An In-depth Guide to Running Early Stage Startup Boards — Part 1 of 3

Part 1: What is a Board and what are the key legal considerations? What is the purpose of having a Board, when do you establish one and how do you compose it?

A board of directors is an integral part of every company and can play an important role in the success and growth of an early stage startup. In this three part series, we will dive into the ins and outs of early stage startup boards (topics covered are given below). Follow us on Medium or Twitter to stay tuned on the next two posts.

Part I: This first part covers the purpose of having a board, when to establish one and board composition.

Part II: The second part will cover board member recruitment strategy and compensation.

Part III: The last part will explain the process of running an effective early stage board meeting.

WHAT IS A BOARD

A board is a person or group of individuals representing the shareholders of a company. It is a governing body that is responsible for corporate oversight, participates in key decision making, steers the strategic direction of the business, approves the company budget, and helps establish management compensation and fundraising strategy. Strictly speaking, every corporation has a board of directors from the moment it is formed, even if that is just a single person.

Legal Considerations

Directors of a board have responsibilities and liabilities that are rooted in the law of corporations. Directors are required to comply with local and federal regulations and in extreme cases may even be held liable for their actions in court. In Canada, similar to other jurisdictions, board directors are treated as fiduciaries that owe a duty of loyalty and duty of care to stakeholders in the company. Without getting deep into legal jargon, the essence of these legal responsibilities is that each individual member of a board is expected to act in good faith and in the best interests of the company, the shareholders, and other stakeholders they are representing. Business decisions should be made with prudence and after conducting sufficient due diligence that allows the board member to exercise good faith business judgment. The Business Judgement Rule, often seen in common law jurisdictions, assumes that when board directors make decisions related to the business, they are acting in accordance with fiduciary standards unless proven otherwise. Unless they are clearly in violation of a rule, the court will not challenge their business decisions. This is to protect directors from frivolous lawsuits and enable them to make business decisions without the fear of being sued. The specific scope of these rules is based in the law of the jurisdiction in which your company is incorporated — your lawyer should be well versed in what is important to you specifically.

WHEN TO ESTABLISH A BOARD

By law, a board is required to be established from the moment a company is incorporated. In fact, you will find a lot of useful information and legal requirements pertaining to your board in the corporation’s articles and by-laws.

Typically, before a startup raises external financing, a board tends to be comprised of the startup’s co-founders that are named as directors. For a friends and family round, new investors likely will not ask for board representation. However, as you raise further financing from institutional investors such as venture capital firms, be prepared to open your board up to allow representation from those investors.

WHY ARE BOARDS IMPORTANT

Boards can bring tremendous value to a startup. Your board can guide you in developing the strategic direction of the business, help you navigate priorities, assist in difficult situations, help with hiring and compensating key team members, establish business connections and act as a sounding board along the way.

Greg Wolfond, Founder and CEO of SecureKey, told us, “Boards are important. They can bring a breadth of experience and advice that is invaluable to a startup. At SecureKey our board has evolved over time with sound business leaders like David House (past president of American Express), technology leaders like John Swainson (ex. IBM), Michael Lee of Rogers Ventures and Hugh Cumming (now at ManuLife). We also bring our strategic partners (like the Banks) in as well as board members and observers as they are vital to our long term success.”

BOARD COMPOSITION

Some of the key terms of the financing deal will be around board composition and the business decisions that will require board approval.

We always recommend founders to choose their investors carefully and the same principle applies when selecting your board members. Often, investors with a large participation in your financing round will request or insist on a board seat. So consider whether or not they would be strategic additions to your board when bringing in new investors. If you have the right people around the table, your board can add tremendous value to your business. Conversely, individual board members who are not aligned with the mission or vision of the company can create a toxic environment that hinders progress.

Board Size

We recommend setting an odd number of directors for your board. This is not required by law, but it will eliminate the chances of tied votes. A board can only act on motions that are approved by a simple majority (depending on the specific issue). Generally speaking, a tie results in no action and the maintenance of the status quo.

Following a financing round, it is typical for the lead investor to occupy a seat on your company’s board. Another large shareholder or co-lead investor may also request a board seat or an observer seat (see below for more info on observer seats).

At the early stages, we do not recommend having a large board, as it may slow down decision making processes. If you really want to have a formalized relationship with a strategic advisor without growing the size of your board, consider adding them to your advisory board. An advisory board consists of individuals who bring highly strategic value to various aspects of your business, but they are not legally bound in the way board directors are.

In our experience, board composition for a late Seed or Series A startup generally follows one of these scenarios:

• Two co-founder directors (common shareholders), one investor director (preferred shareholder)
• Two co-founder directors, one investor director, one investor observer
• Two co-founder directors, two investor directors, one independent director

Role of an Independent Director

As the name suggests, an independent director is an independent party. They are not investors in the company, nor are they involved in its day-to-day management. An independent director is often brought in to add specific expertise or ensure that “control” of the board is not swayed in either the direction of the founders or the investors. In addition, an independent director who has been a successful entrepreneur can be a great coach and mentor to the CEO. Independent directors may also provide the perspective of other stakeholders of a corporation, such as clients, partners, suppliers, etc. This could be great in helping overcome herd behaviour.

We will cover details on how to recruit an independent director in Part II of our blog series.

Choosing your Board Members

We recommend assembling your board with the following areas of expertise in mind:

• Relevant domain expertise — Consider choosing a director who has deep knowledge of your industry and a strong network in the space. At the same time, be wary of building a board consisting of only domain experts as this may promote groupthink. Deep domain expertise may also lead to lack of flexibility and openness to new ideas. A study published in the Academy of Management Journal speaks in detail about this topic.
• Strong functional experience — Consider choosing a director with strong functional expertise related to the key drivers of success for your business. For example, if your business depends on enterprise sales, a director with proven expertise in this area can add tremendous value. Another option is to choose a director who has been a successful entrepreneur / CEO themselves. They can provide valuable guidance on various business building issues such as hiring and retaining talent, driving organizational culture and more.

Your investor director(s) may fill some of the above-mentioned criteria (and this also highlights the importance of choosing the right investors). You should discuss with your investors who will represent them on the board if they require a seat.

Generally speaking, if your board contains an independent director following a round of financing, that director will be appointed in mutual agreement by the rest of the board.

Board Observer

Board observers have the right to participate in board meetings, but are not entitled to a formal vote. Observers are not subject to fiduciary duties, however, they usually have the same information rights and confidentiality obligations as official directors.

There are several typical scenarios where someone might request an observer seat — a VC wanting to bring on another team member to help them with supporting the portfolio company; a sizeable shareholder who was not granted a board seat but is willing to accept an observer seat; or a strategic corporate investor who may not want to expose their corporation to various legal liabilities. While observers do not hold official votes, they can significantly influence board discussions. Observers may occasionally be asked to leave the room during a board meeting when certain topics are discussed, such as legal matters or if there is a potential conflict of interest. Even in a scenario where an observer does not have information rights, most startups typically share their board packages with observers so that they can add meaningful contribution during board discussions.

While there are many debates on whether or not to have observers on a company’s board, we think it comes down to context and a case-by-case basis. Observers can add a lot of value to your board discussions, especially if they are domain or functional experts, or if they have built companies themselves.

Chairperson / Executive Chairperson

When the word “chairperson” comes up, people often tend to think of someone with the ultimate power in a boardroom. In reality, the role of a chairperson is to be a more active director within the board, and collaborate with the CEO to manage the board of directors and the board meetings. They can also coach the CEO and liaise between the CEO and the other directors during a conflict. When the chairperson is also involved in the day-to-day operations of the company (e.g. the CEO), the Executive Chairperson title is used instead.

Build a Diverse Board

Many studies confirm that diversity (of gender, race, ethnicity, experiences and cognition) at the board, managerial and employee levels can lead to many tangible benefits for a business such as better financial performance. A diverse board provides differing perspectives and more insightful debates, a better representation of your company’s client base, greater awareness about blind spots and demonstrates your seriousness about equity and inclusion to your employees.

However, we are still not seeing these benefits manifest into proper board level diversity. According to First Round Capital’s State of Startups 2018 report, 54% of the 500+ startups surveyed did not have a single female on their boards. Of the startups surveyed, 97% were headquartered in the U.S. and 77% were between the Seed and Series B stages.

State of Startups 2018 report by First Round Capital showing the male to female ratio of the boards of the startups surveyed

Once you have decided to prioritize diversity representation on your board, you may want to take the following steps:

• Formalize your board recruitment process (more on this coming in Part 2) and make diversity a priority. Communicate this with whoever is helping you with the recruiting process.
• Select a point person to lead the initiative. This could even be yourself. The idea is to hold someone accountable.
• If needed, expand your recruiting criteria to include first-time directors. Given the low past representation of women and minorities on boards, chances of finding someone with prior board experience may be a long shot.

Your board members will provide you with guidance, strategic direction, support and mentorship so it is important to be thoughtful about your board’s size and composition. This enables you to have productive board discussions, aligned interests and insightful contributions.

This is the first blog in a three part series on early stage startup boards. Make sure to follow us so you get the next part of this blog series, which will cover topics such as independent director recruitment process, compensation, getting liabilities insured and more.

We hope this post was helpful and if you have any comments, questions or suggestions, feel free to reach out to us.

Laviva Mazhar — Investment Analyst

About Luge Capital

Luge Capital is a venture capital fund focused on early stage fintech and artificial intelligence (AI) applied to financial services. We invest in talented teams shaping the way the world interacts with financial services. Luge looks for founders that improve customer experiences, remove complexity, make financial institutions more efficient and use data-driven methods for decision-making. We work closely with entrepreneurs and their teams in their efforts to build world-class companies by sharing our extensive network, experience and industry insights. www.luge.vc — Building fintech champions