In recent years, more and more investors such as angels and early stage venture funds are reluctant to take up a board seat due to governance and compliance reasons. In this article, we’ll take a look at the advantages and disadvantages of board observer status in a company.
Board observer rights – how does it work?
Board observer rights are not defined under the companies law. There is no common law right that allows an investor to attend and observe board meetings including receiving a copy of the board pack (eg, board papers and disclosures) or receive the records or minutes of the board meetings. In other words, the board observer rights are covered and defined in a contract (usually inside a shareholders agreement).
Who gets to be a board observer?
In practice, there is no hard and fast rule on who gets to be a board observer. A board observer status can be granted from anyone from owning just over 1% to as much as 10% of a company. In other words, there is no specific formula per se on who gets to be a board observer.
Advantages of board observers
Board observers are not formal members of the board. They are not aware of fiduciary duties to the company. But a board observer usually has the same confidentiality obligations as members of the board. Additionally, board observers may even get excluded from meetings to preserve the company’s confidential discussions or if there is any potential conflict of interest.
Usually, early stage investors from angels and early stage venture funds tend to take a back seat role in the company. As a founder, so long as the usual monthly or quarterly business reports and accounts are sent to the investor, they would probably just leave you alone to run your business.
As a passive shareholder (eg, venture fund or angel), it may be a hassle for the investor’s director to be involved in signing the usual paperwork and annual returns every time the filing month arrives. Additionally, a director is personally liable for any breach of laws by the company. For instance, if a startup fails to pay the usual statutory contributions for its employee, all the board members are personally liable. Directors have been fined and even jailed for failing to fulfil the employment laws.
In several venture details I’ve involved recently, it is more common for venture funds not nominating any board member despite the subscription and shareholders agreement allowing for such venture capital to nominate a board member.
I can understand their reservation.
A venture partner in a venture capital may be sitting on numerous other boards in other portfolio companies. Also, devoting the necessary time and resources to prepare for a board meeting can be a hassle. Although it is easy now for all board members to get together via a virtual call, getting every board member to agree on dates and times can be a nightmare (especially if you have board members living in different time zones).
So a venture partner may be reluctant to take up a board seat because of the additional statutory duties and obligations imposed on him.
Disadvantages of board observers
Unfortunately, as a board observer, you may not have the real voting powers unlike a director under the companies law.
This is not a deal breaker.
An investor who is a board observer can address other corporate matters and decisions by incorporating the usual reserved matters to the board observer with an affirmative or vetor right.
Usual corporate decisions like hiring new staff or firing existing staff, dividends declaration, capital expenditures or even future funding rounds can be agreed inside the shareholders agreement between the existing shareholders (eg, founders and other founding team) and the investor.
In practice, a venture fund may also request for a plus-1 which means that the venture partner may bring along his or her associate or analyst to tag along during the board meetings.
As an early venture company, you need to manage your board carefully so that you don’t end up with too many board members (or ‘too many cooks inside the kitchen!’ scenario)