Board composition and voting considerations in growth-stage transactions
As an emerging company grows and raises fresh injections of equity capital, its board composition will invariably change over time. At the start of its journey, its board will typically be small and comprised of the founders and their nominees with a straightforward approach to governance.
As the company closes each priced equity financing round, it’s common for the board to grow or for its composition to change, with the addition of one or more directors representing new investors from the latest funding round. A board seat is, almost universally, a key condition for an investor leading a priced equity funding round, and it’s not uncommon for significant co-investors to request board representation as well.
While it may appear to the founders that they're forfeiting a degree of control each time a new director joins the board, this is an unnecessarily negative outlook on the situation. When looking to secure investments, founders have an opportunity to not only make their choice based on the soundness of an investor's financial terms, but also based on the reputation, support, experience and business connections that the incoming investor (and particularly a lead investor) will bring to the company.
Increasing the size or changing the composition of the board (or both) should therefore be viewed not as giving up control, but rather as a positive step forward, with more experience and firepower joining the ranks. It's important to find the right investor not solely for their ability to fund the business, but what they can bring to the table.
Taking a pragmatic approach rather than a defensive one can produce a stronger and better equipped board. This will be worth its weight in gold when critical decisions arise in mature companies like considering liquidity events or operational or capital-related crisis situations occur."
Changing board dynamics
Board seats allocated to incoming (lead or co-lead) investors aren't offered in perpetuity; it’s common to require an investor (or group of investors) to hold a certain minimum number of shares or a minimum ownership percentage in the company to qualify for and maintain their board seat. This helps align ownership interests with board representation as the company welcomes new investors in the future while existing investors get diluted or divest a portion or all of their shares.
The tipping point for founders typically occurs after closing a series B or series C investment round as they find themselves in a position where the number of investor-represented directors equals or exceeds the number of founder directors. This is due to the increase in investor representation on the board after each funding round, assuming earlier round investors have maintained their qualifying ownership in the company.
Some founders respond to this by seeking to increase the size of the board by appointing additional founder-represented directors to bolster their influence on the board in order to maintain majority control, or at the very least have the power to cause a stalemate on voting or quorum.
Caution should be taken with this approach as larger boards can be unwieldy and place administrative burdens on the company. It's also a more control-based approach, which may not attract the most proficient or independent directors to the board at a time when experience and objectivity are needed the most.
The alternative approach to this is having a balanced board with sensible founder representation, appropriate investor representation and one or more seats allocated to independent directors with the expertise to help elevate the company’s strategic approach and operational performance.
Governance rules could also provide that, in addition to directors appointed separately by the founders and the investors, a number of other directors may be appointed based on a joint nomination by both founders and investors. In this case, and with a balanced and experienced board, decisions would occur organically by a majority of directors with the best outcome for the company in mind.
Enabling effective decisions
While no single shareholder may control a majority of the board, this doesn't automatically mean that a founder or any one investor has relinquished decision-making control. There are other mechanisms (like board reserved matters) available to ensure founders and investors alike are given a degree of influence over certain key decisions. It’s also typically the case that founders occupy most of the C-suite positions in a business, and therefore maintain day-to-day management of the business.
Board reserved matters, being a list of key decisions which both the founders and the investors agree are of material importance to the business, will almost certainly be included in the underlying transaction and governance documents. A decision in respect of such matters would typically require a greater quorum threshold (by way of example the attendance of a larger majority or the attendance of a specific director or group of directors), as well as greater voting thresholds (by way of example a larger majority of the board or the approval of certain directors).
Board reserved matters and unilateral veto powers on decisions should be approached with caution as they may inadvertently give one director (or a group of connected directors) the power to cause a deadlock on decision-making.
Setting aside the more draconian approaches to resolving deadlocks (for example, put and call options over shares), it's much better for founders and their investors to discuss and devise a collaborative and sensible approach to voting on reserved matters, which safeguards the company’s decision-making process and enables it to act on critical matters swiftly and in the company’s best interest.
A key consideration is also managing conflicts of interest with appropriate governance rules to alleviate any concerns that board members may take their decisions based on any personal or professional interest as opposed to the best interest of the company.
Setting yourself up for success
Director experience, the size of the board and ownership dynamics influence the composition and voting mechanics of a board. Such circumstances are continuously evolving in an emerging company’s life cycle. There's no silver bullet that will solve key questions on board composition and voting powers, and there’s no one way to get it right.
But taking a pragmatic approach rather than a defensive one can produce a stronger and better equipped board. This will be worth its weight in gold when critical decisions arise in mature companies like considering liquidity events or operational or capital-related crisis situations occur. In the case of the latter, a balanced and well-constituted board can make the difference between life and death for a company in distress.