Few first-time startup founders have ever been privy to the somewhat arcane structure known as a board of directors, which complicates the founder’s need to make smart decisions about who sits on the board and how to manage it. Gust Launch handles the paperwork and processes of board management, but to use them correctly, it’s important to understand what a board of directors is and why a startup needs one.
Why a startup has a board of directors
The short answer: Delaware law. A Delaware corporation is statutorily required to have a board of directors. The board of directors manages the business and affairs of the corporation as provided in the company’s certificate of incorporation and bylaws, so they have a say in declaring dividends, buying property, and issuing debt, stock, and options. Additionally, the board appoints the initial officers of the corporation (CEO, COO, CTO, etc.) and delegates some of its powers and responsibilities to those officers.
Functionally, you can think of the board being responsible for setting the strategic long-term vision and priorities for the company. The officers are responsible for executing those directives and are ultimately controlled by the board.
For an early-stage startup founder, distinguishing between the board, shareholders, and officers can be confusing since the founders generally fill all three roles. However, it is important for founders to know the differences between acting as an officer, a board member, and as a shareholder. Each comes with different responsibilities. These roles become more pronounced as the company grows and takes on additional investors.
Fiduciary duties of the board of directors
Directors of Delaware corporations have two primary fiduciary duties they owe to the corporation’s stockholders: the duty of care and the duty of loyalty. In breach of fiduciary duties cases, courts generally have wide discretion to fashion remedies for aggrieved parties. This could mean the removal of the board member, personal financial consequences, or a number of other potential consequences.
The duty of care obligates board members to reasonably avail themselves of all material information before making a business decision. This means that board members must perform due diligence and possibly consult outside experts while making decisions for the company. Further, this means that directors must review material that is sent to them ahead of meeting, must be engaged, and must take sufficient time to evaluate and consider any possible decision. Under Delaware law directors are presumed to have made a business decision by acting on an informed basis, in good faith and in the honest belief that the action was taken in the best interests of the company. This presumption is called the business judgement rule.
The duty of loyalty requires a director to put the interests of the stockholders ahead of their own individual interests. This means that a board member cannot use the company’s confidential information for their own personal gain, engage in self-dealing that is unfair to the corporation, take an action to entrench himself or herself as a board member, or place their own benefits (or those of affiliated entities) ahead of the corporation. This duty also requires the board member to disclose any potential conflicts of interest that are relevant to any decision or action, or risk losing the presumption given in the duty of care.
How many directors do startups have?
Delaware only requires corporations to have one board member, and while sometimes startups will stick with one, the best practice is generally to name three board members. The advantage to having three is that an odd number of votes means a majority can always be reached, protecting the corporation from being caught in a voting deadlock, which could cause many headaches and complications.
As the startup grows and takes on more institutional investment, the board will usually grow to five. Some later stage companies may have boards as large as seven, but rarely more, mostly due to the increasing complexity of coordinating members as the board grows.
Who sits on the board of directors?
When the corporation is initially formed, a three-member board usually consists of two cofounders and a trusted advisor. The advisor is generally someone who is helping the company grow and may have either subject matter expertise or connections to the investment community. When the company takes in its first professional investment from either angels or VCs, the investor (or investors) usually choose a person to take the advisor’s board seat, so the new investors have some control over the corporation.
After a few rounds of VC financing, the board usually grows to five board members and its composition slightly changes. Typically, two of the board members are founders representing the interests of the common stockholders, two board members represent the interests of the preferred stockholders, and the fifth board member is an independent third-party upon which the founders and the investors have agreed. This composition serves to balance control of the corporation between the investors and the founders, with the fifth board member acting as an impartial tie-breaker in the event of a disagreement.
Finally, the most senior member of any board is the “chairman of the board.” This individual is a current board member elected as chairman by the other seated directors. The chairman is generally not an employee of the corporation and is usually an early lead investor. This person is responsible for running board meetings and sits on all board committees that form. While the chairman only has one vote (like the other board members), the chairman is generally regarded as the most senior member, wielding the most clout.
Board members vs. board observers
In addition to actual board members, there are often other participants in board activities, known as board observers. Board observers are individuals who are involved in communications between board members and attend board meetings but do not actually have a vote. Companies may give board observer seats to certain investors that did not receive a board seat as part of the terms of their investment.
Startups should be careful about granting board observation roles. Board observers increase the complexity of the board and can express their opinions about the direction of the corporation. Founders should make sure that anyone given a seat at the board table, including observers, is going to be a productive and valuable addition who helps guide the company towards success.
Overall, managing the board of directors is not an intense or particularly onerous task, but it does require a startup founder to be familiar with the relevant structures and vocabulary. Learning the rules that govern a Delaware C-Corporation’s board of directors means one less thing to worry about when it’s time to incorporate or take investment.
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This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.