CONTROL PACKAGE: how to maintain control over the board of directors and why it is important
For you, as a founder, it is of utmost importance to maintain control of the company. Therefore, it is extremely important at an early stage to pay attention to corporate governance issues, especially the composition of the board of directors. This will help to give out cards in your favor before any subsequent rounds of financing, when investors show interest. If you do not think about the issue of corporate governance in advance, this can be detrimental. Having lost control of the board of directors, you can hardly restore it.
Fortunately, founders can rely on several legal strategies to maintain control over their advice and companies. The extent to which they will apply these strategies will depend on their familiarity with them and on their use in fundraising negotiations. Sometimes the lawyers managing the venture rounds are young and underestimate these corporate governance strategies. Too often, founders choose to finance at the expense of corporate governance. Wiser founders are able to approach the formation of the board of directors in the same way as the economics of transactions.
You control your board of directors while the number of “ordinary” seats on the board is greater than the total number of seats for investors plus the number of seats for independent board members
Management for Board Seats
What does it mean for the founder / CEO to control his board of directors? You control your board of directors as long as the number of “ordinary” seats on the board is greater than the total number of seats for investors (which are often called preferred) plus the number of seats for independent board members.
As a rule, a new place for an investor in the board of directors is added with each new round of financing. New investors want to be on the board of directors, and, ideally, their participation adds value to the company. It is important for the founders to understand that you can add the number of seats for regular members during any round of funding. These places do not need to be filled with specific people – CEOs or other founders can simply control them. This is vital and is often misunderstood.
For example, the board of directors may initially have five regular seats and add two in each round. This may seem extreme, but the key point is: as long as the founders have leverage, they should never allow the number of regular seats to fall below the sum of seats for investors + seats for independent members. When the founders “hide” ordinary places in their favor – this is, in principle, a wise idea, if they succeed. Of course, control over these additional places can be discussed in subsequent rounds of financing, but it is better to be able to force new investors to make such concessions.
It is also advisable to discuss the composition of the board of directors and the willingness of earlier directors to resign from the board and make room as the company expands in the future. This problem can be solved by assessing the contribution of the participation of different director-investors at earlier stages to the growth stage.
Independent Board Members
Independent board members can offer valuable advice and tremendous benefits to companies. However, they may also affect the final control of the board. Adding an independent member to the board of directors may seem like a harmless step, but when the board has two regular seats, two investor seats and one independent one, the founders run the risk of losing control of the board of directors. There is a high probability that an independent member of the board of directors will vote together with investor members. If founders add the number of independent members, they must add the same number of ordinary seats in order to maintain control. It is also nice to choose an independent member of the board of directors who shares the founder’s vision (s).
Investor Unilateral Voting Rights
New investors may also try to create a separate voting class for themselves. They do not seek super-voting rights, but want one-way blocking rights on issues such as change of control (M&A) and future rounds of investment. Their argument: if they vote along with other preferred shares, they will not have a majority and will not be able to defend their interests. This concept will sooner or later be implemented in the life of the company, but it is important to restrain it for as long as possible. As soon as you cross this line, there is almost no turning back, and all future investors will most likely have the opportunity to block the sale of the company. The following example emphasizes the main argument that should be used with new investors: if the founders transfer blocking rights now, similar rights could harm these current investors in future rounds.
Example: After a “seed” round, you receive $ 10 million for receiving $ 50 million from a series A investor. A series investor will inevitably require unilateral blocking rights, and let’s say you agree.