In a young business, the founders are likely to be both the owners and the managers of the business – the shareholders and the directors.
How decisions are made differs between the board meeting and the members’ meeting.
The directors of most start-ups vote on board level decisions on a show of hands. That means each director has an equal vote regardless of whether he or she owns equity, or how much.
By contrast, most shareholder motions are carried based on the approval of the shareholders who between them carry the majority of the equity. That rule can be varied by mutual agreement between them all, but in general, it is the larger shareholders who sway the decisions.
This difference means that any large shareholder, such as an angel or venture capital investor, is likely to want at least one seat on the board in order to keep some control of the company between shareholder meetings. The founders might not want to give more control of the company to the investor (who already has significant power as a shareholder). The question then becomes: how should the investor participate in board decisions?
One way of doing that is for the investor to have the right to appoint at least one non-executive director. That person wouldn’t be a management-level employee of the company, but rather simply someone who can express the opinion of, and vote in the interests of the investor.
Founders (or indeed other investors) might not agree that the investor should have board level voting power. A compromise is often that the investor can appoint an observer to the board instead. The observer has the right to attend meetings, to speak (express his or her opinion) and to listen, but doesn’t have the right to vote.
Observers seem to be a harmless compromise. But there are many reasons why founders should be wary of giving observer rights to an investor.
An argument for appointing an observer is that he or she can bring additional knowledge to the debate. That might be the case. If the observer also has sat as an executive director on the boards of other companies, he or she is likely to have a great deal business experience and a network of contacts. But it might also not be the case. Because it is the investor’s decision as to who to appoint, founders may find themselves with someone with little operational experience who wants to be seen to be talking for the “most important” shareholder. That person may be difficult to get along with, may distract the directors from day to day business, and may not understand what the founders intended the business to do. Although the observer might have invaluable knowledge, but just because he was appointed by a professional investor, doesn’t guarantee that.
A second argument is that investors should have a right to know what is happening in the business. That is a valid point, but not one solved by having an observer on the board. The solution is to give “information rights” – the right to have a face to face meeting with certain executive directors every quarter where any matter can be discussed. If an investor has information rights, then having an observer shouldn’t be necessary.
An effective board of any company should consist of members who vote independently. That doesn’t necessarily mean that directors should listen to the opinions of other members of the board, but rather that they shouldn’t follow the leader.
In practice, founders tend to look to an experienced investor for advice. They also tend to be in agreement on many issues, so opinion is unanimous and voting is not required to make a decision.
That means that even as an observer, an investor who can speak at a board meeting can have a disproportionate influence on the board (almost the same power as a non-executive director). It is hard to disagree with someone who is funding your dream, especially if they have been there before. To be cynical, if you are looking to make sure you always meet your fiduciary duty to the company and the shareholders, then voting in the way the largest of the shareholders wants is not likely to land you with problems.
An observer could be asked just to observe, and not to speak. Often venture capital companies bring in a less experienced employee of the firm, to be trained up to a position where he can himself sit on the boards of investments. The directors may have no issue with this, but there shouldn’t be a need to have a right to do this. The VC firm should simply be able to ask the directors whether they mind.
Lastly, there is a practical argument why you should not have observers to board meetings. It isn’t a particularly strong one, but could be valid. It is that many voices in a meeting take time to hear and can side-track the meeting. With a strong chairman and an agenda, this shouldn’t happen, but it could be a risk.
Should you grant other shareholders observer rights?
Good advice is never to let anyone attend board meetings that you wouldn’t value as a board member. Don’t let someone sit in an empty seat. Make sure you know who is taking that seat and what value he or she brings to the discussion.
If you are undergoing a financing round, observer rights might be something you have to concede to bring in investment. It might be better to concede an observer position than a non-executive directorship. But make sure you agree on certain terms.
What should be in your agreement?
Observer rights might be granted as terms in the shareholders agreement, or in a separate investor agreement.
Parties to the agreement, and the name of the observer
The company and the investor are the main parties to the agreement. But even if the observer is a representative of the investor, he or she should be specifically named (perhaps in a secondary agreement so as not to have to amend the primary agreement if the identity of the observer changes).
If the investor wishes to change who the observer is, then all observer rights should be temporarily suspended until the new observer is named or otherwise brought into an agreement.
Notification of meetings
Board observers have no statutory rights to be notified of meetings, unlike directors. So that right needs to be given contractually instead.
Restrictions and process
There may be restrictions on which types of meeting an observer may attend, or for he or she will be given notice. There may also be a process that must be followed for the observer to be allowed to attend, for example, the observer must give notice that he or she will attend within a certain timeframe.
An investor may also want the right to receive all notices, reports, documents and minutes relating to a meeting. If so, this should be specifically agreed. However, also in place should be confidentiality clauses to protect sensitive information.