TL;DR Nutshell: There are few governance-related decisions with a more outsized impact on a company’s power structure than the selection of an independent director. Do not take that selection lightly.
In assessing financing terms and interacting with their lead investors, most founders instinctively focus on two core things: economics and control. And, broadly speaking, that is correct. But the devil is in the details, and too many teams overlook extremely important details. They’ll focus on high-level issues like valuation, liquidation preference, and board composition (# of seats), and then prematurely check out once a term sheet is signed. And that’s when sophisticated players start executing their playbook for maneuvering into a controlling position regardless of what the black-and-white text says.
I’ve already written extensively on how one part of that playbook is for investors to push companies to use their ‘preferred’ company counsel. Another classic maneuver is to push the company to elect an ‘independent’ director with whom investors have significant ties and influence.
Independent Director as Tie-Breaker
Independent directors are, arguably, the most important people on Boards of Directors. They are supposed to serve as an objective voice on what’s best for the Company overall; balancing the incentives of common stockholders (management/founders) and preferred stockholders (investors) that can often pull in different directions. They should have no reason to be driven by control or personal payout.
It is not unheard of for there to be significant disagreement between the common and preferred stockholders on how to approach an important issue, and the independent director serves as the key vote in deciding which path will be taken. Having a trustworthy independent director is a great deterrent to stockholder lawsuits, as his/her approval makes it that much harder for a disgruntled stockholder to claim foul play.
For real independence, dig deeper
But what does “independent” really mean?
The wrong way to define “independent” is simply as “not an investor or employee.” That absolutely is part of the definition. But smart teams know that a person’s judgment and independence are heavily influenced by far more than just their front-facing professional status.
- Does the candidate regularly invest in other startups alongside your investors, perhaps as part of a seed fund, accelerator network, or other group?
- Is the candidate looking for other appointments, either as a director or a more-involved executive; potentially at companies where your lead investors could deliver access?
- Does the candidate spend time in social / business circles where, if they were forced to make a hard decision that angered one side of the board, either members of management or the investor base could exert pressure out of retribution?
Sophisticated business players are masters at finding leverage in their social / business relationships to push a deal in the direction they want it to move. And some founders are quite good at it too. A truly independent director should be minimally exposed to the carrots or sticks that either side of the Board might use to sway a key decision in their direction.
Ideally, an independent director will be someone who has a relatively equal pre-existing relationship both with the founders and with the investors. But because founders often have significantly narrower networks than their lead investors (who are repeat players), that is easier said than done.
More often than not, VCs will propose someone from their preferred ‘roster’ of independent directors; people whom the founders (particularly first-time founders) don’t know at all, or only barely know. Given the loyalty and history that ‘roster’ will have to the VCs for dishing out serial appointments, those people should almost always be avoided. They’re not independent at all, no matter how much they might argue the contrary.
Specialized industry expertise is valuable.
If no viable candidates are available whom both sides can trust, then agreeing on a list of well-known industry players and pursuing their service together is often a very good idea. Any arguments that an independent director must be local should be pushed back against if the right person is located elsewhere. Videoconferencing and teleconferencing are highly effective, as are airplanes. If your independent director doesn’t ‘feed’ from your local ecosystem, that can be a good thing in the right context. Skillset trumps geography.
Someone who not only has the necessary character to be independent, but has specialized knowledge that management and (often) generalist VCs do not, can be invaluable by opening up industry contacts, and helping overcome challenges that are unique to the market a company is engaging.
If you’re building a health tech, or energy tech, startup taking on a massively complex and entrenched market and no one on your board has engaged deeply with that market, that is usually a red flag that politics has trumped performance in determining the board makeup.
Avoid an empty seat.
When no one is available locally whom both sides can trust in the independent director seat, companies will often be pushed to leave their independent director seat empty until after closing. I typically suggest that companies avoid a vacancy if they can, unless they’ve built such a strong level of trust/rapport with their VCs that they’re 100% confident a true independent will get selected, relatively quickly, post-closing.
If you are closing with a balanced board structure of 2 common, 2 VCs, and 1 independent, but your independent seat is empty, you are set up for a stalemate; and stalemates work (like a game of ‘chicken’) against the people with the most to lose; which means founders. By simply refusing (often with any number of excuses) to approve a key transaction, a key hire, or a new fundraise, investors can push founders into a corner to get their preferred independent director elected. Yes, this happens.
Agreeing on a ‘temporary’ independent director to take the seat at closing, to be replaced when a permanent one can be found, is sometimes a good idea. Not ideal, and you should still be very careful who gets chosen, but it is often better than an empty seat. If you are stuck with an empty seat at closing, push hard to keep the selection of an independent director on the near term agenda, and call out delay tactics when you see them. Your leverage decreases proportionately with your bank balance.
It’s not cynicism. It’s experience.
If in reading the above, you feel the advice carries a perspective that is a tad too cynical and untrusting, I suggest that you go talk to multiple founder CEOs who have gone through rounds of funding with institutional investors. They will educate you, off the record. Some stories will have happy endings. But others will teach you the value of a little preparedness and skepticism.
Trust is extremely valuable in business, and I always tell companies that if they’ve found people that they can really trust, and who have proven themselves to be trustworthy over time, hold onto those people with their lives. Make them directors, advisors, officers, your kids’ godparents. Surround yourself with people you can really trust. See: Burned Relationships Burn Down Companies.
But institutional investors have a job to do, and it’s not to be your BFF. It’s to make a lot of money by (1) getting into attractive deals (buttering up), and then (2) once inside, pushing companies to achieve lucrative exits as fast as possible (turning up the heat). Pay close attention to how the behavioral incentives at stage (1) and (2) are very different, and prepare for it, so you don’t end up as the cooked turkey.
The best analogy I’ve found for how companies should interact with their lead investors is that of foreign diplomats engaging in high-stakes trade negotiations. They have something you want, and you have something they want. And while you’re visiting, smile, crack jokes, share photos of your kids and focus on growing the pie together. Try as hard as you can to make the ‘partnership’ resemble something close to a friendship. But when you get back home, make sure the arsenal is well-oiled; just in case.
When all your eggs are in one basket, and you’re sharing that basket with money-driven people who are 10x more experienced than you are, a healthy dose of skepticism keeps you alive. Others will say to relax, let your guard down, and not be so cautious; but their net worth isn’t riding on one horse. Do your diligence, and then build a relationship that you can leverage for the success of your company. But never lose sight of where everyone’s incentives lead. The moment you do, the reality check will be costly and painful.
Having a balanced power structure, instead of a founder-controlled or investor controlled one, is a great way to build trust and alignment. If your VC terms call for a balanced board, make sure what gets implemented is actually, not just superficially, balanced. Treat the selection process of your independent director as seriously as that of your company counsel, and don’t let anyone take it off the agenda.
Originally published at Silicon Hills Lawyer.
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