The Board works for the Common Stock

TL;DR: Under Delaware law, the Board’s primary fiduciary duties are to the common stock; not the preferred. That includes Board members who are themselves investors. Keeping that in mind when interests between investors and common stockholders diverge is important for preventing lawsuits.

Background Reading:

Note: For purpose of this post, we’re going to assume Delaware corporate law, because the vast majority of startups are Delaware corporations. States like California, Texas, Colorado, etc. have different laws, although they are not that far off from Delaware (usually).

There are situations in which the “right” thing to do is a black and white, easy to identify issue. But in many other situations, contextual nuances, ambiguity, and human loyalties/incentives make finding an answer more opaque. In those situations, I’ve found that two questions can help provide clarity:

  • Whom do you work for?
  • (and related) Whom do you not work for?

Corporate governance is the broad term for how corporations should be “governed” in the best interests of their constituents. And under Delaware corporate law, it’s a well-known fact that a Board of Directors, which manages the Company at the highest levels, works for the stockholders. The job of a Board of Directors is to maximize value for the stockholder base. 

But which stockholders? Again, we have some ambiguity. Some of the stockholders are sophisticated, repeat player investors holding preferred stock, and the ability to fund (and negotiate) future financings. Other stockholders are first-time entrepreneurs, or employees, with far more of their net worth already sunk in the specific company, in the form of common stock.

Common v. Preferred

As I wrote in Common Stock v. Preferred Stock, anyone who speaks of Common Stockholders (founders, employees) and Preferred Stockholders (investors) as being fully aligned economically either has no idea what they’re talking about, or is deliberately obfuscating the facts, and the relevant case law on the subject. Investors are typically diversified, experienced, advised independently by personal counsel, and have contractual rights that allow them, in certain exit scenarios, to take 100% of exit proceeds. Common Stockholders are typically significantly less diversified, less experienced, reliant on company counsel for guidance, and lacking in contractual preferences on their equity.

In one sense, Common and Preferred stockholders are aligned in desiring for the Company to get as large of an exit as possible. But after that point is made, it has to be acknowledged that between them (distributionally), they conflict in terms of how much risk they are comfortable taking on to achieve that exit, what percentage of exit they will take, who else might join the cap table to share in that exit, when to go for an exit, and any number of other scenarios.

So again returning back to the point made earlier: a Board of Directors works for the stockholders. But there are conflicts between the stockholders. So whom does the Board work for?

Delaware courts give a clear answer: the Common Stock. For those interested, the most commonly cited case on the issue is called In re Trades Shareholder Litigation, although there’s a huge amount of other material available online on the subject.

Yes, all Board members work for the Common Stock; even the directors who are themselves investors and preferred stockholders. That means that, when deliberating on issues for the Company as Board members, directors are supposed to put aside their personal interests, and all the ways in which they might benefit themselves over other stockholders, and do what’s best for the common stock, as a class. And if they don’t, they are open to being sued by common stockholders.

The Job of Company Counsel

Delaware’s answer to whom the Board works for also illuminates what the job of company counsel is: to help the Board do what’s best for the common stock. That includes paying attention to circumstances in which investor directors may be, shall we say, distracted by personal interests in ways that aren’t beneficial to the overall stockholder base.

The job of independent company counsel is, in part, to help a Board of Directors remain mindful of their fiduciary duties to the company’s stockholders, particularly the common stockholders, and to avoid placing itself in situations where they’re exposed to fiduciary duty violation claims.

Because company counsel plays such a key role in corporate governance and keeping self-dealing in check, very aggressive VCs will maneuver to have the company engage lawyers who are “captive” to the interests of the lead investors. I’ve written about this extensively, including in How to avoid “Captive” Company Counsel. By “owning” the person most capable of noticing and raising a red flag when self-dealing is occurring, investors eliminate the largest check on their power.

If the job of the Board is to do what’s best for the common stock, and to avoid favoring the preferred, then clearly the last thing a well-governed Board would do is force the company to hire lawyers who have long histories working for the Company’s lead preferred holders. In 90% of Boards I work with, this is seen as an obvious, plain as daylight fact; the Company should hire independent lawyers. Outside of the startup/VC world, it would be seen the same way by 100% of Boards.

But there’s still that 10% of funds (bad actors) who use any number of excuses for putting captive lawyers in the counsel seat. And yes, I have seen lawsuits, both against investors and against lawyers, result from parties playing those kinds of games. Piss off the wrong stockholder, and leave enough evidence, and you won’t like the outcome. 

When Boards don’t do their job

It’s one thing to say that the Board’s job is to represent the best interests of the common stockholders, and not take actions to enrich the investor base at their expense, but ensuring that it actually gets done is a whole other issue. Again, there are many funds out there who care deeply about their reputation, and try hard to fulfill their fiduciary duties. But every serious corporate lawyer knows of the tactics that bad actors will use to push through their agendas, often with thinly veiled arguments about why they are best for the company. Some examples:

  1. Telling management that they should not be talking to outside investors (who might offer competing terms, or more competitive valuations), because it is “distracting” and they should “focus on the business.” Or that they simply “aren’t ready” for fundraising yet, despite the fact that the company will run out of cash without getting talks going.
  2. Making up reasons why their preferred lawyers / firm will offer favorable economics (lower cost) to the Company if they are engaged, and using cost savings as a reason why it’s best for the company.
  3. Running executive recruitment processes without the involvement of founders/existing management who are Board members, citing that they prefer not to distract them. The end result being that their loyalists end up getting hired, and not other candidates.
  4. Insisting that their preferred “independent” director choice be elected, despite clear loyalty issues, and holding up other key decisions until they are put in place.
  5. Using made-up data to impose onerous budget constraints on the Company, unless management “gives” on other issues they want.

Unfortunately, once you’ve allowed an asshole onto your Board, it takes constant vigilance and offense/defense to counter the many tactics they might use to push the Company in directions that increase their power and ownership, without actually benefiting the company overall.  Sometimes you have no choice but to go down that path.

But without a doubt, the best thing a team can do to ensure their Board stays aligned with its fiduciary duties is to avoid bad actors altogether, and that takes diligence before any checks are written. All money is green, but some of it is rotten.

As I wrote in Local v. Out of State VCs and Ask the Users, as startup ecosystems become more transparent and open, relying less on one or two dominant funds, the value of diligencing the reputations of investors goes up significantly.  VCs rely heavily on their reputations for deal flow, and there are many good players in startup ecosystems who will use reputational information to either push more deal flow toward VCs who play by the rules, or penalize bad actors. 

I have seen companies go deep into talks with Fund A, and then choose to go with Fund B primarily based on very negative feedback they received, off the record, from entrepreneurs and other market players who know how Fund A worked. Reputation is powerful. Use it.

Key takeaways to wrap this up:

  • The job of a Board of Directors is to do what’s best for the common stockholders of the Company by maximizing shareholder value for the aggregate stockholder base, and not enrich or empower themselves at the common’s expense.
  • Even with that fact, bad actors will use shady tactics and excuses to push companies to do things that favor the VCs over the remainder of the stockholder base.
  • Your best defenses are (i) do diligence to find out who the bad actors are, and avoid their money if you can, and (ii) hire independent advisors who will hold their ground against bad actors during Board meetings.

Negotiation and Inexperience

TL;DR: Having access to trusted advisors, and the time to consult with them, is essential for anyone negotiating terms with which they have very little experience. Don’t accept someone’s argument that you must negotiate important issues live. It’s simply untrue, and a tactic for gaining unfair leverage.

Background Reading:

A recurring theme of SHL posts is that entrepreneurs, particularly first-time entrepreneurs, need to be extremely mindful of the imbalance of experience between themselves and the many sophisticated, repeat players they’re going to be negotiating with as they build their companies. It’s obviously common for entrepreneurial personalities to be more comfortable (than most) with risk, and to go head-first into negotiations and activities without proper backup. But for really big, irreversible decisions, it will backfire, and others will happily use it against you.

One of the most overused phrases for getting naive negotiators to give in on issues they should push back on is “this is standard.” When you have no historical or market perspective – what’s normal, what’s fair, what are the risks, how will this play out in 5 years? – you can be easily manipulated into all kinds of bad outcomes. I’ve been at more than my fair share of board meetings or negotiations where someone at the table makes a completely biased, nonsensical claim that something is “standard,” at which point I’ve had to step in to set things straight, and gladly offer up data or a quick market survey.

There are two main things that I tell all companies to focus on in this regard:

  1. Have a group of experienced, trusted advisors that you can quickly communicate with on serious issues.
  2. Do not let yourself be bullied into a setting where your inexperience puts you at a substantial disadvantage.

Trusted Advisors

When I speak of trusted advisors, I’m not referring necessarily just to your Company’s “advisory board,” which serves a broader purpose of helping you on long-term strategic, business, and technological issues. I’m referring to people you can call or e-mail for specific, tactical guidance on more pressing matters; your “inner circle.” Seasoned entrepreneurs, mentors from accelerators, lawyers (who are independent from your lead VCs), and trustworthy angel investors often make up this group for most CEOs I work with. The most important thing is that they (i) have visibility into the broader market, to help you actually understand what is acceptable, and (ii) will be direct and honest with you when you most need them to.

Imbalanced Negotiation Settings

While it is far less common in the tech world than in other areas, you occasionally still encounter people (particularly VCs) who insist that the only appropriate way to “really” negotiate is live, and in person. And let me tell you: this is bullshit.

Of course, live discussion is important for communication and relationship-building; it has its place. But more often than not, attempts to force entrepreneurs and company executives to negotiate key issues live, or under a very tight deadline, is a tactic to gain unfair leverage from their inexperience. Of course the guy who’s done this type of deal 30 times wants you to agree to terms live, face to face, away from your set of advisors. It has zero to do with business norms. Plenty of high-stakes deals are negotiated asynchronously. 

How you push back and (respectfully) assert yourself in negotiations with other business parties will set the tone for your long-term relationship. If you allow them to force you into circumstances that favor them, they will do it indefinitely. There is nothing wrong with responding, diplomatically, that while you of course would love to grab beers and meet up in person for more casual matters, for real business, you expect time to consult with advisors.

If you’re working with people whom you should want to build long-term relationships with, they will respect your request.  In fact, I’ve known some great VCs and other business people who are very upfront about the experience imbalance with new entrepreneurs, and insist that companies work closely with key advisors.  Those are people playing a long game, and who know that their reputation in the market matters more than short-term opportunism.

If the person you’re negotiating with rejects your request, and dictates to you the medium of negotiation, then at a minimum you’ve gained some key information on what the relationship is going to really look like if you choose to move forward.

Commercial / Tech Transactions Lawyers

TL;DR: Apart from early-stage specialized corporate lawyers (startup lawyers), there’s a second kind of lawyer that almost every early startup needs: a commercial/tech transactions lawyer.

Background Reading:

Imagine you run into a doctor who says he can (i) perform heart surgeries, (ii) treat cancer, (iii) treat your asthma, and (iv) provide pregnancy care, on his own, and all at a lower than market cost. Is your first reaction “wow, this guy is an incredibly affordable genius!” ? A cardiologist, oncologist, pulmonologist, and OB/GYN all in one!

Probably not.

One of the first points I make to young tech entrepreneurs about how to source legal counsel is that the statement “I need a lawyer” is almost completely useless without specifying what kind (specialty) of lawyer. The complexity of the legal issues that even young emerging companies deal with is simply too high to entrust all of them to a single “generalist” claiming to be a jack of all trades. This is not a coffee shop, or a bakery. The stakes, and potential liabilities, are much higher.

OK, you might say. I’m a startup, so I need a startup lawyer. Well, that’s an improvement, but what exactly is a “startup lawyer”?

In my experience, the correct definition of a “startup lawyer” is a corporate lawyer with a strong specialization in early-stage emerging companies and venture capital/angel financings. Very different from an M&A Lawyer, or a corporate lawyer who handles middle market or public company work. Startup lawyers typically serve as GC (General Counsel) for early-stage startups, which requires them to have a workable understanding of tax law, securities law, commercial issues, IP, and labor/employment legal issues.  They’re not experts in those areas (corporate law is their specialty), but they’ve seen those issues enough to cover the basics, while also knowing when to rope in deeper expertise. Your corporate/startup lawyer should serve as the quarterback of your general legal team.

For most startups we see, probably 50-75% of Pre-Series A legal needs are covered by these startup-specialized corporate lawyers: formation, financing, hiring and firing, equity compensation, etc. Small amounts of patent or trademark work may be needed by appropriate specialists, but that’s a minority of cases pre-Series A.  But there’s a second kind of lawyer – who isn’t a “startup lawyer” – that virtually all of our early clients end up needing, and that all founders need to be aware of in sourcing their own counsel: commercial, or sometimes called “tech transactions” lawyers.

Startup/corporate lawyers typically handle the more ‘internal’ issues of a company and its stakeholders: relating to the company’s founders, its employees/service providers, and stockholders.  Commercial or Tech Transactions (let’s use C/T) lawyers, in contrast, typically manage legal issues and contracts relating to a company’s customers/users and potential commercial partners. A good 25-50% of pre-Series A legal needs will often get handled by a C/T lawyer. Examples of C/T Lawyer work:

  • License Agreements (Inbound and Outbound)
  • OEM, Reseller / Distribution Agreements
  • Terms of Service and Privacy Policies (which may also require Data/Privacy Lawyers, but usually not)
  • EULAs, API / SDK terms
  • Technology Transfer Agreements
  • Manufacturing / Supply Agreements

The nature of these kinds of agreements is very different from the kind of work a classic “startup lawyer” does, and while most solid corporate lawyers probably could wing a simple version of a tech transactions document, I am deeply skeptical of a lawyer who claims to be able to handle both all of a company’s corporate needs and their commercial/tech transactions needs for a serious amount of time. In the very early days it *may* work, but even with a small level of scale it’ll start to look a lot like the “genius” doctor mentioned above. The most dangerous (and, in the long run, expensive) type of lawyer is the one who doesn’t admit what he/she doesn’t know, but incentives to maximize personal revenue often lead lawyers to exaggerate their abilities.

So, in short: if you’re building a tech startup, you don’t just need “a lawyer.” You need specialists. And a true startup lawyer, even a very good one, is very rarely enough. Ensure you have access to a solid commercial/tech transactions lawyer (reputable startup lawyers work with them). If you don’t, you’ll eventually regret it.

More Tech Startups are LLCs

Background Reading:

If you have spent almost any time reading about the basics of startup legal issues, you know that Delaware C-corps are the default organizational structure for a “classic” tech startup (software, hardware) planning to raise angel/VC money and scale. I’m not going to repeat what you can read elsewhere, so I’ll summarize the core reasons in 2 sentences:

Delaware because DE is the “english language” of corporate law and all serious US-based corporate lawyers (and many foreign lawyers) know DE corporate law.  C-Corp largely because (i) VCs have historically favored C-Corps for nuanced tax and other reasons, and (ii) virtually all of the standardized legal infrastructure around startup finance and equity compensation assumes a C-Corp.

However, times are changing. Over the past few years, we’ve seen a noticeable increase in the number of emerging tech companies that, despite knowing all of the reasons why startups favor C-Corps, deliberately choose to organize their company, at least initially, as an LLC. To be clear, C-Corps are still the norm, by far. But the C-Corp / LLC mix has, for us at least, moved maybe from 95/5 percentage-wise to about 85/15. That’s an increase worth paying attention to.

The growth in interest around LLCs has very little, or really nothing, to do with legal issues, in the sense that nothing much has changed about LLCs or C-Corps to drive people in one direction or the other.  The main drivers, from our viewpoint, are:

  • Many tech entrepreneurs no longer view venture capital as an inevitability in their growth path, and have grown skeptical of the traditional “growth at all costs” mindset found in many startup circles; and
  • An increasing number of VCs are growing comfortable with LLCs.

Profitability is now a serious consideration among tech entrepreneurs. 

C-Corps have 2 “layers” of tax: corporate-level tax, and then tax at the shareholder level. LLCs don’t have a corporate-level tax, and therefore have only 1 layer. Speaking in broad terms, this “disadvantage” of the C-Corp structure has not deterred tech startups for one simple reason: the corporate level tax is on profits, and many tech startups don’t intend to be truly profitably any time soon. Achieving very fast growth through reinvestment of any ‘profits’ has been the dominant growth path among tech entrepreneurs, which means no “profits,” which means being a C-Corp doesn’t really result in more tax.

However, the zeitgeist among startup ecosystems is shifting from “focus on growth, and raise VC” to “unless you’re absolutely positive you’ll raise VC, keep your options open.” Keeping your options open favors starting out as an LLC, because converting an LLC to a C-Corp is way easier than converting a C-Corp to an LLC. The reason for that is simple: the IRS welcomes you with open arms if you choose to move from 1 tax layer to 2. But going in the opposite direction costs you significantly.

As more tech entrepreneurs take seriously the possibility of building a profitable, self-sustaining business, their interest in starting their companies as LLCs is growing, because building a truly profitable business as a C-Corp is much more expensive (tax wise) than it is as an LLC. Many angel investors, and also strategic investors, are comfortable investing in LLCs, particularly under a convertible security structure that doesn’t immediately result in equity holdings.

So starting as an LLC allows you to build your company, and even raise some early capital, while letting things develop to see if you’re really building a business that needs conventional venture capital (and then convert to a C-Corp), or if you’re building one that may instead become profitable and distribute profits to investors (stay an LLC).

VCs are also growing more comfortable with LLCs.

The conventional line given for why VCs “must” invest in C-Corps is that the “pass through” treatment of LLCs can result in various negative consequences to their own investors (LPs), many of whom are tax exempt – so the C-Corp structure prevents the tax problems. However, more sophisticated VCs have realized that in most cases this problem is quite fixable. They can set up what’s often called a “blocker corp” that eliminates the possibility of pass-through income negatively impacting their tax-exempt LPs. Problem solved. It’s not that hard to do.

Truth be told, a lot of VCs still don’t want to mess with LLCs. But at this point it has more to do with inertia and a desire to minimize their own legal bills than any real legal issue. Also, most VCs are only looking for companies in a high-growth track where any net revenue will be reinvested for growth (no corporate profits, no corporate tax), so they are selecting for companies for whom an LLC structure isn’t really that appealing.

But not all VCs think that way. VCs are growing increasingly comfortable with LLCs, and when it makes sense, they will invest in them.

If you are an LLC tech startup, you need tax counsel.

If you are a tech startup that wants to be an LLC, realize that while LLCs may save you taxes, they will not save you legal fees. Equity compensation, particularly to employees, is much more complex under LLCs, and requires the oversight of true tax lawyers. It is not something to be handled solely by a “startup lawyer.” Any law firm working with LLCs should have access to tax specialists, and if they don’t, that is a red flag.

Also, as startups move from a uniform growth path to one that considers a wider variety of sources of capital (angel, non-traditional seed, strategic, private equity, debt, royalty-based, etc.), they need to accept that the standardization found in conventional Silicon Valley-style fundraising is simply not a possibility. The huge push to standardize investment documentation into templates that can be almost automated stems from the “billion or bust” mindset of classic VC-backed startups. In that world, everyone is a Delaware C-Corp. Everyone is trying to be a billion-dollar company that will eventually get acquired or go IPO. All the angels talk about the same things on twitter and are comfortable investing on the same docs. So just automate a template, plug in some numbers, and focus on growth.

But in a world where everyone isn’t a Delaware C-Corp; everyone isn’t on the same “billion or bust” growth path, and there is far more diversity among companies and investors, the conditions for heavy automation and standardization simply aren’t there, and likely never will be. It requires real financial, tax, legal, etc. advisors to handle real complexity, while right-sizing it for the stage and size of each particular business.

The truth is that outside of a few large startup ecosystems, there has always been much less uniformity among financing structures. Software engineers – frustrated with their inability to force everyone into uniform documentation that can be automated – have criticized this reality as backward and just needing to “catch up,” but to people on the ground it’s been pretty obvious they’re just hammers screaming at everyone to become a nail. More entrepreneurs are no longer comfortable being pigeon-holed into a one-size-fits-all growth path or legal structure, and long-term that’s a good thing for everyone.

“Founder Friendly”

TL;DR: “Founder friendliness” should mean not being hostile, but also not being submissive, to founders. Good entrepreneurs and advisors know that.

Background reading:

Because we’re known as Startup/VC lawyers who don’t represent Tech VCs (just companies), I often get asked about my thoughts on “founder friendliness.” Occasionally it’s someone inexperienced expecting me to say something totally one-sided, as if “founder friendly” means always giving founders what they want. The truth is, I’ve put my fair share of founders in their place, when appropriate. As I’ve written before, company counsel does not mean founder’s counsel.

Serious lawyers provide counsel, and represent something apart from the preferences of any particular person. They don’t just push paper in whatever direction someone tells them to. Real lawyers know when and how to say “no.”

To me, “friendly” means the opposite of “hostile.” It means respecting a person as an equal, being transparent with them, and strongly taking into consideration their own values, goals, ideas, etc.  But that is very different from spinelessly doing whatever they want you to do. The best founders seek out advisors, including investors, who will provide real, critical input; knowing that a bunch of sycophants will get them nowhere.

Founder Hostile

On the one hand, there is very much a culture among certain venture capitalists that treats entrepreneurs as necessary, but ultimately dispensable, steps toward returns. I have seen it firsthand, and while it exists everywhere, it is directly (negatively) correlated with (i) the number of investors willing to write checks into a particular ecosystem, and (ii) the degree to which entrepreneurs confidentially share information among each other on VC behavior, producing adverse selection issues for the real assholes. You very rarely hear about this on blog posts or twitter, but when the pep rallies and PR-oriented speaking panels come to an end, it is there.

VCs in this category vary in the level of sophistication with which they implement their “founder hostile” strategy.  Most know that playing hardball out of the gate won’t get them the deal, and they prefer more of a “bait and switch” approach where they sing the praises of the entrepreneurs upfront, and then slowly move the chess pieces over time. The moves are identifiable by people who know the game:

  • put “captive” lawyers and advisors in place;
  • avoid providing coaching / training resources to founders;
  • tightly control the recruitment of new executives to phase in loyalists;
  • keep a tight grip on unreasonable budgets so that achieving results is very hard, and failure justifies “necessary changes”;
  • maneuver to prevent competitive funds from putting offers on the table;

In the end, it doesn’t matter what the cap table says; it’s “their” company now.

Founder Submissive

On the other hand, in the most competitive deals and ecosystems, there is a counter-dynamic where VCs compete with each other, essentially, on how much unilateral control they’ll give entrepreneurs. This dynamic is strongest in California. It’s, in part, due to the failure of many VCs to effectively apply basic strategic concepts – like differentiation – into their market positioning. If you’re just another VC/fund with a few connections and ideas among dozens of others, what else can you do but try to be the “easiest money”? The end-result of having these “founder submissive” investors is often immature management teams that aren’t able to effectively scale. VCs with real brands are able to avoid this. 

As I’ve written before, a Board of Directors has fiduciary duties to all stockholders. As you’ll read in many different places, the moment an entrepreneur decides to take on investors, they have to step off the “king” train and focus on growing the pie, and eventually achieving an exit, for everyone.

That being said, under DE law Boards have primary fiduciary duties to common stockholders, insiders and outsiders.  As the largest common stockholders (usually), and those who’ve held the equity the longest, entrepreneurs are extremely important representatives on the Board for fulfilling those duties; whether or not they are in the CEO seat.  We know that preferred stockholders and common stockholders regularly have misaligned incentives.  A truly “balanced” Board will prevent one part of the cap table’s incentives and preferences from overriding those of the others.

“Founder hostile” VCs are problematic because they push for the perspective of institutional investors to override those of all the other constituents on the cap table. “Founder submissive” VCs are equally problematic because they expose the company excessively to founders whose priorities may conflict with the economic interests of the broader stockholder base.

The proper balance is, of course, in the middle; where the VCs with the best reputations operate.  Be transparent about your goals, incentives, and plans. Don’t beat around the bush about your investment horizon, exit expectations, and how you’ll approach executive succession when that time comes. Let the common stockholders, including founders, do the same. No BS or opaque maneuvering. And then work together, knowing that no one has the singular right to override the perspective of the others at the table.