Members of the board of directors are elected by the stockholders, and represent the stockholders’ interests. In preferred stock financings, the lead investor will usually obtain the right to appoint a director to the board. If the lead investor doesn’t obtain a board appointment right, then the investor may obtain the right to be a “board observer.” Board observer rights are sometimes granted in addition to board appointment rights.
This blog discusses an investor’s rights to appoint a member of the board and/or a board observer.
Board Members’ Role and Responsibilities
In addition to the responsibilities mentioned above (hiring and firing senior management, deciding to raise capital, sell the company or go public, approving material contracts, etc.), board members of early-stage companies establish executive compensation, approve employee stock option grants, provide management with strategic advice, mentorship, help with recruiting (by using their personal networks to identify talent), help with customer introductions, and more.
The members of a company’s board of directors are elected by a vote of the stockholders, and the board members represent the interests of the stockholders. Board members act as fiduciaries for the stockholders, meaning that the board members have a legal obligation to act in the best interests of the stockholders. If a board member breaches this fiduciary duty, they can be sued by an aggrieved stockholder. In extreme cases, board members may have personal liability for breaches of these fiduciary duties.
The lead investor in a preferred stock financing round establishes the valuation for the company and negotiates the term sheet for the financing. As part of these negotiations, it is customary for the lead investor to obtain the right to appoint a member of the board of directors. What this means is that as the company grows and has more rounds of financing, the size of the board will also grow. In addition to appointing a director, the investor obtains the right for their board representative to sit on the board committees. This is important because it is often in the committees where the substantive work is done.
The way board rights work mechanically is that the certificate of incorporation (the company’s charter documents that are filed with the secretary of state where the company is incorporated), has a provision stating that the preferred stock has the right to elect a certain number of directors, and then there’s a separate voting agreement where the preferred stockholders all agree to vote for the nominee of the investor(s) with the board and committee appointment right.
However, preferred stock financings often have many investors in addition to the lead investor. If there’s a very large investor in the preferred round, the investor may push for a board right, and if they aren’t able to get that, they will ask for the right to have a board observer.
Board Observer Rights
A board observer is a person appointed by an investor who attends board and committee meetings and importantly participates in the discussions. Board observers receive the same materials (board packs, etc.) that are sent to the board members and basically have rights similar to board members, except that (1) the board observer doesn’t vote, and (2) the board observer can be excluded from any discussions that are highly sensitive (such as discussion of legal matters or trade secrets, or where a conflict of interest exists). Some venture capitalists like being observers because they can exert similar influence as a board member without the potential legal liability of being a board member.
The board observer rights are typically found in an investor rights agreement.
Some lead investors ask for both board rights and board observer rights. Often this is to enable a junior investment professional at the firm to attend the board meetings as an opportunity to gain experience and learn.
The board observer rights terminate when the company goes public or when the company is sold. Note that more recently I have seen a push to have the board observer rights terminate in other situations, such as after some period of time, or on the closing of another preferred financing round. The concern is that the board room gets too crowded with multiple board observers.
If an investor in a preferred stock financing can’t get board or board observer rights, the fall back is to obtain information rights. These will be discussed in a future post.
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