Introduction
“If men were angels, then no government would be necessary.”
– James Madison
Founders’, executives’, and investors’ respective claims on a company should be formally defined. You need good people who get along with each other, but you also need a structure to keep everyone aligned for the long term.
Ownership, Possession, and Control
To anticipate likely sources of misalignment, it is useful to distinguish between three concepts:
- Ownership: who legally owns a company’s equity?
- Possession: who actually runs the company on a day to day basis?
- Control: who formally governs the company’s affairs?
A typical startup allocates ownership among founders, employees, and investors. The managers and employees who operate the company enjoy possession. A Board of Directors, usually comprising founders and investors, exercise control. Oversight from the board places managers’ plans in a broader perspective.
In theory, this division works smoothly. Financial upside from part-ownership attracts and rewards investors and employees. Effective possession motivates and empowers founders and employees – it means they can get stuff done.
Most conflicts in startups erupt between ownership and control – that is, between founders and investors on a board.
(From Peter Thiel’s Zero to One)
Roles and Responsibilities
It is important to be very clear about a founder’s role(s) in the company and how those roles can differ. A founder can have three, or even four, “roles”:
- as an employee
- as a director
- as a shareholder
- as a CEO
It is tricky to separate the different obligations if you fall into more than one of the above categories, but understanding the separation is vital to how a company operates.
Founding shareholders who are employees but not directors should be very aware that board decisions will be taken by the board. In that context: while a senior shareholder employee may be invited to give input as part of good management, strictly speaking, they will have no control over board-level decisions so long as that decision is not one which must be put to shareholders. It is only at the stage that decisions are brought to shareholders that the founder-shareholder’s sphere of influence becomes more than a non-shareholder-employee.
If you are a director, the duties you owe as a director trump your own desires as an employee.
Shareholders do not owe independent duties to the company and thus can support/reject certain actions if they believe those actions are not in their own personal interest. Disingenuous as it may sound, there can be circumstances whereby a director may support an action in the best interests of the company, but may then vote against that action as a shareholder.
A founder CEO has perhaps the most complex relationships to manage, likely falling into each of the four categories above. The CEO reports to the board and must separate potentially competing desires as an employee or shareholder from the obligations they owe as a director.
The Law Donut has a great FAQ on shareholder and boardroom disputes, looking at many of the areas of potential disagreement at the early stage.
A note on observers
A board observer is someone who has the right to attend board meetings of the company. They are not an official director and cannot vote on matters before the board.
Always ask the question: “Why would someone want to be an observer rather than a director?”
Even if the observer is not a director, if they are permitted to be involved in the board discussions, it becomes very difficult for the board to operate as a board. Imagine a significant disagreement where you have two observers and perhaps another director arguing for a particular position? It becomes extremely difficult for the board to take a contrary position, especially if the observers and director actually outnumber any other directors.
This is not how a board is supposed to work; the board is the body that makes the decisions about the company, and it should not be disproportionately influenced by people who are not members of that board.
Be slow to agree to allow an investor to appoint an observer if you would not also agree that they can appoint a director.
In the following circumstances, the appointment of an observer is more acceptable:
- if the investor is an industry investor/strategic investor, whereby that investor may have a hard-and-fast policy against appointing a director. In this case, it is vital to agree specific terms to protect confidential information and to outline when that observer may be excluded if particularly sensitive topics are being discussed
- if observers are permitted to attend, but not participate in the board meeting; the observer can be permitted to submit queries in advance and can be called on to give an opinion, but otherwise must “observe” the meeting only
But I don't have a board!
Some people tend to think that, because the company doesn’t have an external director (an investor, adviser, or chairperson), the company “doesn’t have a board.”
While the practical basis of this perceived distinction is understandable, all LTD companies have a board of directors. That board may consist of only one director and a secretary, but it exists nonetheless, and directors have duties under the Companies Act and powers to manage the company.
Directors’ Duties
The most important category, in terms of your obligations to the company, is if you are a director.
Directors owe “fiduciary duties” to the company itself — the directors must act in the best interests of the company, having regard to the interests of all its shareholders and those of its employees. The primary fiduciary duty is to the company as an entity.
What does that even mean? Well, when you are a director, you must only look at what is in the best interests of the company and you must take your own personal interests out of consideration.
For example, you might be both a director and the main salesperson of an Ireland-based company. You might also know that, in order to give the company its best chance of success, your main salesperson needs to be based in the US. If you do not want to move to the US yourself, it may be in the best interests of the company that you step aside from the sales role; a desire to remain the most senior salesperson should come secondary to the decision that is in your company’s best interest.
There are many other directors’ duties: not putting themselves in a position where they have a conflict of interest without fully disclosing that conflict to the board, not using company property for personal use, not using information of the company for your own personal gain, etc. This is one area where you should read up on the legalities.
Why is it so important? Taking away the moral rights and wrongs of not acting in the company’s best interests, if you breach your duties as a director and cause the company damage as a result, you can held personally liable for the company’s losses — that means your own money, not the company’s.
This manual expands on each of the important elements of directors’ fiduciary duties and includes some real-world and hypothetical examples. Law Donut also has an excellent, UK-based FAQ on directors’ duties.
There is also some very useful and readable information available from the Irish Director of Corporate Enforcement on Directors’ Duties (.pdf).
Board Composition
In the boardroom, less is more. The smaller the board, the easier it is for directors to communicate, reach consensus, and exercise effective oversight. At this stage, ideally your board should not exceed five people. At least two of these should be from the executive team. (Peter Thiel, Zero to One)
Board members should be aware of the intended development of the board and whether certain board members should expect to be replaced in the future. This is very important — for example, initial angel investor-directors who, if they do not have deep domain expertise, should expect to step down from the board in favour of an experienced chairman/industry expert once the company reaches the appropriate stage.
Non-Executive Directors
You may want to appoint a non-executive director to your board, particularly if that person can add value specific to the industry in which you operate. The most important thing to address with any non-executive director (apart from any shares/options which they may be granted) is the situation where that director may be asked to step down.
As you take on external investment, it may not be appropriate/desirable that the first non-executive director remains on the board. Under normal company law in Ireland (i.e. without a specific provision in your Constitution or another written agreement to the contrary), the only way that a director can be removed other than certain unlikely circumstances (such as the person going into bankruptcy or becoming “of unsound mind”) is by resolution of the shareholders.
While a reluctant director is unlikely to force the company to pass such a resolution, you want to avoid that potentially contentious situation. A written agreement outlining the situations where the director will resign, such as on the majority vote of the existing board or at the request of a future investor, clarifies everything at the outset.
There is a template Non-Executive Director Agreement in the Downloads.
Pitfall
A company raises angel funding from a group of wealthy former co-workers, most of whom invest similar amounts of money. The company offers the first investor a board seat and then proceeds to offer all of the angel investors board seats, bringing the total number of people on the board to seven, even before VC investment has been secured. This leads to a number of consequences:
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It is harder for the company to raise money because VCs believed that the board size evidenced naiveté on the part of the management team generally and the CEO specifically.
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Directors do not want to resign from their board positions if others are not asked to do the same.
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Making board-level decisions is far more complex due to the numbers involved and this leads to more frequent disagreements.