Great form, wrong director formulation

Some law firms (big emphasis on some) are adapting documents, technology and processes to drive out waste and reduce costs – just as the startups we represent are doing in their industries.  My colleague Jose Ancer calls it The Economic Deflation of Startup Law.  The startup legal environment has continued to change for the better, and part of that has been built on the continued move to more universal standardized legal documents.

For early stage equity financings, Egan Nelson clients typically use forms.  It provides a set of docs for an early round and let the company and the investors close a deal with minimal back-and-forth… if the company and the investors and the lawyers are willing to avoid tinkering around too much (big emphasis on if).  No time needs to be burned talking about things that can wait for later financing rounds, like IPO registration rights.  

I’ve seen the forms – initially developed by Ted Wang and team at Fenwick, with more recent modifications by Cooley – more frequently in east coast deals, and I’ve found them to be straightforward and generally very well balanced between serving the interests of companies and investors.  

Using the forms can drive out waste, and reduce costs.  But for docs that are otherwise very balanced, they often lead to a director formulation that, as a lawyer for early stage companies, is too investor-friendly. 

The Board of Directors, post financing, will consist of three categories of director:

  1. Common Board Designees (usually the founders will control this category)
  2. Series Seed Board Designees (the investors will control this group)
  3. Mutual Consent Board Designees (requiring the majority investors and majority common stockholders to agree on a designee)

Now, the forms do say how many of each category of director the company will have.  So a negotiation could lead to two Common Board Designees, one Series Seed Board Designee and no Mutual Consent Board Designees.  That would be a “founder friendly” result.  But all too often, I’ve seen this element of the deal negotiation lead to a “simple” 1-1-1 formulation where there is one director seat for each category.  The problem for founders is that it gives away board control at such an early stage.  Generally, too early.  Yes, the “mutual consent” part means that the board seat can’t be filled without the consent of the common stockholder majority.  But it doesn’t protect the founder from that director acting with the investor’s board designee to – worst case founder scenario – change company leadership.  Fire the founder.  Now, that’s the worst case scenario.  

The broader problem is that 1-1-1 puts the founder in a minority position from the moment the first outside equity investment hits.  That’s usually too early in the company’s development for the founder, the investors or anyone else to know exactly where the company is headed.  When we are company counsel, we’re the lawyers for the company, and not for the founders individually.  The founders are an integral piece of the puzzle, and it’s in the best interest of the company for founders to feel “all in” from the beginning.  You’d be hard pressed to find smart seed investors that back ideas alone or code alone, but somehow don’t want that founding team there.  So if the investor is backing the company because of the founding team, then the founding team should use leverage at the seed stage to be sure that the company’s destiny – at least as it relates to the operation of the board – initially remains in the founding team’s control.

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