth the most critical deal terms, including the share’s purchase price, details about the counterparties, representations and warranties on both sides, indemnifications, and any other transaction terms agreed to by both parties.
- Shareholder [Rights] Agreement (SHA): A legal agreement between the holders of shares in a given corporation that details the full scope of their rights. Most relevantly to the topic at hand, SHAs provide specifics around the election of the boards, their powers and privileges, special shareholder approval rights, and more.
Sample Governance Section of A Shareholder Rights Agreement
Most outside investors who invest quantums that they consider meaningful will insist on receiving a board seat or at least a board observer seat (to be discussed shortly) who will serve as stewards of their capital. So oftentimes, institutional investors with minority stakes in startups will negotiate disproportionate influence at the board level via the SHA. In lieu, it is worth every entrepreneur taking the time to understand each of the above four legal documents and the range of direct and indirect avenues of control that investors might exert to establish control.
The Business of Building Effective Boards
“A veteran board can bring 50-100x more experience to a room than a first-time founder.”
– Steve Blank (serial entrepreneur, Stanford professor, and author of The Startup Owner’s Manual)
Fred Wilson, a partner at Union Square Ventures, stated that “a perfect startup board should be comprised of the startup’s CEO (which may or may not be its founder), one financial investor (e.g., an experienced/influential Angel or VC), and two to three fellow CEOs (peers) who have built or are in the throes of building successful companies of scale.” Brad Feld, serial entrepreneur, author, and venture capitalist, takes this a step further in recommending in his book, Startup Boards, that every startup board should also include at least one independent director and, where possible, the company’s legal counsel.
How to Identify and Fill Your Board Seats
Boards evolve and change over time, as do their functions, requirements, and roles. In lieu, building an effective board is best approached as one would in building an effective management team: First, decide how many seats you need, want, or are appropriate for your company’s stage. Most veteran directors recommend no more than five-person boards for young companies.
Next, identify the skill gaps or skill requirements your young company is/will most be in need of over the next 18 months to two years and solve for those. Third, map these skills to each prospective board seat and then to one’s extended pool of potential directors (extend this pool to the furthest reaches of your network’s network).
And finally, dimension each of your shortlisted directors’ personality traits and characteristics and ensure that they are not only in sync with your company’s values but also complementary to your other potential board members. If I may, I suggest beginning with the following:
Typical Skill Gaps or Skill Requirements for Early-stage Companies:
- Product development: Though the best board members are “strategically engaged but operationally distant” and so won’t be designing/coding themselves, they can be invaluable in bringing customer insights, technical expertise, a network, and coaching to this end, thus helping you iterate faster toward product-market fit.
- Customer/market development: In the earliest days of your startup, cracking your go-to-market strategy and four Ps of Marketing as part of your marketing mix will be critical to achieving early traction. This process is nonlinear and fraught with challenges, pivots, and failures and as such, a board member with experience who is also fluent in established methodologies for getting to the right outcome will be invaluable in the early days.
- Business model development: As you experiment with various revenue models, profit formulas, and monetization plans, the right board members can again bring experience, not just in helping define and refine these elements but also in introducing you to your first set of big-name clients to get you from zero to one.
- Team: In addition to helping identify, recruit, and add credibility to bringing on the best talent, your board can also serve as a set of effective coaches, advising on best practices for hiring, firing, motivating, and culture building within fast-growing and generally unwieldy organizations.
- Fundraising: “Helping define your funding strategy, identifying the right sort of potential investors, making introductions, and adding credibility to your fundraising process” should, at a minimum, be another core attribute to most of the elected directors on your board.
Beyond the technical skill requirements you would love to build your board around, you must also pay special attention to, as you would if you were diligencing a new management hire, the personality traits and character attributes of each potential board member. In this regard, I recommend seeking individuals with the following:
- Early-stage mindset and entrepreneurial experience: An individual who understands the startup struggle, trajectory, psychology, and uncertainty—an individual comfortable making decisions with imperfect information, and above all, one that is emotionally balanced.
- Domain expertise: An individual with extensive domain experience and a strong network within your chosen industry. This attribute will go a long way in helping you avoid unforced errors as you grow as a founder, will be useful in commenting on the market-readiness of your technology and product, and will be able to open doors to potential customers, employees, industry heavyweights, and capital sources.
- Trustworthiness: An individual with whom you can be vulnerable, who can see you at your lowest/weakest and not weaponize that information against you, and who can be a non-judgemental sounding board for early ideas and pivots.
- Understands that though you report to them, they’ve been appointed to work for you: An individual who is resource-rich in time, capital, and relationships, and one who is able and willing to extend them your way.
- Personality, style, and perspective are diverse but complementary to the rest of the board: A critical attribute to establishing a healthy, engaged, and effective board whose vision and energies are singularly unified in the direction of your venture’s success.
For early-stage companies, little literature or go-to practice exists on the matter of board compensation, which often varies by venture-stage and renown of the personalities that agree to sit on it. Board members belonging to institutional funds (VCs) typically do not get compensated for their time. Independent board members with little economic interest in the company, however, often (but not always) do. Usually, early-stage companies, should they choose to compensate their directors, almost universally do so with non-qualified incentive stock options in the company, derived from the existing management equity pool. Grants to early-stage board members typically range from 0.5% to 2% of equity, rising and falling in lockstep with the maturity of the company at hand or profile of board member in question.
Other Quick Tips:
- Most companies almost always reimburse the directors for out-of-pocket expenses, such as business-related travel costs.
- Companies typically indemnify directors from any liabilities they incur in their capacity, though this can never be total and absolute.
- Finally, and to the extent the startup can afford it, some directors will insist on their company taking out directors and officers (D&O) insurance of at least $1 million to supplement their indemnifications.
Parting Thoughts: Best Practices for Assembling and Negotiating for Effective Boards
Resist the temptation to stack your early board with folks you can control. Trust me, I understand. I’ve been there! It was you who was on the ramen diet for two years; you who sacrificed the friends, the family, the significant other, to get the venture to investment-ready. So, I totally understand your attempt at backdoor control. But trust me (and Katherine), so does everyone else. Your VC will negotiate all your lemmings away before investing a dime; and in the long run, it is a decision that ends up working against you emotionally.
At all times, solve for balance (not control), and leverage independents. As was best said by Scott Weiss of Andreessen Horowitz, “neither founders nor VCs should control any given board; always seek balance and give your company its best chance at survival.” A great rule by the same is that “with every VC, financial investor, or any other individual with a vested interest, add one independent director who will maintain perspective even as founders and VCs pursue their agendas.
Be wary of granting board observer seats as concessions for not granting full board seats. Though they may seem harmless, board observers regularly contribute to and influence board discussions. In time, they actually often turn into full board members, so though they have fewer legal rights than full board members, there is often very little functional difference between the two, especially where smaller boards are concerned.
Be careful with big names, and pay attention to subconscious power alignments. It is fine to appoint high-profile individuals to your board, but do so carefully. Often, the lesser known or younger board personalities will subconsciously suck up to more powerful counterparts, sometimes out of hero-worship but also to further their agendas.
Take the time to pick a strong chairperson. A board’s chair is its leader and tends to be one of the more important leverage points for founders/early CEOs. Your chairperson provides leadership to the company’s board members, acts as the liaison between the board and the executive team, orchestrates meetings, coaches the CEO, teases out insights from the other directors, and encourages variety of opinion while avoiding conflict. Put your ego aside if you aren’t the right person for the job and solve for the best persona for your startup’s chair.
Avoid even-numbered boards (deadlocks are painful), avoid giving veto power as much as possible (everything slows down) and include a provision somewhere that, as CEO, a six-month remedy/improvement plan must be enacted before you can be terminated by your board (for obvious reasons).
Do your homework. Diligence each prospect methodologically. Just as you would scrutinize, diligence, and reference check every important management hire and teammate, extend the same discipline to your board selection process. This discipline becomes especially important for high profile personalities (fight the halo effect).
“In the land of the blind, the one-eyed man is king.”
– Desiderius Erasmus (first editor of the Bible’s New Testament)
The entrepreneur’s journey is many things—tumultuous; psychologically, emotionally and economically trying; and characterized by periods of dizzying ambition and also crushed dreams. What is also unique to this journey, however, is that it is one almost entirely shrouded in uncertainty. You are iterating toward a new product not yet known to your audience, attempting to create new markets that may never come to exist, or navigating a fundraising terrain full of people who harbor almost as many doubts as you do about your prospects. In this land of the blind, please take my advice: Let your one eye be a carefully curated, five-person board of veterans who have each been there before and can bring capital and relationships to the table as well as the emotional fortitude required to help you navigate your way out of the turbulent early waters. Happy building!
Understanding the Basics
Does a startup need a board of directors?
All legally incorporated for-profit businesses must establish a board of at least one individual at founding. It is recommended, though not required, that this board be expanded to include outside directors capable of governing the company's actions as it navigates toward success.
Do board members get equity?
Though not mandatory, most startups grant their board members between 0.5% and 2.0% worth of non-qualified incentive stock options for one to two years of service on the boards.
Can a CEO sit on the board of directors?
A CEO can, and usually does, sit on the board of the company that they run. The CEO is the authority when it comes to the day-to-day execution of the board-approved strategy. As such, it is advisable that they maintain close proximity to the rest of the board that they report to.