“Bored” of Directors Can Become Clash of Titans

Rhetoric has the power to engage or alienate, to enchant or disaffect.  Perhaps no better example exists than the term “Corporate Governance.”  Even the wonkiest law geeks like me find our eyes glazing over as soon as the term is mentioned.  Yet I’ve rarely seen entrepreneurs more fired up than when recounting war stories of startups whose founders had control of the company wrested from them, were forced to take financing or compensation deals on outrageously onerous terms, or worst of all, fired from their own companies.  Framed that way, “corporate governance” starts seeming a lot less dry and academic.  It’s probably no coincidence that one of the questions I get most often from founder is “How do I keep control of my company?”

Corporate governance structure flowchart

Typical governance structure (Sony Corporation)

The basic structure of corporate governance is well ingrained among the legal and investment communities, but it’s worth reviewing for those who don’t enjoy dealing with Board resolutions and proxy statements for a living.  In a “plain vanilla” corporation, shareholders own the company and have the right to vote their shares to elect directors periodically.  (They also are entitled by law to vote on certain rare events or activities, but let’s set that aside for now.)  The Board of Directors makes most strategic decisions for the company at a high level, including, crucially, the appointment and removal of executive officers (CEO, President, CFO, and so on).  For startups, it’s also important to understand that Board approval is required for a corporation to issue any new shares of stock or other equity instruments such as stock options.  For that reason, approval of the latest employee stock option grants recommended by the CEO is a routine action item at most startup Board meetings.

In a nutshell, the executive officers run the company in most respects; the Board appoints the officers, gives them feedback and strategic direction, and sets the company on a course for value creation for the benefit of all shareholders.  Ordinary shareholders do little more than monitor their investments, vote in the annual or other election of directors, and on rare occasions, cast special votes on certain decisions such as accepting or rejecting an acquisition offer.

At a large corporation, the separation of ownership and control leads to all sorts of challenges in the general theme of principal-agent problems.  Here is where the concept of fiduciary duty looms large.  Nevertheless, if the company is run by professional managers who have incentives to get friendly parties elected to the Board — whose responsibilities include approving executive employment contracts and setting their compensation, among other things — it’s easy to see how the best interests of the company and its shareholders can get lost in the shuffle.  This tension explains why shareholder advocacy groups, large investment funds, and (to a varying extent) the SEC put so much energy behind initiatives related to executive compensation, Board independence, shareholder proposals (the corporate equivalent of direct democracy — e.g., propositions on the ballot in California), and so forth.

The example shown above from Sony Corporation looks more complex, with several extra boxes in the org chart.  The reason is that Sony, as a publicly traded company, is obligated by stock exchange rules and SEC regulations to appoint committees of the Board with specific responsibilities.  That’s well beyond the scope of this article (unless your startup is planning an IPO in the next few weeks), but the extra bells and whistles don’t change the fundamental governance structure.

OK, if you’re still awake at this point, set all of that aside as we return to startup land.  At inception, the typical startup is the radical opposite of the large corporation:  There is no separation of ownership and control.  Founders are often the sole shareholders, the sole Board members, and the sole executive officers of the company.  That keeps things straightforward, which can be a logistical blessing when trying to take care of urgent business such as closing a financing round:  Generally, only a handful of individuals need to approve everything and sign all of the paperwork, albeit in different capacities.

Walking through the formative steps of a new startup, let’s take a look at the typical corporate governance items:

  • The incorporator (often a founder or lawyer) files the Certificate of Incorporation, adopts initial Bylaws, and appoints the first member(s) of the Board of Directors (usually the founders).
  • The Board meets formally for the first time, often called an “organizational meeting,” to take care of a long list of corporate housekeeping matters.  Among these include authorization to issue founders’ stock and appointment of executive officers (again, usually founders).  If things are properly documented, the Board can take action by unanimous written consent rather than actually holding a meeting.  (This approach is particularly logical when the Board consists of only one director!)
  • As a matter of law, certain items, such as the adoption of a stock option plan or indemnification agreements between the company and its directors and officers, require shareholder approval.  It’s common to include these two subjects in some of the earliest Board and shareholder consents of a new startup.  (In general, anything to be submitted to stockholders for a vote must first be approved by the Board.)
  • As new people join the team, either as employees or as outside contractors, advisers or consultants, it’s common to grant them options, requiring Board approval.
  • If and when the company runs out of shares, with Board and shareholder approval, it can file an amendment to the Certificate of Incorporation to increase the number of authorized shares.
  • In a similar vein, if the company does a round of preferred stock financing (call it a traditional “Series A“), the Certificate will be amended extensively to authorize a whole new class of securities and related rights and preferences.

We’ll revisit some of these in future posts.  Getting back to where we started, founders want to know, “How do I keep control of my company?” The most straightforward answer is to keep control of the Board.  In the beginning, that should be a no-brainer, as the Board can (and usually does) consist solely of founders.  Where things get interesting is after the company takes on significant investment such that “outsiders” negotiate the right to hold Board seats.  In fact, the whole subject of control changes so dramatically that it makes sense to think of governance rights and documents as divided into two discrete periods of corporate history:  Before funding and after funding (or “B.F.” and “A.F.” if you prefer).

The addition of a Board member who is not part of the founding team can have profound consequences — even if he or she is constantly outvoted by the others who control the Board.  I’ll close with a quote from Kevin Rose, coming on the heels of Digg‘s less-than-glorious exit:  “You don’t have any idea how it feels to have someone tell you you can’t sell your company for $60 million.”  Stay tuned as the corporate drama unfolds in Part II.

 
This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship.

Antone Johnson , Founding Principal, Bottom Line Law Group
July 18th, 2012