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May 8, 2024

The Case for the Independent Director

Episode Summary

An independent director can play a crucial role in mitigating conflicts of interest among board members while also providing valuable input. Heidi explains what an independent director does and why it’s important for a founder to include one on their board.

Full Transcript

HEIDI: Welcome to the Startup Solution and “The Case for the Independent Director.” I’m Heidi Roizen from Threshold Ventures.

In the last episode, I talked about why good governance generally leads to better outcomes. And how good governance can also help entrepreneurs stay out of trouble.

I want to build on that today by focusing on a role in governance that I think is super valuable, even though it’s often overlooked.

. . .

I’m talking about independent directors.

Independent directors are exactly what it sounds like they are. They’re directors who have no other affiliation with your company – they’re not employees, they’re not investors, and they don’t do any other form of business with your company either.

So, if I think they’re so great, why don’t more startups have them? Well, first of all, I think it’s because they’re not required for early-stage companies to have, so nobody seems to push for them or even think about them in the early days.

. . .

The first directors are usually the founders – one or two of them – who name themselves as the directors when they incorporate the company since all C-corps are required to have at least one director.

Typically, the next time a board discussion comes up is when they go out to raise money. As I covered in the last episode, we investors usually have a fiduciary responsibility to our limited partners to manage those investments as well as we can. And taking board seats is considered one of the best ways to do that. So, those board seats typically get added and given to one or two investors with each new round of financing.

But when it comes to independent directors, there’s no forcing function requiring you to have them until you go public.

But while they’re not required, let me explain why I think you should have at least one on your board, even at the very early stages. And two would be even better.

. . .

Independent directors are unique in that all the other directors, including the founder/employee directors, are conflicted in some way. And that can become problematic.

The investor directors are conflicted because they almost always have preferred stock, which stipulates that they get their money back – or more – before common shareholders get anything. And even more complicated, some companies have stacked preferences, which means some of those investors will get their money even before others of those investors – and all of them still before the common shareholders.

I’ve gone into detail about stacked preferences in prior episodes, and I’ve put a great explanation of them in today’s show notes. But the key point is, when all shareholders won’t be treated the same in certain outcomes, and some of those shareholders also sit on your board, what may be in the best interest of your company may not always be aligned with their individual best interest. And that’s the conundrum of conflict.

. . .

Founder-directors tend to hold common stock, so they’re largely aligned with other common shareholders, but there are situations when they can also be conflicted. For example, imagine the company is in the process of being acquired, and there are two offers. One of them is lower, but it has a way-over-market employment agreement for the founder-director to join the new company. That person’s now conflicted because that offer gives them an additional benefit that other shareholders aren’t getting.

Virtually every startup board is filled with conflicted directors. It’s nothing new, and boards can still be highly functional even with these inherent conflicts. In fact, it’s often quite useful to have all the big shareholders already around the table. It’s not all bad.

. . .

Plus, as you learned in the last episode, all directors are bound by the duty of care and the duty of loyalty, including conflicted directors. That means that they’re supposed to give thought and attention to their service as a board member – and that they’re supposed to put the needs of your company and all its shareholders ahead of any competing interests they might have.

Those aren’t just words – that’s the law. In outcomes that end up in litigation, such as acquisitions that leave some of the shareholders in the money and others out, the legal process will seek to uncover whether all the directors operated with those duties of care and loyalty. And if they didn’t, that can mean big trouble.

The vast majority of entrepreneurs and investors I’ve sat on boards with work hard to honor those duties in their board work. But not everyone does. And even those who do can get into sticky situations that may look like they didn’t – when they get sued, years later, about something they barely remember and didn’t properly document.

. . .

The point is that disappointing outcomes may be contested months or years later, and your defense of your actions will come down to who made the decisions and what process they used to come to those decisions. And independent directors can play a key role in making those processes stronger and more defensible.

If you have one, or even better two, use your non-conflicted directors to lead the M&A process. This is often done by forming a special committee of only non-conflicted directors to be the first line of consideration for any transaction. They should also be given a budget for subject matter experts such as bankers and lawyers to aid in both the process and the documentation. This will be hugely helpful in defending what the board did if you do end up in litigation.

But you can’t form a committee of independents if you don’t have any. And if you’re already in the heat of something like this, it’s pretty much too late to bring them on. Not impossible, but it’s sub-optimal to have people brand new to your company suddenly in charge of a transaction so big and important. So best to get them on board much earlier than you’re going to need them.

. . .

Independents can also make great chairs for compensation committees. I don’t know why, but some investor directors can be a bit cheap about paying people, especially for pre-revenue companies. And equity grants for founders can become contentious, too. I’ve chaired a number of comp committees myself, and I think I’ve done a good job – but I’ve also been on many committees chaired by independent directors, and I have to admit, their independence can give the investors, the founders, and the employees extra comfort that they’re being objective.

Another thing about independents is that they report to no one. All your investor directors likely report to someone in two ways that may impact you. First, their seat is usually designated to their firm, not to them as an individual. And that means that their board seat might be swapped out to someone else at their firm, outside of your control.

Investor directors also usually report back to their partners about your company and what’s going on with it. This means that even when they’re trying really hard to be unconflicted, a part of their brain is always thinking about what they’re going to report to their partners. And how their partners – who don’t have to worry about director duties, just about the shares they own – will react to what they report.

On the other hand, independent directors don’t report to anyone in a boss sense, nor in an informational sense. Their only job is to be a voice representing what’s best for the company and all its shareholders, so they can put all their focus on just that.

. . .

Here’s another advantage I’ve seen. For many entrepreneurs, they find it hard to lean on their investor directors about some of their personal struggles, or use them as a sounding board, because in the back of their minds they’re always thinking, “I need this person’s fund to support my next financing”. Because an independent director is not going to be a check writer, there’s a comfort level a founder can have with them that some may not feel with their investor directors.

Some companies also designate an independent to be the lead director. This gives the independent director extra weight in sorting out issues where investor directors might disagree with the CEO or even with each other.

Of course, all this goodness only happens if you pick people who are highly capable of doing the job. Someone who doesn’t have the willingness and the knowledge to do this kind of work isn’t going to give you these benefits. So, choose carefully.

. . .

The expectation is that board members are not just there to govern – they’re there to help. So, I’d focus on finding people who can not only do that governance job but who will also bring additional superpowers to your company. You might want to pick someone with experience in your sector. You might want someone who has been a founder or CEO themselves, who will have empathy for your job and experience that can help you.

Maybe you want someone with experience related to your company’s current stage of growth. Maybe you want one who has been through the IPO process and can help you get through it yourself – and if that’s the case, congratulations!

Oh, and one more idea – not to demean my industry, but the VC world is not exactly a bastion of diversity. If your board members are all a little too much alike, the independent seat gives you a chance to improve on that.

And as a final consideration, you want someone you can trust, and someone you’d enjoy spending the next three or four years working with, since that’s the typical term for an independent director.

. . .

So, who actually picks the independents? Well, it’s not set in stone, but it’s usually up for negotiation when financing rounds are done. Usually, independents are not picked exclusively by investors. (I think the reasons for that should be obvious). Most often, they’re nominated by the common shareholders and then approved by the rest of the board.

Luckily, the vast majority of investors see the value in independent directors too, and investors like me are happy to have them. After all, they improve board processes, which can lead to better outcomes. And in not-so-good outcomes, well, we investor directors get sued too, so we should be happy to have them around.

And a final point – for most private companies, at least until a much later stage, independent directors are paid only in common shares, no cash, so they’re highly aligned with the other common shareholders.

. . .

So, what can you learn from "The Case for the Independent Director?"

First, independent directors can play a crucial role in mitigating conflicts of interest among board members. Since everyone else on the board usually has a conflict, whether that’s due to preferred shares or employee considerations. Independent directors provide valuable input unencumbered by any other competing interests.

Second, independent directors, coupled with good processes and documentation, can add an extra layer of proof that the conflicted directors did not overly influence what happened, especially in M&A. This should help you not only achieve better outcomes but also avoid costly lawsuits down the road.

Third, because independent directors report to no one and are not beholden to any other interests, they can provide unbiased guidance, especially in sensitive areas like compensation. They’re also great when the founder wants to talk to someone who both knows the company well and is not directly involved in its future financings.

And finally, independent directors can also bring diverse skill sets and experience to the boardroom, beyond just the governance part. Whether it's industry expertise, CEO experience, or familiarity with the IPO process, they can bring extra superpowers to help you and your company be successful.

. . .

HEIDI: And that concludes “The Case for the Independent Director.”

Thanks for listening to The Startup Solution. We hope you have enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

Every entrepreneur who raises capital should understand how preference structures work and the inherent pitfalls this creates in corporate governance. Excellent article on the topic here.

Fortune recently published an interesting piece on director independence. While it is mostly aimed at public companies, there are good considerations for private companies too: Why director independence matters, and how boards can ensure it

PwC issued this handy guidebook to the whys and hows of adding independent directors to private boards, which you can find here.

A solid checklist from Underscore.vc for bringing on an independent director here.

And finally, when you’re ready to actually look for that great independent director, theBoardlist can be a great resource for you, as can Bolster.

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