Setting Board Size and Composition in Anticipation of a VC Financing

When forming a tech company, one of the key inputs in connection with the incorporation process is board size and composition. It is typical for multi-founder companies to throw each of the founders on the board out of the gate but it is also not unusual to have the lead founder serve on the board in their sole capacity. For sole founders, there may not be a choice.

In the case of a single member board, a common question from founders is how should one be thinking about board size and composition heading into the company’s first institutional raise. In most cases, once past the “friends and family round”, the first meaningful capital into the company will take the form of a Series Seed Preferred financing. So what can you expect from your lead seed round investor in terms of how they will think about the board make-up and what should you single board member founders do to set the stage appropriately for negotiating a board composition that shifts the balance of power into the hands of the founders?

As you would suspect there is no golden rule but here are a few bullets to get you thinking about the topic:

• A professional seed investor will require a board seat. In the cases they don’t, I think that might actually serve as a red flag around sophistication of investor/dedication to the investment (outside of unique circumstances).

• Depending on how close the company is to actually receiving a TS, it might not worth the exercise of extending the board pre-round. Many early stage companies are “preparing” for an equity round but in some cases it takes them another 6-12 months to see a TS (particularly in a tightening east coast seed market). If the founder thinks they have sufficient runway until they see that TS, I might say that exploring a board increase now by adding other common holders or founders might be a worthy chess move. In the alternative, if the company is moments from receipt of a TS, papering the increase pre-round might look hasty only to have the board completely renegotiated anyway in connection with the round. In the latter case, it probably makes sense to leave as a point of negotiation.

• Regardless, adding members to the board should not be taken lightly. It comes with fiduciary duties/decision making responsibility that doesn’t always make sense to give to your co-founders. Plus what happens if the round doesn’t come together in the near future? Then you’ve added two people that you didn’t think were initially worthy of such position out of the gate.

• Not always the case, but the advice I find myself usually giving is sit tight. Get your TS and mark it up to make the board size 3: 1 investor designee, 2 common seats. This is where things should really shake out at the series seed equity round. In fewer cases, I might see an investor push for 1 investor designee, 1 common seat, 1 independent but finding the right independent at this stage can be extremely difficult.

• But the fight will not be over there. Even in the 2 common vs 1 investor board construct, expect negotiation around who holds the power to vote in the common seats. Are those seats controlled by:

o “majority of common” (ie holders of common across the entire cap table)?

o “majority of common held by the Founders” (ie two named individuals)?

o “majority of common held by Key Holders” (ie common holders holding over a threshold of stock)?

o “majority of common held by Key Holders who are then providing services to the company” (so if you leave the company or are terminated no longer influence the vote)?

o A “CEO seat” (ie whoever serves in that role at any time)?

Lots to think through around board composition heading into your first institutional raise with consequences not only for operations following the round but also in the context of setting the stage for you’re A round….and just think…. that is only the board composition discussion!

NVCA Model Docs....times are a changin'

For the first time since 2014, the National Venture Capital Association, or NVCA, has updated its model financing documents to reflect a handful of key updates in order to account for the changing world over the past 4 years. In particular, two updates really stuck out which emphasize the times we live in:

Blocks on Crypto-Currency offerings

A new protective blocking right has been added to the model charter to provide investors a veto over token, crypto-currency and block chain related offerings given that the pre-existing veto rights did not clearly apply to or cover these new types of offerings. Without the change, existing investors may have been exposed to a portfolio company circumventing the standard block on future financings by pursuing alternative crypto offerings.  
 
Anti-Harassment/Code of Conduct

A covenant has been added to the model IRA that requires the company to adopt a code of conduct governing appropriate workplace behavior and a policy prohibiting discrimination and harassment at the company. Previously, the covenants contained in the form financing documents had never gone so far as obligating the company to adopt employee handbooks, particular policies, etc. To ease the pain and cost for companies, the NVCA published a sample HR policy to address this point. This is a welcome change for the tech/VC industry and emphasizes the issues that have plagued the community the past couple years.

Kudos to the association and its general counsel advisory board!

Wire Fraud on the Rise… Could the VC Community Be Hit Next?

It has been widely reported that cyber criminals are hijacking real estate transactions by finding increasingly sophisticated ways to intercept and make alterations to wiring instructions being distributed between parties leading up to a real estate closing, resulting in the wiring party being duped into releasing funds to an alternative (and often times, off shore) bank account. Over the last year, hackers are starting to apply the same techniques to prey on the venture capital community and financings transactions. Read here. 

This got me thinking about the standard practice for how venture financings are closed, specifically the process around how wiring instructions are shared between a company and its soon-to-be investors as well as the particular ripeness of the industry to be targeted by similar scams.  

It is customary that leading up to the final moments before a VC transaction closing, lawyers find themselves caught in the middle of coordinating distribution of final deal documents along with the company’s wiring instructions. Here’s how it typically unfolds: (1) a company will email its lawyers the company's wiring instructions to distribute along with executed documents and the filed charter, (2) the company's lawyers turn around and send a closing email, which contains those instructions, to the Investor’s lawyers, (3) Investor’s lawyers then forward along to their client with confirmation that the closing conditions have been met and the wire should be released. By my count that is 3 emails sent containing wiring instructions…. which is 3 emails too many!

It is time for lawyers to insist that the parties to a transaction take much more calculated steps to limit the risks associated with this particular style of cyber crime. Founders and VCs should communicate directly on wiring instructions, separate from the lawyers' deal document distribution, through secured means other than email and, prior to wiring any funds, the VC (or a member of their finance team) should contact the company by phone and confirm that the wiring information sent over email is accurate. In my experience, this isn’t common practice. But it should be.