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.
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, or who depend on them for referrals. In 80-90% 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 10-20% 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 with sufficient assets to litigate with, 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:
- 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.
- 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.
- 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.
- 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.
- 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.
Also published on Medium.