The Real Reason Your Startup Needs an Investor on the Board
When our investment group negotiates the term sheet with startups, the most contentious item other than valuation is frequently board representation. Early stage startups are resistant to having an investor on their board.
You’ve heard all the usual reasons why your board ought to include an investor representative, which basically comes down to helping you run a professional organization. But here’s the real reason you absolutely need an investor on your board…
What is a Board & Do I Even Need One?
But first, a little background. A corporation is a legal entity owned by its shareholders. A private company can have a single shareholder, though a public company may have tens or hundreds of thousands. A Series A startup typically has a dozen to two dozen people on the cap table.
Once the company has more than a few shareholders, it becomes impossible for all shareholders to vote on every important decision, so the shareholders elect a Board of Directors to make decisions for the company. The board then hires the officers to run the business. The board meets periodically, typically once a quarter, to review the operations and discuss company strategy.
Before taking outside investment, the shareholders, board directors, and company officers at most startups are all the same people — the co-founders. The board is a mere formality. However, once the company brings in outside investment, the situations changes.
Investors want a board to oversee the business and move beyond a seat of the pants operation. Founders are hesitant to give up any control to outsiders or lose the flexibility to adjust strategy daily as they try to find their niche.
Delaware, where most companies are incorporated, requires only that the board consist of at least one person. Further, most early investments are SAFEs or convertible notes rather than equity, so seed investors aren’t even shareholders that the company owes a fiduciary duty.
So there is no legal requirement to establish a formal board that includes outsiders. But investors will demand it, and may not invest without one. They’ll give you lots of reasons why you ought to have a board. But I’ve never heard any give the real reason you absolutely need one.
Reasons Why You Ought to Have an Investor on the Board
Here’s the usual reasons why you should have an investor on the board:
Outside board members provide experience and guidance
Face it — you don’t know everything about building a company from scratch to exit, and having an experienced advisor to keep you on track can be useful. An outside board member with a history of building businesses can help the company avoid the fatal mistakes that come from inexperience. However, reporting to a board can feel like having your parents watching over your shoulder.
Investor board members can help you raise your next round of investment
The investor board member usually represents the lead investor that made the largest investment in the previous round and negotiated the deal terms. It may be an individual investor, or an angel group or VC fund. This investor will usually make a substantial investment in the following round, and can help bring in other investors.
Outside board members are free consultants
Although not an official responsibility, board members will do everything they can to help the company succeed. If they come from the same industry, they may be able to introduce the company to big customers and partners. They may be able to help out with everything from hiring an accounting firm to recruiting key hires.
I’m calling bullshit on the above reasons. Not that they aren’t true. They’re all good reasons why you ought to have an investor on the board. But not the reason you absolutely need one. You can get most of the same results with a board of advisors, which is just a list of people you can call whenever you have questions, or by inviting an industry expert to the board instead of an investor. But there is a reason why you absolutely need an investor on the board.
The Real Reason You Need an Investor on the Board
You probably think investors want an investor on the board so they can manage you. And while there is some truth to that, the real reason you need an investor on the board is so you can manage your investors.
The real reason you need an investor on the board of directors is to help you manage your investors.
Over the life of a company, questions arise that require shareholder approval. Some will be perfunctory such as changes to the articles of incorporation to create an employee stock option pool. But some will be substantial, including whether to accept an offer to acquire the business.
Life would be easy if investors simply agreed with whatever you decide is in the best interests of the company. But, of course, we don’t. We want to understand what the changes mean to us and what the alternatives are. We want to be know that what you’ve decided is in our best interest and not just that of the founders. In many situations, the interests of the founders is not aligned with that of early investors.
If there’s a huge acquisition returning 100x, we break out the champagne and don’t argue. But that’s rare. More typical is what happened in a recent acquisition.
A company I invested in announced it was accepting an offer and needed our approval. It wasn’t a great deal for investors, a 2x return if the company hit milestones after acquisition, and less than 1x if they didn’t.
We were disappointed, especially after hearing for a couple years how wonderful the company was doing. Some investors suspected the founders were getting golden parachutes to make the deal more attractive, which isn’t uncommon in marginal deals like this. So our inclination was to vote against the deal.
At that point, the investor on the board reached out to each investor personally. She discussed the feasibility of raising another round of funding and the dilution that would entail. She explained how the board had negotiated the best deal they could get and how they’d shopped the company around but found no better offers. In the end we weren’t thrilled, but voted to approve.
A difficult situation was alleviated because someone we trusted was part of the process. She was one of us, spoke the same language, had the same incentives, and shared our concerns. When she said this deal was the best alternative for us, we had no reason to doubt her.
Acquisitions are far from the only time when an investor on the board makes a big difference. Here are some common events that require overcoming investor resistance:
· The company has to accept a down round.
· The company needs to raise more funds much earlier than anticipated.
· Later investors condition new investment on terms detrimental to early investors.
· The company is accepted to join an accelerator which requires handing over a chunk of equity at a huge discount.
· Founders want to begin taking a salary or raise it to something reasonable.
In the end, if you take money from outside investors, it’s in your best interest to have one of us on your board. She’ll not only help you manage the business, but more importantly, she’ll help you manage your investors.