Originally published on JD Supra
Everything you've read about selecting a startup board of directors is wrong.
Okay, that may be an exaggeration. But a casual internet search regarding the selection of a board of directors for a startup corporation produces hundreds of well-intentioned articles about the characteristics to look for in director candidates. These articles urge a balanced, qualified and engaged board of directors. They rightly point out that board members provide strategic advice, lend credibility, provide oversight and expertise. A large, diverse board will expand access to sources of funding and employee recruitment. The articles recommend that you select board members to offset your weaknesses and challenge your assumptions.
In short, the common wisdom is that an entrepreneur should select qualified, intelligent, experienced individuals who have the breadth and depth of experience that he may lack, as well as an objective outlook. An ideal board, they argue, consists of a mix of company executives, shareholders, and unaffiliated individuals who bring unique talents and perspectives. For purposes of this article, I will call this the “Dream Board”.
Who can argue with this idealized business school view of the world?
A Dream Board sounds like a perfect idea. However, these experts are wrong. The concept of a startup corporation having a Dream Board completely ignores stark legal realities.
No one wants to be on your board
First, except in the rarest of circumstances, an entrepreneurial startup cannot attract such a board of directors. For liability reasons, qualified, intelligent, experienced and valuable board members do not want to be on a startup’s board. Board members can be targets of litigation. Startups can rarely afford meaningful Directors and Officers insurance. The startup cannot offer compensation or benefits that justify any reasonably intelligent and qualified individual to join the board. Indeed, the only way to lure these individuals in is to give up a stake in the new company, which may interfere with needed future financing in the future, as well as deprive the entrepreneur of control of the business. To paraphrase Groucho Marx, you do not want on your board any director who would agree to be on your board.
The board controls rather than advises
Second, while a dream board might provide great advice and guidance, the primary duty of a startup’s board of directors is to protect the interests of the shareholders. Because a startup typically has at most a handful of shareholders, the persons most capable of protecting the interests of the shareholders are the shareholders themselves. Therefore the founders of the corporation should be on the board.
Indeed, while it is nice to discuss “selecting” an ideal board, the startup board is selected by the owners, and they may have conflicting views on who should be on the board. But typically they will agree that each of them should be on the board.
The shareholders who have invested in a startup should not give up the control of the corporation to third parties who do not have the same substantial investment that the founders do. The board of directors votes on critical issues such as raising capital, selecting officers, approving mergers, acquisitions, dissolutions, and the like. While founders getting advice on those issues is great, actually making the decisions about the company’s future should stay in the hands of the founders. Even adding one outside director can shift control so that a minority owner can join forces with the outside director and wield control.
In short, the board of directors should represent the interests of the owners, because the board makes critical decisions that may significantly impact the owners.
One important issue often overlooked by the experts who recommend the Dream Board is that directors have the unfettered right to inspect the books, records and properties of the corporation. This right can be used as a weapon if there is a disagreement on the board. A dissident director can wreak havoc, asserting legal rights and disclosing information about the company that the company might not want public.
My recommendations for the composition of a startup board of directors are as follows:
- Make the number of seats on the board as few as are legally permitted (typically the lower of three or the number of shareholders of the corporation).
- Consider how many directors each founder will be legally entitled to elect under applicable law and determine the board seats based on that analysis.
- Strive to have an odd number of directors to avoid deadlocks.
- The directors should be the founders/major shareholders.
- Avoid independent directors (that is, directors who are not officers or shareholders).
- Consider a separate board of advisors (which has no authority) or simply hire as consultants the outside experts who can provide the same additional perspective, backgrounds and ideas as a Dream Board.
If the startup thrives, new investors and adequate finances may allow the corporation to select and recruit its Dream Board. Until that happens, striving to build such a board will be a waste of time and energy, likely be fruitless, and even if successful, create as many issues as it solves. Keep the board size small and closely related to the corporation’s owners, and the corporation will be more likely to function properly and set itself up to grow.