Lately I’ve heard several entrepreneurs express concerns about investor rights, board seats and other terms that are typical in investment agreements. I’ve even heard a speaker warn entrepreneurs at a startup event not to allow early stage investors any representation on their board because they, “Should not have to give up control of their venture.”
This seemed like a good time to set the record straight about proper startup governances and oversight for early-stage companies.
Despite the occasional angel investor who thinks putting a little money into your venture gives him or her management decision-making authority, professional fund managers don’t want to make any management decisions for their portfolio companies.
Most professional investors know that they don’t have the day-to-day information required to make the best decisions. Only the CEO and management team is current enough to make those decisions. This is why investors depend so much on their management teams.
As an investor and board member, I tell my entrepreneurs that I am still only an advisor and that they are ultimately responsible for making all of the tough calls and living with the consequences, good or bad. Even when my entrepreneurs try to get me to make a hard decision for them, I push the final decision back to them.
CEOs cannot be held responsible if they shirk off management decisions to investors.
Terms give confidence to investors’ investors
So, if professional investors don’t want to (or have the time to) manage your company why do they attach terms to their investments requiring a board seat and board approval for certain decisions?
Just as startup founders have obligations to investors, fund managers are also held accountable to their investors. The fund manager’s legal and fiduciary responsibility to the fund investors, also known as limited partners, is to both invest the fund’s capital judiciously and to ensure that the invested capital is used appropriately for the agreed upon purposes.
Imagine an investment agreement that had no investor rights and required no board approvals. Theoretically, a CEO would have the right to give the entire investment amount to himself or herself as a bonus, or maybe loan it to a poor relative who had come on hard times.
You might say that is ridiculous, but the simple fact is if no decision requires board approval then the CEO could take these actions legally.
A CEO could decide to take the investment money and start a new venture totally unrelated to the original investment plan. What if the company becomes a lifestyle business and the CEO decides to pay out all of the company’s profits each year to the management team and never pays investors back?
What if the company is sold but only the founders benefit from the terms of the sale?
Without proper board oversight, these types of things could and unfortunately sometimes do happen. Without some oversight control, there would be no safeguards and sophisticated investors would stop investing in early stage ventures all together.
Checks and balances are good governance
If you are looking to raise investment from a venture capital fund, you should expect to work with someone who is sophisticated and trustworthy enough to represent their own investors’ interest as well as your own.
Fortunately, none of the entrepreneurs I have worked with have been dishonest or unreasonable but attorneys can tell you many stories of deals that did go bad for all stakeholders involved. There are many ways a company can misappropriate the precious investment dollars provided.
Any fund manager who does not insist on some controls and investors rights is betraying the trust of his or her limited partners and probably not someone who will fight to protect your interest either once a deal is signed.
A just and stable government is based on agreed upon checks and balances. Good governance makes a solid foundation for any investment structure, giving entrepreneurs the power and freedom they need to make management decisions and fund managers the oversight required by their limited partners.
Just as good fences make for good neighbors, good investment agreements form the foundation for a good partnership between an entrepreneur and his or her investors.
Create a board structure that’s fair
At Cofounders Capital, we typically establish a three-person board with the founder/CEO holding one seat and the seed investment fund holding one seat. The third seat is independent and mutually agreed upon by both parties and serves as a swing vote.
The third seat is usually a respected business person in the industry who is not associated with either the company founders or the investment fund. This is referred to as a balanced board because if the CEO/founder and investor disagree over an issue requiring board consent then the tie can be broken by the independent board member and the business can keep moving forward.
This being said, after investing in dozens of companies over the last two decades I have never been in a situation where the swing vote board seat had to decide the outcome of a deadlocked board.
None-the-less, such agreements and structures are designed for worst-case situations. It sets the tone for fair decision making that takes all stakeholders into account, which is the primary fiduciary responsibility of any board member.
Boards give confidence in decision-making
As an entrepreneur with seven of my own startups behind me, I always wanted a board of directors from day one. I liked the credibility and weight that the board gave to my decisions.
This was especially true in areas where I was obviously conflicted, such as in setting my own salary.
I often asked my board to vote on high-risk decisions even if they did not require board approval because if things went bad and people lost money I liked the protection of knowing several reputable people were consulted. Having a board discussion in the minutes indicates that major decisions were not made in a knee-jerk manner or in a vacuum. I would seek advice from my board frequently asking, “What am I missing here” or “Help me see this from a different perspective.”
A well-managed board protects the entrepreneur from lawsuits and appearance-of-evil criticisms. As entrepreneurs look to future rounds of funding, a well-functioning board communicates to potential investors a desire to socialize and discuss major decisions. Setting regular board meeting creates a cadence of accountability needed in an early-stage startup environment.
As an early-stage investor, I often work with first-time, young entrepreneurs. They are all smart, driven and passionate, otherwise I would not have invested in them. But they are also typically inexperienced.
The problem with experience is she gives you the test and then the lesson. Much misery can be avoided if young leaders can learn from the mistakes and experiences of advisors who have a vested interest in their success.
As I think of a few major mistakes made by my entrepreneurs over the last few years, a lot of them could have been avoided if the entrepreneur had slowed down long enough to discuss the matter at the next board meeting. I always coach my teams that sometimes fast is slow and slow is fast.
Your investors are on your side. Your success is their success, so utilize them.
Lawyers can help set the record straight
Finally, I’d like to give a little advice to our local attorneys representing first-time entrepreneurs in early-stage funding transactions.
I know that your job in representing your client is to try to negotiate away investor rights and to reduce the number of matters requiring board approval. But hear me out.
You are often doing your clients a disservice in the long run by pushing back too hard on board approval requirements.
Experienced oversight is often exactly what first-time founders desperately need. And sometimes the only way to get these passionate fast-paced entrepreneurs to slow down long enough to think critically about decisions with potential far-reaching consequences is to require a board consent/discussion.
In summary, a sophisticated investor does not want to run your company.
As a board member, I never want to make any decision for one of my CEOs but I do want to make sure that he or she has taken the time to gather and weight-in good counsel and to think critically about major decisions before making the final call.