Understanding Startup Board Control
A few days ago during the holiday break, I saw a tweet from a CEO of a Techstars company called Bench. The tweet said that apparently, he was let go three years ago and that now the company is shutting down.
I wasn’t an investor in Bench, but I knew Ian from the Techstars days way back and was disappointed to hear the news. Failure is never a pleasant thing, especially after more than a decade of hard work.
I don’t know the details of what happened, but the thing that stood out is that the founder was fired by the board. This, unfortunately, is not uncommon and happened to me as well with my second startup.
After a decade in venture, I am very firmly in the camp of founder-led companies, for as long as possible, and as long as practical.
I believe that founders are magical and visionary; I believe that they are essential to building generational companies. That said, there are times when founders are not scaling, and for one reason or another, they themselves choose to step down or have to be forced to leave by the board.
The Purpose of the Startup Board
So how do you, as a founder, ensure you maintain board control?
To do that, you first need to understand how and why boards work.
When the company starts, only founders are board members, but once VCs invest, they often want a board seat.
Why?
Because they want to have influence and control. Because the board appoints the CEO, and that is the ultimate form of control over the business.
The main purpose of the board is to appoint the CEO.
Many founders are confused about ownership and board control. Just because you own more of the company stock it DOES NOT mean that you are in control of the board. Read this post to understand how roles of founders, directors and executives work in the early stage startuo.
This is because investors own so-called Preferred stock. This stock often comes with specific rights, and one of them is to appoint a board member. If you look at your financing documents, you will see it spelled out.
So, even though investors OWN LESS of the company, they GET THE RIGHT to appoint a board member THROUGH PREFERRED STOCK.
Let’s look at this example: two founders, who were initially equal, sold 20% of the business to an investor. Each founder now has 40% of the shares, and the investor has 20%. If the investor purchased common stock, then each share of the stock could vote to elect the board, and the investor would never get a board seat.
But instead, the investor asks to get Preferred stock and, among other rights for the Preferred stock, to appoint a board member.
The Basics of Startup Board Structure
All startup boards consist of board members and so-called board observers. Board observers don’t have votes, so they don’t matter for board control.
Board members, on the other hand, typically have a single vote. There are also ways for board members to have more than one vote, but we will touch on this later.
A simple way to think about the board is that if you have a three-person board, there are three total votes, or if there is a five-member board, there are five votes.
The financing documents spell out fully how the board is structured.
Typically, the Seed financing document would say — the board shall consist of two common directors, one of whom shall be the CEO, and a Preferred director appointed by the majority of Preferred shareholders or a specific VC firm that led the seed round.
Here is how the boards typically look at different stage of the company:
Pre-seed — Founders only board — 1 or 2 or 3 founders make up the entire board
Seed — 3 Director board — 2 common elected by the founders, 1 Director representing Majority of Preferred Seed shareholders
Series A — 5 Director board — 2 common, 1 Director representing Majority of Preferred Seed, 1 Director representing Majority of Preferred A, and 1 Independent Director
Independent directors are common at Series A and beyond. They are voting directors that are typically industry experts and help bring — as the name implies — an independent view to the board. These independent directors are typically mutually agreed upon by the common and Preferred shareholders. Sometimes Independent director seat is vacant, and the board is 2 common and 2 preferred, and in this case the founders effectively still maintain the board control.
Series B and beyond — Investors typically have more representation on the board, and have board control.
What Can Founders Do to Maintain Board Control?
Make sure you understand how boards work
First and foremost the founders need to understand how board control works and think about the board composition as a key negotiation term. Most founders unfortunately and naively focus on dilution and post money valuation as the main terms when raising captial. Board control matters no less and potentially more over the long run.
So the first step is to recognize that Board composition is extremely important.Have more Founder Seats out of the gate
Founders, especially those with larger founding teams, should ask to have more common seats out of the gate. If there are three founders, you should ask for all three founders to be on the board. The founders will have control in this case, but co-founders may side with the investor and still remove the CEO.Don’t give up board seats easily
Founders should not give up board seats in pre-seed and should never just give a board seat to an early angel investor. When we lead a pre-seed round at 2048 Ventures, we always take a board observer role but never a board seat. It doesn’t make sense for super early investors to take the board role — so if your investor is asking for it, point out that it is not market.Negotiate that Seed Investors Leave the Board
If you have to give a board seat to an early Angel or pre-seed investor and even to a Seed investor you can ask for them to give up the right at Series A or Series B. Make sure that this is part of the investment documents. This is a good compromise if early investors insist on having a board seat - founders can offer it to them up to Series X and that way founders can still maintain board control for longer.Choose your investors wisely
This is an obvious one but still founders don’t always pay attenton to — do reverse due dilligence on your investors. Board relationships spawn years or even a decade - don’t partner with investors you have concerns about. Before accepting someone as a board member speak with other founders who know the investor in the board capacity. Founders should also always backchannel the investors through their own network. No matter how desparate you are for investment don’t skip this step as it may end up being really costly in the future.Raise fewer rounds
It depends on the startup but the less rounds you raise the more likelyhood you will maintain control. Startups need capital as growth fuel, so avoid raising more than you. More importantly, when you are raising you should be raising from the position of strength.Pull off Zuckerberg’s trick
And this brings us to the last and best possible although hardest to pull off trick - super votes. Mark Zuckerberg as well as some other prominent and successful tech founders gain so much leverage they’ve been able to circumvent the conventional board structure by getting essentially super votes. Mechanically there is a separate class of stock, lets call it Founder Preferred that has more board votes than other classes. By having these super votes founders can maintain board control permanently.
How do you get founder preferred? It is exceptionally hard, and not really market.
The only way to get Founder Preferred super votes or extra board seats for common is the company is a total rocketship and founders have very strong leverage.
The leverage is the most important thing in any negotiation, and it is particularly important when negotiating with VCs. I wrote a separate post about leverage, go read it here. The summary is you want to come to negotiating table with really strong growth, and get multiple VCs to bid on the round so you can have strong leverage.
In summary, founders should obsess over board composition as much as they obsess over dilution.
