You’ve Got VC Money: Board Duties

Now that you have a VC-backed board, good corporate governance and a well-functioning board are even more necessary than when your board was made up solely of founders.

Oversight and Supervision

The board is collectively responsible for promoting the success of the company by directing and supervising the company’s affairs. The board must oversee the management of the company (rather than directly manage). This means that directors must keep themselves well-informed of the status of the company’s business, risks facing the company and its industry, and the performance of its officers. Accordingly, all directors should have an understanding of the following:

• Principal operational and financial objectives, strategies, and plans of the company.
• Results of operations and financial condition of the company.
• Key risks in the company’s industry and business.
• Relative standing of the company and competitors.

Risk Assessment and Mitigation

The board should conduct a risk assessment at least annually to identify key risks in the company’s industry and business. Then, the board should work with its advisors and management to establish, and evaluate the effectiveness of, board-level systems of monitoring and reporting on each of the company’s key risks. The board should ensure there is a process mandating that they receive the right information at the right frequency from the right person to alert the them to red flags and evidence of serious problems or misconduct. As part of this, the board must actively determine what information they need to properly monitor the risk, ensure compliance with law, and reduce exposure to liability. For specific risks, the board could consider implementing higher level safeguards, such as dedicated board committees; regular executive sessions to discuss key matters; and third-party monitors, auditors, or consultants engaged to assist with compliance and oversight functions. Also, the board should ensure effective channels for reporting on key risks and misconduct, such as audit or risk management committees, officers, and whistleblower or ethics reporting systems, as well as ensure that all persons making reports will not face any kind of retaliation.

Compliance With Law

The board has an obligation to see that the company complies with the law. Generally, the company’s officers keep the company in “good standing.” They make sure that all reports are filed, including annual reports to the Delaware secretary of state, all taxes are paid, the company and its officers maintain all required licenses (including foreign qualifications to do business in other states), and the company and its properties are adequately insured (or that a reasonable business decision was made not to obtain insurance). In addition, the board must also see that the company follows proper accounting and auditing procedures.

Fiduciary Duties

Fiduciary duties are owed to all stockholders irrespective of equity interest, and the risks associated with breach increase as the company grows and brings on new investors. All directors and officers have an obligation to act in the best interests of the business—sometimes to the exclusion of their own interests.

The fiduciary duties of directors are encompassed in two broad categories: (1) duty of care and (2) duty of loyalty. Below is a brief summary of the standards that directors must observe in their capacities as corporate fiduciaries or risk liability for breach:

• Duty of care. Directors must be diligent and invest significant amounts of time and energy in monitoring management’s conduct of the business and compliance with the company’s charter, bylaws, applicable laws, and operating and administrative procedures. In doing so, directors are entitled to rely on reports; opinions; information; and statements of the company’s officers, legal counsel, accountants, and employees, subject to reasonable circumstances (i.e., directors are responsible for remaining informed and making further inquiry when alerted by the circumstances).
• Duty of loyalty. Directors are required to exercise their powers in the interests of the company and must not use their corporate position to enjoy a personal benefit, gain, or other advantage at the expense of the company. Directors must also act in good faith, disclose to stockholders all material facts relevant to a stockholder decision, deal with all matters involving the company in confidence, and maintain the company’s confidential information.

The Business Judgment Rule and Entire Fairness

The business judgment rule is neither a fiduciary duty nor a standard for determining whether a breach has occurred; it is a judicially adopted procedure for giving deference to board decisions and analyzing whether a court will entertain a challenge to a board decision. The business judgment rule is a judicial presumption that directors have exercised their business judgment with due care, good faith, and the belief that they were acting in the best interests of the company. The effect of this presumption is that, absent a showing of a breach of fiduciary duty or no rational business purpose, judges will not substitute their own judgment for those of the directors.

In breach of fiduciary duty cases, plaintiffs must first establish sufficient facts to overcome the business judgment rule’s presumption that directors acted with due care and in good faith. However, if a plaintiff is able to show that the directors may have breached their duty of loyalty (e.g., because the majority of the board is conflicted, a controlling stockholder has a conflict, or there is “fraud on the board”), the burden of proof shifts to the directors to provide evidence that they did not commit the breach. Where directors are found to have breached their duty of loyalty, to avoid liability they will be required to prove that, notwithstanding this breach of duty, the stockholders were not damaged because the transaction in question was entirely fair to the company’s stockholders.

Fairness is an extremely high standard, requiring an analysis of two components: fair dealing and fair price. Fair dealing relates to the process the board followed from negotiating a proposed transaction through seeking and obtaining stockholders’ approval for the transaction. Fair price relates to the economic and financial considerations of a proposed transaction. When a court reviews whether a transaction was entirely fair, it will carefully analyze the totality of the factual circumstances of the specific case and focus on both the procedures and economics of the transaction.

Directors lose in most cases where the entire fairness standard is applied, so the name of the game is staying well within the business judgment rule by ensuring that board decisions are made by a majority of directors who are both disinterested and independent.

Avoiding Conflicts of Interest

If a transaction occurs which potentially gives rise to a conflict of interest involving a director, the board should (1) seek approval from disinterested directors or stockholders; (2) appoint an independent committee of disinterested directors with its own legal counsel and financial advisors to consider and approve the transaction; and (3) ensure the interested directors disclose such interests and all relevant material facts, abstain from voting on the matter, and completely recuse themselves and avoid being present while the disinterested directors or stockholders discuss and vote on the matter.

Do I Need an Independent Director?

Your financing agreements may designate one or more members of the board as “independent” directors, meaning directors who are not employees of the company or affiliated with any major investor. Often, independent directors have industry contacts or professional knowledge to provide to company management and the board. It is best not to leave any vacancies on the board, so if you have an independent director “seat” on your board, you should try to fill it as soon as possible. Note that independent directors, unlike directors who are executives or who are representing investors, typically receive compensation in the form of stock options for their board service.

Duties of Investor Directors

All directors, including those affiliated with the company’s stockholders (e.g., venture fund directors), are subject to the same fiduciary duties and are required to exercise independent judgment and make decisions for the overall benefit of the company and its stockholders. The interest of a VC fund is imputed to the director designated by that fund, so when the board takes actions involving that VC fund, the investor-designated director must be careful to disclose any interest to the board, completely recuse themselves from any board discussions on the matter, and obtain approval from the disinterested directors and/or stockholders. If the transaction involves a down round, cramdown, or other type of reorganization or transaction that presents a particularly detrimental effect on stockholders other than the VC fund or funds with designees on the board, then the board should appoint an independent committee of disinterested directors with its own legal counsel and financial advisors to consider and approve the transaction.

Corporate Opportunity Doctrine

In general, an officer or director may not divert any business opportunity presented to, or otherwise rightfully belonging to, the company. Doing so would constitute a breach of the duty of loyalty. However, your charter likely includes a waiver of the corporate opportunity doctrine with respect to the directors designated by your investors, which protects those directors and their respective VC funds from liability in the common event that they become involved with or invest in multiple companies (including competitors) in the same industry.

Protections for Directors

Other than the business judgment rule, directors have various protections that reduce or eliminate their liability when acting as a director of the company. Directors are entitled to rely in good faith upon the company’s records and information presented by third-party advisors (e.g. legal counsel and investment bankers) and the company’s officers, employees, and board committees as to matters that are within such persons’ professional or expert competence and have been selected with reasonable care.

Subject to certain limitations, directors are also indemnified and entitled to advancement of expenses under the company’s charter, bylaws, and indemnification agreements. Indemnification agreements for investor directors usually include language making clear that the company (and not their VC fund) is the primary indemnitor for such indemnification obligations. Also, VC-backed companies are usually required under their financing agreements to purchase directors and officers insurance (D&O) to reinforce these indemnification obligations.

Rights of Directors

In connection with carrying out their responsibilities, each of the directors have the right to:

• Communicate with executives.
• Inspect books and records.
• Inspect facilities as reasonably required for the performance of duties.
• Receive notice of all meetings in which the director is entitled to participate.
• Receive copies of all board and committee meeting minutes or reports.
• Communicate directly with the company’s external and internal advisors and, when appropriate, obtain the advice, at the company’s expense, of outside legal counsel, investment bankers, accountants, and other consultants.