Posted 07 Jan 2014
In conversation at various startup events, I hear a common but potential misconception relating to “control” and the board of directors. For example, I often overhear “it’s great that the founders only had to give up 1 board seat, so they still retain control of the board/company.” But board composition is not necessarily the sole determinant of control, as certain mechanisms can erode or supersede the traditional majority rules formula of control.
Beginning at a significant seed round, it is not uncommon for an investor to require certain elements of control, in addition to a board seat. For example, they may require that in order for a certain corporate action to be approved, a specified board member such as the board member appointed by the investor, must approve such action (in addition to a majority vote of the board). This can allow an investor, through their board seat, to maintain control over specified matters while possessing a minority of the board seats. Additionally, certain corporate actions may require approval of certain a class or series of a startup’s stock (in addition to a majority vote of the board).
Alternatively, and rarely, a startup may set up a board structure that gives certain directors more than 1 vote per seat. Thus, one person on a three-person board could ‘control’ the board if they were given enough votes for their board seat. This is another instance of control being retained by a minority of the board in terms of the numbers. (Note: I don’t recommend startups start working this mechanism into their docs.)
A startup needs to look closely and understand each and every control aspect of a deal, as it could be giving up only one board seat in absolute terms but effectively relinquishing control if there are certain strings attached to the investment. The founders should know exactly how much control they are losing — and that it is not always determined solely by the number of board seats.