Chapter 5: Forming Your Board of Directors
Startup founders often find themselves needing to attend to the nuts and bolts of building a new company. It is easy, therefore, to brush off the need for creating a board of directors, which can seem too formal and a bit extravagant for a small startup.
But when founders are too busy trying to cut their way through the trees, they can often miss sight of the forest. An effective board of directors offers startups the ability to view the larger picture. Tapping into the knowledge, skills, and experience of others can result in huge gains for a new company.
What Does a Board of Directors and Advisory Board Do?
There are basically two types of boards: (1) Board of Directors (BOD), and (2) Advisory Board. The essential difference between the two types of boards is that management is obligated to execute a Board of Director’s directives, while an advisory board offers general guidance.
Specifically, a board of directors is generally responsible for directing a company’s general strategy and policies. Directors have explicit legal and financial duties and are charged with holding officers accountable for the proper management of a business by providing corporate governance, setting goals, and measuring performance. An advisory board consists of individuals who provide business advice and guidance. They offer management valuable feedback and support as mentors or informal consultants.
Why You Need a Board
Sometimes a Board of Directors is established because investors make it a requirement of funding. But why create a board if it is optional?
One very practical reason is that if you plan on seeking financing through multiple funding rounds, then having a Board of Directors can attract quality investors.
An effective BOD will have members with specialized expertise that will keep steering you in the right direction, enhancing the company’s overall profitability. If a public offering or the acquisition of your business is part of your exit strategy, then a functional Board of Directors can help you get there faster with their expertise. An effective board – whether a Board of Directors or advisory – essentially eliminates the need to reinvent the wheel. With the right people, a board can provide a new company with important guidance from which a new company can benefit. An ideal board will have members with experience relevant to the company’s business. In addition to steering a business away from avoidable mistakes, board members can also help make an emerging business more efficient and profitable by providing a new company with access to expanded professional networks connecting to potential customers, suppliers, and investors.
Effective board members have two key characteristics: (1) they have a genuine interest in your company, and (2) they have valuable knowledge and experience. Simply put, they are committed to seeing your company succeed and are willing to use their resources to promote its prosperity.
Who Should Be a Board Member?
The first step in creating a board of directors is to carefully select criteria that will best serve your company’s needs. The expectations and requirements of a board member will vary depending on the type of business; however, all boards require assembling a board with individuals who are willing to commit their time and energy to developing your business.
The core criteria for considering a board member consists of the following:
Balance: In addition to founders and investors, a well-anchored board ordinarily has independent directors who can protect shareholder interests without a conflict of interest.
Experience: Ideal directors should have both a fundamental understanding of business and a skillset that complements management.
Diversity: Directors should have diverse skills, expertise, and demographics.
What Size is Best?
A small startup should have a minimum of three members. Too few can be as ineffective as too many. Most small companies that create a Board of Directors begin with three or five members. The goal here it to keep the number uneven to avoid tie votes.
How Does a Board of Directors Work?
Assembling a robust Board of Directors can offer a new company some significant advantages. Creating the foundation for a functional board is the first step.
The early days of a young board are usually devoted to drafting corporate bylaws. These are the policies and procedures that govern a company’s daily activities. It defines the responsibilities of managers, how the business will operate, what the voting requirements are, when and where shareholder meetings are held, and an array of other rules that generally address the obligations of officers, directors, and shareholders. As part of their responsibility for charting strategy, a board will develop the company’s value proposition and market opportunities.
As a company grows, there will be a need to create committees. These typically include compliance and governance, finance and audit, and compensation.
A functional board will schedule regular meetings usually every other month. Most board meetings run from three to four hours. Within a week prior to the meeting, members should receive a board package. This includes a detailed agenda in addition to documents relevant to the agenda. Actions are recorded by the corporate Secretary and inserted into the board minutes.
How Are Board Members Compensated?
With cash in short supply, bootstrapped startups are usually not in the position to offer cash compensation to directors. (Expenses, however, are normally reimbursed.) Instead, a young company often offers directors equity in lieu of compensation.
The customary range is between 0.5 to two percent of outstanding shares vested over a period of between two to four years. Lead directors can receive as much as 10 percent more than other members. Founders and investors who sit on the board should not be compensated with limited exceptions.
If a company reaches the Series B round of financing, directors should be compensated with cash retainers and offered new equity incentives.
In contrast to a director, who owes fiduciary duties to the company, an advisor does not vote on corporate matters and is typically engaged by a founder for their domain expertise. However, evaluating an advisor’s style is just as important as gauging expertise.
An advisor is like a coach: some styles are tough and confrontational while others are more easy-going and encouraging. These stylistic differences fall along a wide spectrum of approaches. Selecting an advisor who can compensate for your deficits is one criteria that can be helpful when choosing a compatible advisor.
After you have determined what skills and approaches you are seeking from an advisor, you will need to identify candidates and start the interviewing process. Make it a point during the interview to present them with an actual or hypothetical dilemma relevant to your business. Ask them about their experience in helping other founders with the same or similar concerns. Listen carefully to how they describe their experience; if they focus more on how they helped a founder resolve a challenge rather than on themselves, that is a good indicator that they will have your back.
Finally, be vigilant about candidates who are too keen to give you answers. Advisors should guide a founder, not replace them. You know what is best for your company and a reliable advisor knows this as well. Accordingly, a good advisor will listen more than speak, ask many questions, and help you define your challenges so you can focus on finding the solution that is right for your business.
Test Drive First
When you have identified a promising candidate, ask for several names of other individuals they have advised. Make sure to follow-up with these references to learn more about the candidate’s style and accomplishments. If the responses are positive, ask your potential advisor to help you with a current challenge. If the experience proves valuable, then you are ready to begin a more formal engagement and discuss compensation.
There are several schools of thought on advisor compensation. Some entrepreneurs firmly believe that it is best to begin by asking an advisor to invest in your company. Since most advisors are not inclined to agree to this arrangement, the more common alternative is to offer advisory shares.
Advisory shares are not a legal animal. When you hear the term “advisory shares,” it typically refers to common stock options that are issued to a startup’s advisors.
Startups usually offer an advisor who has been with the company from the beginning anywhere from 0.2 percent to two percent depending on several variables, notably the magnitude of their value and which round of funding you are in.Vesting is usually monthly from one to two years.
Advisory share options normally do not contain a cliff, so vesting begins immediately. For this reason, and further, to ensure that your advisor delivers the promised value to your company, founders need to be cautious about compensating advisors with equity.
When assessing how much equity to allocate to an advisor there are a couple of key considerations. First, evaluate the advisor’s experience. It can be helpful to consider whether they have first, second or third-tier experience. Think about it this way: a first tier advisor has an established track record of successfully launching startups; a second tier advisor has a decent amount of experience in the advisory role, but they’re still building their portfolio; a third-tier advisor is one who is fairly new to your industry or the role.
Next, think about which stage you’re in: Pre-launch, Seed, Series A or Series B. When you are considering your advisor’s equity allocation, the length of time combined with results should yield a higher percentage. On the other hand, an advisor who enters in a later funding round perhaps provided advice on a more sophisticated level that significantly moved the company forward. Their value should be rewarded with stock options toward the higher end of the advisor compensation spectrum.
There is no one-size-fits-all formula. Since each company is different, you will need to weigh the circumstances and results that are unique to your situation. Engaging a knowledgeable business attorney to guide you through these decisions can save you costly mistakes and maximize the value of these transactions.
Chapter 5 Checklist
In summary, we covered how to…