Trouble With A Self-Serving Board Member? What Every Founder Needs To Know
The original article was published in Forbes on Aug 10, 2021 - Trouble With A Self-Serving Board Member? What Every Founder Needs To Know
Most venture capitalists don’t fully grasp their legal duties as board members. The good news is that when it come to self-serving VC board members the law is on the founders' side.
These issues often arise in the context of follow-on financing and pro-rata rights. I’ve witnessed questionable behavior, including directors pressuring founders to accept valuations below market rate—in effect making it easier for their firms to acquire more shares and/or control at a lower price.
At first glance, this might seem like perfectly reasonable behavior: Aren’t the VCs just looking out for their financial interests? Wasn’t that the motivation when they negotiated their initial investment?
VCs who think this way have forgotten that as directors, their role is different than as investors. As directors, they are legally bound to make decisions for the benefit of the company, not their firm or its limited partners. Board directors are bound by both a Duty of Care (the fiduciary obligation to act in a way that someone in a similar position would reasonably believe to be appropriate in similar circumstances) and a Duty of Loyalty (acting in the best interests of the corporation and its stockholders).
Does that mean board members can’t consider the needs of specific stockholders, such as their own LPs? They can, but again, they must balance these considerations against what they believe to be best for the entire company and all of its stockholders — that’s the legal requirement under the Duty of Loyalty.
This isn’t an academic or legalistic point that can be ignored in the real world. While it’s rare, founders can, in fact, sue their investors for abuse of power. In a recent Delaware Chancery Court’s decision in Carr v. NEA, the court upheld the principle that a controlling stockholder cannot take advantage of its dominant position and engage in self-dealing. I advise board members to regularly reacquaint themselves with their duties and obligations as directors.
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And how should founders deal with a self-serving board member? One method is to ensure they have as much data and impartial advice as possible, so it’s harder for investors to lead them astray. In fact, earlier investors can be valuable assets in these situations. Seed investors generally have closely aligned incentives with the founding team and can step in to confront self-serving board members. If the situation seems to be getting dire, the founder can also escalate by having corporate counsel remind the board of its duties to the company.
Resolving these situations can be difficult, but it’s important for founders to remember that they’ve got the law on their side.
This advice is aimed to help founders navigate the challenges of building an early-stage company. If you are a founder or investor that has any additional advice or feedback, please leave it in the comments below or share with us on Twitter: @timy0ung @eniacvc.
