The Board of Directors’ Role, and the Importance of Obtaining Board Approvals
If your technology startup is a corporation incorporated in Delaware or Washington, then it must have a board of directors. The Delaware General Corporation Law and its Washington counterpart, the Washington Business Corporation Act, both require all corporations formed in their jurisdictions to be managed by boards of directors. Under both Washington and Delaware law, the board of directors may consist of only one director, who may also be one of the founders, or any executive officer. Furthermore, in both Delaware and Washington, a director need not be a shareholder of the corporation.
In corporate governance checks and balances, the shareholders elect members of the board of directors, who in turn appoint the officers of the company. The shareholders typically are only required to approve the most fundamental of corporate transactions (including dissolutions, certain merger and acquisition activities, amendments to the articles of incorporation and the like), as well as certain other transactions that might be covered by contractual approval rights that have been negotiated for by investors (often called “protective provisions”). Meanwhile, the board of directors is tasked with approving certain other material transactions and delegating authority to the officers to perform such transactions. The officers report to the board of directors, and the board of directors is ultimately responsible to the shareholders.
Actions that Require Board Approval
The officers of a corporation are charged with making the corporation’s day-to-day decisions, but when decisions or transactions rise to the level of “materiality” they require approval from the corporation’s board of directors. Whether a transaction is material is not always clear-cut, however, there are certain transactions for which board approval is statutorily prescribed, and then there are best practices that can be followed to fill in the gaps. The following, although by no means exhaustive, is a list of common transactions that generally require approval by the board of directors:
- All issuances of securities (whether shares of stock, option grants, convertible promissory notes, warrants, etc.)
- Amendments to the articles/certificate of incorporation or bylaws
- Entering into “material” contracts (materiality could be determined by the dollar value of the contract, or by its effect on the corporation and its assets (e.g., leases of important assets, or outbound licenses of important intellectual property to third parties))
- Borrowing or lending money
- Distributions to shareholders (whether distributions of cash, stock, or other property)
- Adoption of employee benefit and incentive plans (e.g., equity incentive plans, profit sharing plans, 401K plans)
- The sale of all or substantially all of the corporation’s assets
- Dissolution or winding up of the corporation
Consequences of Not Getting Proper Board Approval
It is understandable that early-stage technology startups on shoestring budgets have little money to spare for legal services – and it’s not uncommon to see early-stage entrepreneurs (especially those who are on their first company) enter into “material” transactions without following the appropriate corporate formalities, thinking they’ll have their lawyer go back and clean things up after the company has received financing. This is a very dangerous practice. Sophisticated investors will require some amount of due diligence on your company before they invest, and one of the primary things they want to see is all of your startup’s board and shareholder minutes to confirm that the corporation’s fundamental transactions (and especially equity issuances) have been properly approved and documented. If you’re out there freestyling, thinking you’ll have your lawyer go back and properly document everything once you’re sitting on some investment dollars, you’re setting yourself up for investors to either: (a) stop returning your calls after performing their due diligence; or (b) if you’re lucky, make their investment contingent upon you cleaning up your corporate records – which means you’ll foot the bill for all of the cleanup work before you see a penny of the investor’s dollars. And like anything else, it’s much more expensive to clean things up after the fact – assuming everything can be cleaned up – than it is to just do things correctly in the first instance. Some things, such as stock option grants that weren’t properly documented or missed 83(b) filings, are either very tricky (read: expensive) or even legally impossible to fix retroactively, meaning mistakes made today could haunt your company for a very long time.