This post provides an overview of several of the legal and practical considerations startups should be aware of as they constitute their board of directors.
As mentioned on Bradley’s Family Business Advocates blog, a board of directors is the governing body of the corporation elected by its stockholders. The board will guide the overall direction and strategy of the corporation; it will hire, fire, and supervise the corporation’s officers; and it will ultimately decide all major corporate decisions, such as whether or not to sell the business. Good directors are valuable resources who may provide startups with credibility, technical expertise, industry experience, and access to new business opportunities. Accordingly, assembling a board of directors presents startups with significant opportunities to reinforce and expand on the business’s strengths while also addressing its weaknesses.
The initial directors of a corporation are appointed by an incorporator simultaneously with, or shortly after, the organization of the corporation. An incorporator is the person who creates the corporation by executing and filing the certificate of incorporation, and they will often be a shareholder, director or officer of the corporation or one of its representatives. If the incorporator chooses not to appoint directors in the corporation’s certificate of incorporation, then an organizational action is required by the incorporator to transfer governing authority over to the initial board of directors. Until this transfer of authority occurs, the corporation is governed by the incorporator, whose powers are limited by statute.
Although most states do not mandate when the transfer must occur, some states, such as New York, have held that an incorporator may not operate a corporation indefinitely because the board of directors must manage the corporation. While the NYBCL does not address when the organizational action must be taken, it has been held that an incorporator cannot operate a corporation indefinitely because the board should manage the corporation. The incorporator's powers are generally limited under Delaware law to organizing the corporation, adopting the bylaws, electing directors, and transacting other limited business as is authorized under state law.
Generally state law provides startups with significant flexibility in structuring their boards. A board of directors must have at least one director, and all directors must be natural persons (as opposed to business entities or trusts). Otherwise few limitations apply as to who may serve on a startup’s board. The corporation’s certificate of incorporation or bylaws may fix the number of directors and their requisite qualifications. Corporations often provide a range, rather than specifying the number of directors, which allows for greater flexibility as new directors are added and existing directors are removed or resign. Usually the board will consist of a mix of the corporation’s key management (i.e., inside directors) and other individuals not employed by the corporation (i.e., outside directors).
The legal flexibility that startups have in structuring their boards is constrained by practical and strategic considerations. There is no one-size-fits-all approach to assembling an initial board of directors, rather each corporation must balance competing interests and tailor its board to its current needs. When determining the size of a board, although there is no maximum legal limit for the number of directors permitted to serve, a bloated board will often become ineffective and unmanageable. A board of directors will typically have an odd number of directors to prevent a voting deadlock.
A startup’s shareholder base will greatly affect the composition of its board. Outside investors routinely condition their investment on receiving a board presence that roughly reflects their ownership stake in the corporation. For example, a venture-backed startup may find that an outside investor holding 20 percent of the corporation’s stock would like to appoint one-fifth of the corporation’s directors. Further, depending on the rights granted in the corporation’s organizational documents, such an investor may be entitled to make this election without the input of the other shareholders. Even without command of a majority of a corporation’s board seats, outside investors often feel that representation on the board helps them maintain communication with management and visibility into their investment.
Although directors can often be a significant asset to a startup, it is important to take time to appropriately vet and recruit able candidates for directorships. Initially many startups may wish to proceed with forming a corporation to secure the benefits of the corporate form without appointing multiple directors to their board. In the interim, it is not uncommon for startups to organize an advisory board to realize some of the benefits of a board of directors without handing over actual authority to make business decisions or manage company affairs.
Ultimately, a successful startup will likely see the structure and composition of its board of directors change significantly over time. It is important that entrepreneurs and investors seek corporate counsel throughout this evolution.
Republished with permission. This article, "How to Assemble a Board of Directors for a Startup," first appeared in JD Supra Perspectives on April 13, 2017.