Start-Ups

Startups: Demystifying the board of directors

The board of directors for a startup is serious stuff, but it is sometimes misunderstood. Getting your board right isn't very complicated, but its implications are critical.

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The role a board of directors plays in a startup is not be very visible, but its significance is huge.

Take, for example, the social media site Digg. Founded in 2004, this Silicon Valley sweetheart quickly rose to prominence. Google reportedly tried to buy the site for $200 million in 2008, but apparently walked away from the deal. Then, the company was offered $60 million for the site ($80 if you count the earnout) from NewsCorp. But, at the urging of the board of directors, then-CEO Kevin Rose turned down the deal. Unfortunately, the site ended up selling for $500,000 in 2012.

This may seem macabre, but Digg's story should help founders understand just how paramount it is to be diligent about who comprises your board of directors and how they operate, so that you can make sure you get the best advice.

According to Southern Capitol's Ben Brooks, working with a VC is about a lot more than just getting money. If you simply want money go with crowdfunding or take out a loan. Founders should seek VC funding for the insight and guidance, as well as the capital.

Often, that insight comes through the board of directors. Understanding a board of directors starts with an understanding of how a board works.

SEE: Launching a startup: A primer for new entrepreneurs

The bottom line: A board of directors makes decisions, on behalf of the stockholders, for good of the company. If you are raising outside capital, a board will be required by law and will often be expected by potential investors. While not wholly necessary in the early stages, it's still a good idea to establish your board even before you take any funding because it shows that you are serious about growing your startup into a real business.

In general, there are two types of board structures: unitary (single-tier) and two-tier. Unitary structures are common in the US and two-tier structured board are more common in the UK. A unitary structure is a flat, non-hierarchical board where each director has equal power. A two-tier board is composed of a supervisory board and a management board.

In most cases, a board of directors will contain an odd number of directors for decision-making purposes. Unitary boards usually contain three types of directors:

1. Common directors - These are the directors that represent the common stock and its shareholders. The common stock directors are typically one or more of the company founders and, in rare cases, seed investors or friends and family that invested in the company. Before your company raises any venture capital, you will typically only have common directors.

2. Preferred directors - These are the directors that represent the preferred stockholders. These board seats are almost always filled by lead investors from a round of financing. Their jobs is to make decisions on behalf of the investors, looking at how certain decisions will affect the investment.

3. Independent directors - Independent directors are third-party directors that are appointed to solely represent the good of the company. This is an outside market expert that will often have help make decisions that might have been clouded by allegiance to stockholders. Independent directors hold no stock in the company.

When it comes to common directors, especially if you are facing a multiple founder situation, you want to appoint someone who is practical enough to understand how to make decisions for the short term, but also understand the long-term vision and goals of the company. You'll also want to make sure this person has a reasonably high business IQ, so she or he can hold their own in board meetings.

Preferred directors will almost always end up as whichever investor led a particular round of financing. With that being said, you still do have a say in who that person will be as the leader of a round is often determined by the term sheet, which you have a part in drafting. Keep in mind that as you bring on preferred directors (investors), they have a say in the term sheet for future rounds. Peyton Worley, a partner at Cooley LLP, notes that over time the founders lose control of the board and it becomes more weighted to the preferred and independent directors, so it is important to vet your lead investor.

"When choosing a VC, it's not just about what check they're writing you," Worley said. "It's about that relationship and what are they bringing to the table; how do they help your business. Part of that is their presence on the board and what they can assist with there."

Brooks echoes Worley's sentiment, but he also encourages founders to look at the integrity of the investor when he said, "I've seen several companies that have been damaged by board members who acted inappropriately."

When researching potential preferred directors, reach out to past or present boards that they are sitting on. Try to determine how active a role he or she played on the board and how long they hold companies for. Also, see if you can find out the director's willingness to invest in subsequent rounds. That is important because it gives you someone to go to first if you need additional capital.

The appointment of preferred directors can be dynamic. It's not unusual for some VCs to step down or appoint a replacement, or they might relinquish a board member or even a board seat. For example, after a close on a Series B round, one of the original Series A preferred directors might step down.

Worley also mentions that as your company goes through additional funding rounds, you are giving equity for capital and you typically lose percentage of the vote and percentage of the board representation. There is an overall shift in the ownership of the company.

The independent director will play a crucial role in your board, especially as your company grows. Common and preferred directors are both representing the same company, but they are viewing potential decisions through different lenses. Independent directors carry the duty of acting on behalf of the company itself, to help make sober decisions.

"You want to find somebody with significant industry background in whatever it may be. If it's ReverbNation, it might be the music industry; finding someone who can make the relationships, build the relationships, and have the network in place that a typical financial board wouldn't have," said Brooks.

Your independent directors will act as the voice of reason for your company. By bringing industry knowledge and market experience, they will also serve to attract new talent for your company and potentially help you raise additional rounds of financing. Find someone for an independent board seat who is comfortable making difficult decisions and has the expertise to add value to your company.

The stage of your company will determine the size of your board. After a series A round, your board might consist of two founders as common directors, two preferred directors, and one independent director. As your company grows and you add seats after additional rounds, you could end up with a 15-member board of directors like Box, who raised a Series F round last year and just filed for an IPO.

Just remember, the right directors will make all the difference.

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About

Conner Forrest is a Staff Writer for TechRepublic. He covers Google and startups and is passionate about the convergence of technology and culture.

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