NOTE: This is the fifteenth post in our series about standard terms in early stage equity financings. These posts refer to the model Series A Term Sheet put out by the National Venture Capital Association (NVCA) and available for download here.
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The NVCA model Series A financing documents cover two common provisions in the Voting Agreement: (1) the agreement among the stockholders to elect certain individuals to the company’s Board of Directors, which we deal with in this post, and (2) the Drag Along, which we’ll cover in our next post.
Election of the Board of Directors
The Board plays a pivotal role in the management of a company because it overseas the company’s officers (and has the power to replace them) and because Board approval is required for many corporate actions, including any action that materially impacts the corporation’s business. Not surprisingly, then, the composition of a company’s Board can be a contentious point of negotiation in a financing.
After a Series A financing, a company’s Board will typically consist of three or five directors (an odd number helps prevent deadlocks), with one or two directors elected by the investors, an equal number elected by the common stockholders (including the founders), and one director elected by all of the stockholders voting together. Since the common stockholders often control a majority of a company’s voting shares even after a Series A financing, the balance of power on the Board would favor the common stockholders because they would control the election of the last director. Although the right to elect a director or two, combined with the Investor Director Approval provisions, would give investors significant influence over Board decisions, in many instances the investors’ director(s) could be outvoted. To exert additional control over the Board, therefore, at the time of a financing investors typically seek to require that the company’s common stockholders agree on who will have the right to designate each director, and agree to vote their shares in favor of the election of each designee.
The Board of Directors section of the NVCA term sheet contemplates a typical five-person Board of Directors comprised of two directors designated by the investors, one director designated by the founders, the company’s CEO and one “independent” director who is not an employee of the company and who is “mutually acceptable” to the founders and the investors or to the other directors. A three person Board might consist of one investor director, one founder director and one independent. Both of these scenarios enhance the investors’ influence over the Board by giving them a say in the selection of directors who they do not have the sole power to elect. First, the investors gain a veto over the selection of the independent director, who otherwise would be selected by a simple majority vote. Second, where the company will have a five-person Board the investors ensure that one of the directors elected by the common stockholders will be the CEO. While the CEO is usually one of the founders at the time of the financing, as a company grows a founder-CEO is often replaced by an outsider who the investors will have considerable influence in selecting (recall that the hiring and firing of executive officers is typically one of the matters requiring Investor Director Approval).
Entrepreneurs should be cautious when negotiating the post-financing composition of the Board with investors. Some investors can add significant value to a company as members of the Board, but you do not want to give up complete control. Seed and angel investors often do not receive the right to elect any directors, and should be offered at most a minority position on the Board. In a venture capital financing in which the investors will own less than 50% of the company following the financing, founders can try to argue that the common stockholders should have the right to designate a majority of the Board (2 of 3 or 3 of 5), but this argument is likely to meet with stiff resistance and could backfire if the investors later come to own more than 50% of the company. Rather, it may be more effective to take steps to ensure the Board composition and decision-making remain as evenly balanced as possible by, for example: (a) requiring that the independent director and any new CEO be approved by unanimous consent of the other directors (which would necessarily include any director designated by the founders; (b) insisting that certain major corporate actions be approved by the director(s) designated by the founders, as well as the director(s) designated by the investors; and (c) if the CEO at the time of the financing is a founder, negotiating an employment contract for the founder-CEO that makes it difficult for the company to terminate her without “cause” (i.e. bad acts by the founder), where “cause” is narrowly defined.