How VC Hopefuls Should Form a Board of Directors

In short:

• Companies that plan to seek outside capital should form a board at inception. Even if not legally mandated, it’ll serve you well.
• Avoid recruiting a squad of yes-men; seek directors with expertise in three specific areas.
• Considerations also include potential members’ capacity to invest energy in your endeavor for the long haul.

For some small companies, creating the right board of directors is not a primary goal. But for those who will seek angel and venture funding, it’s critical. And it starts with seeking the right type of relationship to your board. In my experience, the success of the relationship between the CEO (representing the company management) and the board is gauged by the answer to this question: Does the board work for the CEO, or does the CEO work for the board?

The best situations I have observed are the former, in which the board maintains a firm supervisory role but actively looks to help where and when needed. When the board acts as the stern parent in charge, instructing the CEO about whom to meet and which tasks to pursue, the relationship is not symbiotic and can quickly become toxic.

As an early-stage growth company, you’ve got some work to do. Setting up the board is basically non-negotiable — more on that below — as is carefully contemplating its size and makeup, both of which can change as your business grows. Many of the best practices below pertain to firms that intend to pursue outside capital, though others will find them a helpful framework as well.

Setting Up the Board

As soon as you establish your company, you should start constructing your board of directors. The urgency with which you do so depends on the type of business structure you’ve chosen:

*See state-level requirements compiled by Pennsylvania-based Harbor Compliance.

Size of the Board

Most states that have laws regarding company boards require a minimum of three members. An exception is Delaware, the state of choice for most corporations including heavy hitters Apple, Google and Walmart. The popular corporate tax haven mandates only one director.

The traditional first member of the board is the founder and CEO of the company. The founder/CEO often also assumes the role of chairman of the board initially. After the company matures and takes in outside money, it may give the chairman role to an outsider. Roughly 50% of companies have their CEO serve as chairman, while the other half have a separate chairman on their board, according to the Spencer Stuart Board Index.

The CEO generally takes the only internal management role on the board. If there are co-founders, there may be two sitting on the board. If there are other C-level executives such as CFO and COO, they typically report in at board meetings but do not have voting rights. The idea is to preserve critical seats for outsiders who will provide expertise in a specific area: If you’re in ecommerce, perhaps this is a buyer at a target account. If you have investors, they may also demand a seat. However, your C-suite should still be intimately involved in key decisions. These executives often present at the board’s general meetings and are invited into a select few of the closed session portions.

Composition of the Board

Once you’ve raised outside capital, investors will want some ability to influence the business direction, usually via a board seat. Be careful: Just like party invitations, board seats are easy to hand out but nearly impossible to rescind. And if you don’t get along with your guest, it’s difficult to get them to leave your fête.

Unfortunately, I have observed many early-stage companies whose board consists of the CEO/founder and two friends/family members who are likely to see things the way the founder does. Being surrounded by yes-men may make the founder/CEO feel secure in her role, but she is missing out on outside opinions and different perspectives that could prove vitally important to the survival of the company. Further, a board full of pals sends a message to potential investors about your ability to handle constructive criticism and listen to others:

Boards as they mature should seek to include diversity in all its forms. Anecdote after anecdote, along with my personal experience, suggest that diversity of board members — and thereby diversity of thought — is truly a secret to success for most boards. And as you grow, it can pay dividends: A McKinsey survey of public companies found that those in the top quartile for ethnic and racial diversity in management were 35% more likely to have financial returns above their industry mean.

Start With Three, but Not Any Three

For your initial board, be selective and strive to find members with specific skill sets. While all board members will be responsible for ensuring management is operating ethically and in the best interests of shareholders, there are three main areas in which you will likely need help.

1. Fundraising

Early-stage growth companies that are likely on the path to breakeven and steady state profitability should always be either raising or strategizing on when they will need to raise funds. Senior management should be in a regular dialogue with existing investors and plotting funding needs over the coming 12-18 months. A board member with financial acumen in the fundraising world, ideally with a strong network, can be a huge asset. Access to a Rolodex of angel investors, venture funders and bankers can dramatically speed up the process with focused outreach to established contacts at the right time.

2. Strategic Direction and Planning

The CEO and management set the strategic direction of a company, plain and simple. But oftentimes, intelligent prodding from experienced board members — who have built similar companies themselves — can refine and focus the strategy. When management is buried in day-to-day operations, it is often difficult to take a step back, pause and be self-critical. This is where a board can act as a sounding board and therapist of sorts, helping management see the big picture more clearly.

As an angel investor in Fabulis, a social networking website from the early 2000s, I was surprised when, despite early traction, the company decided to “pivot” and become an ecommerce site called Fab. It was the experienced board’s constructive questioning whether Fabulis could scale to become a large company that caused the founders to reflect and ultimately change direction. Fab became quite successful, reaching unicorn status before expanding too aggressively. Nonetheless, its story shows that the board’s strategic focus helps management reflect and plan optimally.

3. Human Resources

Paying recruiters to find key talent, whether it’s a developer, salesperson or marketer, is costly and most times a non-starter for companies closely managing cash flow. A board member with a broad network from prior operating experience and/or investments can lead to top-notch candidates — without the cost. As an investor and board member/advisor, I’m always looking to help, and the easiest way is to match great people with a company I am involved in. If I know the leadership’s personalities and the company’s culture, then I can immediately think of a couple of candidates who may be interested in joining.

A big problem I have noticed while investing and serving as interim CFO is the failure of companies to properly allocate equity to key employees below the C-level. Each quarter during a board meeting, a critical task entails approving employee stock options. At many companies, management crafts the employee option amounts, and the board just provides a rubber-stamp approval. A good board, however, looks at the big picture and ensures that critical employees, whether it’s a young developer or an SEO specialist, are being recognized in terms of equity. Equity can majorly incentivize employees, making them feel like true owners of the business. Use it.

Board Observers

As CEO, what do you do when an early angel investor or VC who made a minimal investment wants a seat on the board? There are a limited amount of seats, and too many opinionated people can lead to paralysis and confusion when making decisions. In these cases, a board observer is the answer.

An observer role allows the person to attend board meetings and stay informed, without voting rights and the corresponding fiduciary responsibilities. Having 2-3 board observers lets you keep your investors in the decision-making loop without making the board unwieldy to manage. It also paves the way for a VC to, for example, increase his investment after hearing about a certain development or strategy in a board meeting. This can save management the time and effort of courting new investors and catching them up on the company story.

Growth of the Board

As your company grows in size and complexity, you will likely take in more outside capital. If they have made a serious financial commitment, large angel investor(s) and venture funds will want, and in many cases demand, a board seat.

As you look at taking investments, be mindful that giving a VC and/or angel investor a board seat is a marriage, not a short-term fling. They may seem upbeat and encouraging in the early days, but when times get tough — as they inevitably do for any early-stage business — they could show unsavory traits, or they may not have the mental acumen and experience to help you navigate the waters.

For growing businesses, board size tends to settle out around 5-7 members. At this point, you should take a serious look at adding independent board members. The New York Stock Exchange defines an “independent” director as one who has no material relationship with the company. Ideally, this independent has a firm understanding of the sector in which the company operates.

Start by searching for an executive within the industry, or one parallel to yours, who has successfully navigated whichever situation your company will likely face in the coming months and year. If you are having issues with your supply chain, look for someone at one of your suppliers or an adjacent one. If you’re scaling downmarket in sales, find someone with a smaller-business sales background.

Oftentimes, venture capital investors will strongly suggest an independent whom they know from prior investment and/or boards. Be careful here: While this person is not directly affiliated with the VC, their allegiance is with the VC. And if/when push comes to shove, this person will often side with the VC in order to preserve the relationship and safeguard potential future roles. Talk with multiple candidates for the independent role. Learn about their history with the VC, and determine whether they can truly serve on your board independently.

Find a truly independent board member early. Their expertise can be in your field specifically, or in finance or governance in general. Depending on the stage, profile and funding of the company, independent board members are typically compensated in equity (.5-2%). In later-stage companies, there can be a salary component.

Pass on Trophy Board Members

Avoid what Fred Wilson from Union Square Ventures terms “trophy” board members. This is someone with a big name who, in theory, brings credibility and connections to your company. In my experience, these members are more concerned about their reputations than your company and will often react badly in times of challenge. They often miss board meetings and show up unprepared, and they frequently don’t take the time to truly understand your business.

Now, do not confuse “trophy” with “celebrity.” You can have a board member who is a big name in your specific industry or category. Just make sure that whomever you bring on will take the role seriously and realize they need to prepare for and participate in regular board meetings — and provide some valuable help along the way.

Board Mechanics

Boards should meet quarterly, either in person or virtually. The trick to productive board meetings is providing regular updates prior such that the meeting is more of a back and forth conversation versus educating board members on the latest company developments.

The cadence at which you communicate with board members early on will establish a precedent, and board members will expect it to continue. I have seen so many situations in which board members become far too involved with management because management didn’t set boundaries regarding the frequency of updates. Board members need to be updated with major developments, but when they get involved in day-to-day operations, it can overwhelm management and serve as a major distraction. I recommend short, 30-minute, informal updates with individual board members either twice monthly or once per month.

A well-constructed board can mean the difference between hiring the key developer you’ve desperately searched for in short order or not at all. It can mean getting critical funding or resetting strategic direction before it’s too late. So be patient, selective and thoughtful. Create a board whose members bring different talents to the table. Don’t rush to fill the board and end up with a squad of yes-men. Make sure members understand the commitment and expectations that come with the role. Above all, management and the board must have a symbiotic relationship for your company to truly work.

Josh Burwick is an active private technology investor with a particular focus on software, Blockchain, e-commerce and sports betting technology. He has served as an interim CFO and advised on strategic fundraising for a variety of technology companies, ranging from Series A to Series D rounds.