When should a company form a board of directors?

Deciding when to form a board of directors for your company may sound like a daunting task, but it doesn’t have to be. The ICELab interviewed Micheal Dill from Holland & Hart to learn more about the process of putting together a board of directors. Micheal serves as co-chair of Holland & Hart’s Emerging Companies group and Fitness & Outdoor Recreation industry group, helping provide innovative, cost-effective, and practical legal advice to clients in the technology, manufacturing, and outdoor recreation industries.

ICELab: Thanks for joining us today, Mike. I’m going to jump right in with some questions on startup boards of directors. In your opinion, when should a company form a board of directors?

Michael Dill: It varies for each company depending on their size, how quickly they’re scaling, and whether they raise funding or not. There will always be a board of directors because one is created when you form a company. Typically, you formalize the board of directors by inviting an investor, independent director or industry expert when you do your first institutional equity raise. This has changed in the last couple of years because of SAFE financings.

I would say your first priced preferred equity round is usually when a board of directors is formalized, but it can be done sooner or later than that. It’s a company-by-company decision. It is usually formed then because an investor wants a board seat. The investor wants to know how the company is operating and you’re already putting together legal documents to do a preferred stock financing anyway. The model from NVCA legal documents assume that you’re going to create a formal board or director.

ICELab: What are signs that it might be too early to add additional members other than the founder onto a board?

Michael Dill: It it’s just an item on a to-do list it’s too early. I always recommend creating an advisory group or an advisory board before a formal board to get feedback from industry experts, customers, etc. I think you can do that for the first few years or however long it takes to raise the price preferred equity round. I don’t think you need to formalize it until you’re absolutely required by investors or it’s going to be a value add with benefits that outweigh the costs. At an early stage, a founder needs to be heads down building the company rather than preparing for quarterly board meetings.

ICELab: When the board grows, why does it grow and who is on it?

Michael Dill: When a board is formalized it usually has three members: a founder, an investor and potentially a cofounder. The third board seat could also be an independent. It’s usually pretty small at the early stage. The recommendation is to make sure it’s an odd number of directors and a structure you think you can grow into.

In the seed preferred equity financing and the Series A preferred equity financing round, you’ll have a three to five-member board. The structure defining who has the right to appoint directors is typically outlined in the priced preferred equity documents; however, we allow it to evolve across Seed, Series A, and Series B rounds to accommodate growth. If you make it past those stages, it usually gets renegotiated once you get closer to a C or D stage where you’re getting closer to doing an IPO.  At that stage, the board structure will again be totally renegotiated. Approximately 40% of companies actually sell after a series A round, though. So, the initial structure should work for most startups all the way from the time they do their first priced preferred equity round until they sell the company.

There are usually a couple of different groups on a board. Lead investors usually get a board seat. So, one board member for that whole class of investors. Founders usually get one or two board seats. Sometimes, if it’s a five-member board, they’ll get three board seats. At some point, you do want to add an independent director for corporate law purposes to approve related party transactions. There are some nuances because sometimes you only want founders to have a board seat as long as they’re still providing services to the company. WeWork is a famous example where a founder kept a board seat even after he was ousted from his own company. Those are some of the things that you end up negotiating when you do priced preferred equity rounds.When you’re looking for independent directors, it’s an industry expert or somebody who’s helped scale companies and will add value to the startup at its current stage.

ICELab: When you have votes that require an independent director does that mean that only one person votes in a board with two insiders and one independent?

Michael Dill: Typically, in matters requiring independence, only one board member is conflicted, while the other is not. It just depends. If the founder wanted an employment agreement then the investor is independent and the independent director is independent. Another example is the lead investor for the seed round also leading the series A round. That means that the investor as a director has a conflict, so you’ll have the founder plus the independent director vote on the terms of the round.

ICELab: Okay, let’s go to the compensation question next. How does compensation work for early-stage board of director companies? And have you seen any trends developing over the past few years in board compensation?

Michael Dill: This is where different attorneys will give you different answers. Many of the startups that I work with have something like a board of advisers, where somebody’s coming in and providing 5 to 10 hours of advisory or consulting services a week or a month. They don’t get paid any cash for that. They might get a small equity grant for providing those services for a couple of years, but again that’s like a board of advisers and that’s at the very early stage. Board members don’t get capital once you’ve raised $4m to $10m or so in capital from an institutional investor in a seed or an A round. Generally, they get out-of-pocket and travel expenses reimbursed, but they’re not paid cash. They’re not really paid in equity either, generally speaking, until the company gets to a much bigger size. I have seen some people only willing to serve on boards if they get small equity grants for that service. An example is equity grants at the high end of 1% for two years. Again, anecdotally based on my experience, that is more of an exception than the rule.

ICELab: Have you seen companies benefit from having a board in ways that the founder did not expect?

Michael Dill: One unique situation was with a company that had a very wealthy angel investor who put a lot of money in and had experience with startups in a similar industry in the past. It was clear that the founder had the technical expertise but not the business expertise. The investor served as a board member and ended up serving as interim CEO for almost two years. It was a unique transition where the board realized there was a gap from the founder’s perspective. The founder was great technically, but wasn’t able to bring the product to market.

I think another way a board can add value is when the business needs to scale past a founder. This is a situation where the founder is still in the business, but not able to run the business. They’re technical or product focused or their skills are in a certain specialized domain, but they can’t truly scale a company, manage it, and run it. I think a board usually has networks they can tap into, but they can also interview and negotiate with a new CEO to make it a smooth transition for the founder. If you don’t have somebody who can fill that role, it can sometimes be a rocky transition.

ICELab: What type of initial and then ongoing legal services are required when a company forms or grows its board? Are there any other considerations a company should focus on at formal board formation?

Michael Dill: Usually you’ll formalize the board as part of a financing. Those documents already have the required language. There’s a certificate of incorporation, also called a charter, and a voting agreement. Both of those combined basically say the number of directors you’re going to have, who has the right to elect directors, who has the right to remove directors, etc. The default under Delaware law is a majority stockholder vote to elect any directors. Usually, when you have multiple constituents, investors are going to absolutely insist they have a right as long as they don’t sell all or part of their equity. A lot of times you will see the board composition match the cap table. This means if the founder owns 80% of the company they have the majority of the board seats. However, once you’ve done a seed and then a series A financing, the founder might own 40% and they may only have two out of the five board seats at that point. Board composition doesn’t automatically follow the cap table, but it usually does. The legal services for this are drafting, executing and filing the necessary documents.

Another consideration when formalizing the board is the need for directors and officers (D&O) insurance. This is sometimes missed by first time founders and board members, but it is an important way to protect the executives and board members of a company.

ICELab: Is there generally an attorney who is part of board meetings?

Michael Dill: It depends. Some of our clients like us to attend quarterly board meetings, some don’t. I would say that if the company’s going through a rocky patch, we are more likely to sit in on the board meetings. If they’re exploring alternatives like selling the company or trying to raise more capital in a distressed environment, we’re more likely to be part of it. More often than not, we’re not on the board meetings for clients, but we do offer that as part of our startup package. If somebody wants us to be on quarterly board meetings, whether it’s me or an associate, we can do that.

ICELab: Can you tell us about how you’ve seen things go wrong? Have you witnessed a situation where a board of directors has caused more trouble than value to a company? So maybe not just the founder but to the actual company and what pitfalls were present that a founder and board could avoid.

Michael Dill: There are two big issues that I regularly see with boards of directors. One is that founders are generally great at creating an idea, building a company around it and scaling it, but they’re usually not as good at raising capital. They would like to have board members add value by helping them raise capital, right? They can introduce them to other people in their network. They can sometimes even negotiate those terms for the company. The boards that add value are generally helpful in fundraising efforts. They may not guarantee they’re going to get capital (they’re not investment bankers), but they have a network you can tap into and will assist through that process. That’s one of the biggest frustrations. There’s often a gap, especially in early-stage companies, with finding board members who have networks that will connect them with capital.

The other issue I often see with boards is a kind of conflict of interest or fiduciary duty issue. What I mean by that is people have different hats when it comes to the entity. They’re stockholders. They can also be officers. When you’re wearing your director hat you need to act in the best interest of all stockholders for the company and not your own personal best interests. I regularly see that people do not understand that distinction. I have board members who are supposedly negotiating on behalf of the company separate from them being an investor and they’re also leading a round as an investor. That situation happens regularly and it ends up resulting in situations where the company doesn’t always get the best terms because why would somebody negotiate with solely their board hat on if they can get a lower valuation and get more equity as an investor? This is a problem because sometimes the founder doesn’t feel like they have the expertise to negotiate those terms on behalf of the company. That’s where I feel like having good legal counsel can help step in and say a director should not negotiate this round. They should only negotiate as an investor, not a board member. It should only be the independent director or the founder director negotiating those terms for the company.

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