I’ve often quipped that board observers should be like Victorian children: seen and not heard.
While that might sound obnoxious, it’s not if you understand how hard board seats are to come by and the process through which you get one.
There are three ways to get on a startup board.
- Found the company
- Invest a significant amount of money in the company
- Get appointed to an independent director seat
That’s it. There’s no other ticket. The composition of the board — the number of founder seats, the number of investor seats, whether smaller or strategic investors get observer rights, the number of independent seats and the process to appoint them — is all highly negotiated.
Once a board is formed, it’s generally one director, one vote. Whether you’re a VC who owns 40% of the company, a founder who owns 20%, or an independent who owns 1%. Board votes are not weighted by ownership. (Shareholder votes are, but they are only used for a small number of decisions.) That makes board seats, who sits in them, and the discussions among the directors quite important to your company [1].
It’s not an accident if one investor has two seats and another has only observer rights. It’s not an accident if the founder can unilaterally appoint an independent director or if they need to be approved by the rest of the board. There are no accidents. Not if everyone has good lawyers, at least. Everything is negotiated.
Let’s highlight a potential problem with a realistic example:
- A company has arrived at a board composition of two founders, one A-round investor, one B-round investor, and one independent. So five directors in total.
- Let’s say the B-round investor also negotiated for an observer seat. They want to use it as board training for a partner-track VP.
- Let’s say the observer starts acting like a director at board meetings. Speaks freely as the directors do. Asks questions of management. So much so that someone watching the meeting couldn’t correctly distinguish between a board member and an observer.
What’s happened? For all practical purposes, the B-round investor now has two seats on the board. But they only negotiated one. Sure, when it comes to voting (which takes about one minute), they’ll only get one vote. But during the discussions leading up to a vote (which take the other 99% of the meeting) they have two voices out of six (33% of the oxygen) when they’re supposed to have only 20%.
That’s the problem. It’s unfair to the other investors. It’s unfair to the other board members. It’s not what was agreed to.
This is not by any means to say that board observers should not add value. I think there are three ways they can do so:
- By answering questions posed to them. Boards shouldn’t pretend that observers aren’t in the meeting. If one of the observers is a category expert, and the board is discussing strategy, then they should ask them. When board observers can add value, the board should solicit their opinions.
- By debriefing offline with the CEO. They can make a list of topics to discuss with the CEO after the meeting. I do this all the time. It’s a great way to add value and often more effective than speaking too much during the meeting. (Just as board observers should avoid talking, board members should avoid grandstanding.)
- By sending the CEO questions in advance, after a pre-meeting review of the board deck. This presupposes observers get the board deck (which they typically do for the general session) and enables the observer to influence how the deck is delivered in the meeting [2].
Now, let’s review two scenarios where you almost certainly want to provide a board observer with more leeway.
- Debt providers. While they may not own equity, they may have millions to scores of millions of dollars invested in the company as well as restrictive covenants that can trigger a loan default. On the theory of “always be nice to people who can bankrupt your company,” I would provide more space here [3].
- Strategic investors. Strategics may decline board seats they’d otherwise be offered, and opt for observer rights in order to limit liability exposure [4] and avoid conflict of interest concerns. On the theory of “always be nice to people who might buy your company,” I’d allow strategics more space as well, particularly if the designated observer is an expert in the market [5].
Note that if your board has a strong, active, independent chairperson, then they will probably handle any issues for you. But, in my experience, most VC-backed boards don’t have one and only some PE boards do [6].
Some CEOs choose to adopt additional rules for observers:
- Allowing observers to attend only via Zoom, even if the meeting is live
- Reserving seats at the table for directors and management, asking observers to sit in chairs along the outside of the room
This can be seen as harsh, but I’ve seen meetings where early-arriving observers take primo seats at the table, relegating directors to the fringe, and that doesn’t work well either. Also, with some companies, when you add up founders, management, directors, and observers, you can get 20+ people in the room, and meeting dynamics become an issue.
Whatever rules you pick, use common sense in picking them, and be respectful in applying them. The best time to discuss rules is while you’re still negotiating the terms sheet [7]. Once a board gets in the habit of treating observers like directors, it can be hard to break. So from the outset, you should be ready to set norms for observers. Talk to new observers in advance so you know they understand the rules. And then respectfully enforce them if they get violated in the meeting.
Most of all, don’t be so busy ensuring that your observers primarily observe that you forget to rely on them when their expertise can help. The point is to have a quality meeting, leverage all the talent in the room — including the partner at your corporate law firm who’s typically taking the minutes [8] — all while respecting the highly negotiated agreements that determine the structure of your board.
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Notes
Thanks to Martin Fincham, Jeff Higgins, and Bob Clarkson for their feedback on an early draft.
[1] This post is written largely for VC-backed boards where there is often a cat-herding problem. If you have a strong, independent chair, they will usually herd the cats for you. But when the founder is the chair — and they don’t visibly “switch hats” during the meeting to act in both roles — it’s effectively the same as having no chair. In boards where a PE firm has a controlling interest, the deal partner is the de facto chair (as well as majority owner) and, like most everything else, it’s really up to them to set the rules for observers.
[2] And implies the need to ensure there is a confidentiality agreement in place with the observer and/or their parent entity. As a friend pointed out: directors have legal agreements, why shouldn’t observers?
[3] And, having done some consulting on the venture debt side, I must say I’ve been surprised at how little respect some investors show to debt providers. While their IRR may not be as high and their MBAs not as shiny, if you start breaking loan covenants, your debt provider will have discretion on whether to call your loan and potentially bankrupt and/or be in control of your company. Be nice. They may be quiet, but they carry very big sticks.
[4] As the deepest pocket around the table.
[5] And/or have rights of first refusal on a future financing round or sale. And where the partnership may be operational as well (e.g., technology sharing, distribution channels).
[6] In my experience the strong, independent chair model seems a bigger thing in Europe than in the US, and bigger in PE than VC.
[7] This is not to suggest that they get codified in the terms sheet, but simply to have a discussion about the role of observers with someone who’s asking for observer rights.
[8] This is more of a US tradition than a European one. In the US, it’s common for the partner on the account from your corporate law firm to attend your board meetings and record the minutes.
