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In our series of posts on Term Sheets, Jason and I thought we’d take on a relatively easy one today. In our previous posts on Price and Liquidation Preferences, we discussed the key economic terms that VCs care about. In this post, we tackle one of the two primary “control terms” that matter to VCs.
VCs care about control provisions in order to keep an eye on their investment as well as – in some cases – comply with certain federal tax statutes that are a result of the types of investors that invest in VC funds. One of the key control mechanisms is the election of the board of directors.
There is no secret science in the board of director election paragraph – it simply spells out how the board of directors will be chosen. The entrepreneur should think carefully about what they believe the the proper balance should be between investor, company, founder and outsider represenation should be on the board. There are many existing VC (and entrepreneur) posts concerning the value of a board, the desired composition of the board, and what a board is responsible for. This post doesn’t delve into those issues – we are simply addressing how the board is selected.
A typical term sheet looks as follows:
Board of Directors: The size of the Company’s Board of Directors shall be set at [n]. The Board shall initially be comprised of ____________, as the Investor representative[s] _______________, _________________, and ______________. At each meeting for the election of directors, the holders of the Series A Preferred, voting as a separate class, shall be entitled to elect [x] member[s] of the Company’s Board of Directors which director shall be designated by Investor, the holders of Common Stock, voting as a separate class, shall be entitled to elect [x] member[s], and the remaining directors will be [Option 1: mutually agreed upon by the Common and Preferred, voting together as a single class.] [ or Option 2: chosen by the mutual consent of the Board of Directors].
If a subset of the board is being chosen by more than one constituency (e.g., two directors chosen by the investors, two by founders / common holders and one by “mutual consent”), you should consider what is best: (a) chosen my mutual consent of the board (one person, one vote) or (b) voted upon on the basis of proportional share ownership on a common-as-converted basis.
VCs will often want to include a board observer as part of the agreement either instead of or in addition to an official member of the board. This is typical and usually helpful, as many VC partners have an associate that works with them on their companies. While there’s rarely any contention about who attends a board meeting, most VCs will want the right to have another person from the firm at the board meeting, even if they are non-voting (an “observer”).
Many investors will mandate that one of the common-stockholder chosen board members be the then-serving CEO of the company. This can be tricky if the CEO is the same as one of the key founders – often you’ll see language giving the right to a board seat to one of the founders and a separate board seat to the then CEO – consuming two of the common board seats. Then – if the CEO changes, so does that board seat.
While it is appropriate for board member and observers to be reimbursed for their reasonable out-of-pocket costs for attending board meetings, we rarely see board members receive cash compensation for serving on the board of a private company. Outside board members are usually compensated with stock options – just like key employees – and are often invited to invest money in the company alongside the VCs.