Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process. In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor. Check out an overview here.
It is probably no surprise that those putting thousands or even million dollars into a company often want some ability to “direct” that company’s affairs. Such is one of the primary rights given by a company to its investor partners when it accepts investor funds.
Today we’ll be discussing board representation.
A corporation is governed, at its highest level, by a board of directors. Though an LLC is not required to have the same structure as a corporation, it too is often governed by a similar body, most often referred to as a “Board of Managers”. In either case, such body will be referred to in this post as the “Board”.
Investors coming into a company often want to see their investment protected through representation on that Board. The NVCA model term sheet we’ve been reviewing as part of this series puts forth a proposed post-financing Board composition:
At the initial Closing, the Board shall consist of [______] members comprised of (i) [name] as [the representative designated by [____], as the lead Investor, (ii) [name] as the representative designated by the remaining Investors, (iii) [name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors].
It’s important to note that even more than the other terms put forth in the NVCA model, the board composition term is really more of a sample than anything else. That is because the board composition attached to any given financing varies widely based on a number of factors including (but most definitely not limited to): the existing capitalization (and rights of the stockholders) of the company, the relative power and or involvement of the company’s founders, and the number of “lead” investors in the present round of financing. There really is no limit on the number of variations possible in putting together a post-financing board. It is one of the areas that demands the total attention of both Company and Investor.
That being said, let’s break down the NVCA model.
The Investor Representatives
The NVCA’s sample Board is comprised of five “slots” and (in most circumstances) five members. The first two slots are designated for the Investors coming in to the company:
(i) [name] as [the representative designated by [____], as the lead Investor
(ii) [name] as the representative designated by the remaining Investors
These slots are what the Company is “giving away” in exchange for the Investors’ money. As you can see, in this form it is contemplated that the Investors will have identified the individuals they intend to serve in such roles. Further, you can see (for the first time in our discussions) the concept of the “lead” investor.
As a practical matter, putting a syndicate of investment together takes a significant amount of work. Very often one investor will take the reins of the process (and will also very often be the investor with the most money on the table). That investor is the “lead” investor, and will usually handle negotiations of all the financing documents (including the term sheet) before getting approval from the rest of the syndicate. That “lead” investor also generally receieves certain benefits, such as the Board representation you see here.
In the model, the second board seat is then to be designated by the remainder of the Investors (presumably by unanimous agreement, though a mechanism for determining the other designee is not given). To be fair, this form of second designation is not one I often see. In my experience, if new Investors are to receive two board seats, it is more common to see either (a) two designees from the most significant investors (i.e., two “leads” for this purpose), or (b) one designee from the “lead” and one from all of the new Investors (i.e., including the “lead”). As mentioned above, however, the board representation term is almost always unique to the transaction at hand. What is useful to know are the options available, not the specific contours of this NVCA sample.
Note finally that the Investors would not take a controlling position on the Board under this model. Generally speaking investors do not want to dictate the actions of the Company from on high. They are in the business of financial investment, not widget making or neurosurgery or what have you. They can provide important insights (and create significant roadblocks), but they don’t generally want the burden (or exposure) or being the final arbiter of Company action.
The Founder/Management Representatives
The NVCA model’s second two slots, (iii) and (iv), outline the Board representatives with ties to the founders of the Company:
(iii) [name] as the representative designated by the Founders
(iv) the person then serving as the Chief Executive Officer of the Company
These are the board members who likely were a part (or the entirety) of the Board prior to Investor involvement. While the concept of a founder representative is simple enough, there is more to note in respect of the CEO director.
In almost all the financings I have worked on, the CEO is designated as a member of the Board. But note the “then serving” portion of the model’s language. The Board designee named as the CEO director is not simply the individual serving as CEO at the time of the financing, it is whoever the CEO is at each applicable time thereafter. If the CEO resigns (or is fired), he or she must resign (or be removed) from their position on the Board and their replacement elected. Note that this means that while the CEO director likely starts out with some alignment to the pre-financing founders of the Company, such alignment is not guranteed and the parties should assume that it will not always be the case.
The CEO director position is an important one for both the Investors and the Company. It is the conduit that makes sure that the officers and management of the Company are heard at the Board level, despite the fact that the Board may only meet sporadically during the Company’s operating year.
(For more on the different roles of a company’s board of directors and officers, check out our Start-Up Entrepreneur Series post.)
The Independent Representative(s)
With Investor representatives on one side and founder (or at least management) representatives on the other, it is often the case that the presence of a “third” side, one not committed to one group or the other, is desirable. That is where the concept of independent directors comes in:
(v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors]
Independent directorships are often used in composing a post-financing Board as shown on the NVCA model; as the “remainder” to fill out any spots needed to reach a certain desired Board size (i.e., if both sides know they want six specific people to serve on a 9 person board, the term sheet would allow for three independent directors to “fill out” the remainder). Very often the term will also specify a certain amount or type of expertise in one or more areas pertinent to the operations of the Company. Perhaps the Board could really use a scientist, or a regulatory expert, or similar. The term sheet would put forth such requirements with a certain amount of specificity.
Because of the roles to be played by the independent directors and the timing requirements often attached to a financing, these seats might only be filled post-closing. If that is known to be the case as early as the term sheet’s drafting, it can be stated in the term itself (i.e., filling of these seats would not be a “condition” to the closing of the financing).
The NVCA model also sets certain parameters on committee composition and meeting requirements:
[Each Board Committee shall include at least one Series A Director.]
The Board of Directors shall meet at least [monthly][quarterly], unless otherwise agreed by a vote of the majority of Directors.
Though not as potentially controversial as the Board composition itself, these terms are important to the Investors (and their representatives). In respect of the first of these, much of the important work done by a Board of any size is done in committee. Often the requirement to have Investor representatives on Board committees is limited to the most important ones; usually the audit (financial statements) and/or compensation committees.
In respect of the second part, it is difficult for the Investor representatives to have their voices heard if the Board never meets. By specifying at least a general meeting requirement, the Investors can ensure that the Board gets together at least some of the time to discuss Company matters. From the Company’s perspective such a requirement is useful in meeting the “corporate formalities” necessary to protect the interests of its shareholders, and so this term is not generally negotated very heavily.
Finally, though not included in the NVCA model term sheet, there exists an additional concept associated with the operation of a Board known as a “Board Observer” (or Board observation right). Board Observers are individuals given the right to attend and speak at meetings of the Board, but not to vote on company matters. Many Investors (especially those in minority positions) seek out such “observation rights”. With such rights they receive many of the same protections as the full Board representatives (in that they receive information and the ability to have their voices heard), without any of the fiduciary obligations or exposure that comes with a Board position. They are favored (even over full Board positions) by many clients I have worked with over the years.
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at email@example.com.