The Role of the Board of Directors
If your startup is a corporation incorporated in Delaware or Washington, you must have a board of directors. The Delaware General Corporation Law provides that the business and affairs of every Delaware corporation shall be managed by or under the supervision of a board of directors. The Washington counterpart, the Washington Business Corporation Act, provides that all corporate powers shall be exercised by or under the authority of the corporation’s board of directors, and that the business and affairs of the corporation shall be managed under the direction of its board of directors, which shall have exclusive authority as to substantive decisions concerning management of the corporation’s business. Under both Washington and Delaware law, the board of directors may consist of only one director, and that one director can also be one of the founders, or the President, or any other executive officer. That is to say, the same person can be the sole shareholder, the President, the Secretary and the sole director of the corporation. Furthermore, in both Delaware and Washington, a director need not be a shareholder of the company.
In corporate governance checks and balances, the shareholders elect the 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 (e.g., dissolutions, certain merger and acquisition activities, amendments to the articles of incorporation, and the like), and certain other transactions that might be covered by contractual approval rights (e.g., preferred stock investors might negotiate for veto rights (commonly referred to as protective provisions) for certain transactions like issuances of equity securities with rights and preferences senior to or on par with the preferred stock, and other transactions that affect the preferred stock). 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 (such as amendments to a corporation’s articles/certificate of incorporation), and then there are best practices that can be followed to fill in the gaps. The following is a list of transactions that almost always 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));
- The Company’s borrowing or lending of money;
- Distributions to shareholders (whether distributions of cash or stock (i.e., dividends), 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 assets of the corporation; and
- Dissolution or winding up of the corporation.
Consequences of Not Getting Proper Board Approval
It is understandable that early-stage technology startups are usually on shoestring budgets, with 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, thinking they’ll have their lawyer go back and clean things up later- after the company has received financing. But this is a very dangerous position to take. For one thing, any sophisticated investor will require some amount of due diligence on your company before they invest, and one of the primary things they want to see are all of your board and shareholder minutes, so they can be comfortable that all of the corporation’s fundamental transactions (and especially equity issuances) have been properly approved. If you’re out there freestyling, thinking you’ll have your lawyer go back and clean everything up once you’re sitting on some investment dollars, you’re going to be in for a rude awakening as investors 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 be footing 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 go back and clean things up after the fact than it is to just do them correctly in the first instance.