Company Formation – Separation and Control
When forming a startup, founders need to understand and appropriately address two important and related governing issues for the startup entity: separation and control.
Separation.
By “separation”, I mean that the founders need to understand that the startup is a separate and distinct legal entity and needs to be controlled, governed and operated as such. Even solely among a group of founders (before investors and employee-owners), any one founder cannot act as if the startup is “my company” to do with as that founder pleases and without consideration for the rights of the other founders or the best interests of the startup. After investors and employee-owners join the startup, the need for founders to separate their personal interests and objectives from that of the startup becomes even more important due to the different and sometimes conflicting interests and legal and contractual rights associated with different groups of stockholders. Failure by a founder to appropriately separate the founder’s interests and objectives from the startup’s interests and objectives, even when the founder “controls” the startup, can result in complicated problems and potential legal liability.
Such conflicting actions can take many forms: the founder who regularly uses company funds for personal purposes, such as to pay for meals with no business purpose or to acquire assets (laptops, iPhones, etc.) that are used more for personal purposes than for business purposes; the founder who engages in insider transactions with the startup without seeking approval from the independent directors or stockholders, whether such insider transactions are with other companies in which the founder has an interest or with other persons with whom the founder has a close relationship; the founder who sets compensation for himself on a materially higher scale than others without a real business justification; the founder who tries to sell the startup early and make a quick buck when the other investors and employee owners are engaged in building the business for the long haul; etc. It is not only bad business for a founder to take such actions, taking such actions in the founder’s interests and not in the startup’s interests can also open a founder up to litigation and potential legal liability. Basic guidelines: understand that the startup is a separate and distinct legal entity and must be governed and operated as such, and understand that, as a founder, you will need to be acting in the best interests of the startup when you are acting in your capacity as an officer and director of the startup; you will need to be sensitive to how conflicts are dealt with, including obtaining approvals from non-interested directors/stockholders when appropriate; and you will need to carefully “wear two hats” – one being looking out for your own personal interests as a founder, stockholder and employee and the other being looking out for the best interests of the startup (often with a need to lean in favor of the startup’s best interests).
So, hopefully with a slightly better understanding of why founders need to separate their personal interests and objectives from how they control and operate a startup, let’s consider how a startup is actually controlled and governed.
Control.
Control of a startup – which for purposes of this post we will assume is a corporation or an LLC organized, as is often the case, with a corporate-type governance structure – is divided among the startup’s owners, the startup’s board of directors, and the startup’s officers.
The board of directors is the body with the centralized authority over the business and affairs of the startup. All corporate powers and decisions are ultimately exercised under the authority and supervision of the board of directors. The board of directors has the power to appoint and remove officers of the startup and delegate day-to-day management responsibilities to the startup’s officers, and typically will do so, but ultimately such officers are acting under, and subject to, the authority and oversight of the board. Directors are obligated to act in the best interests of the startup and its stockholders, and are bound by certain fiduciary duties to act with due care when making decisions on behalf of the startup and to be loyal to the startup (more on this in a later post). Generally, the board of directors will approve material corporate actions and actions outside the ordinary course, such as officer and key employee apppointments, venture financings, material commercial agreements, bank financings, sale of the startup, etc., and unless otherwise specified in the startup’s charter or bylaws a board approves such actions by a majority vote at a meeting or by unanimous written consent. When forming a startup, the founders need to determine who will be on the board of directors and, therefore, who will ultimately exert primary control over the startup. It does not necessarily follow that all founders should be on the board of directors, nor should the board be limited to just one or more founders – independent directors can often bring valuable experience, insight, independent judgement and contacts to a startup’s board of directors. Note that an important consideration is to structure the board to avoid the possibility of a deadlock in decision-making that might hamstring the startup (e.g., a two person board made up of two founders may not be ideal – adding an independent third director might be considered in this scenario for additional insight and guidance and to break potential deadlocks). Other important considerations at the startup stage is to keep the size of the board small enough (probably no need for more than 3 directors before a startup takes on investors), and the relationships, personalities and skillsets of the directors cohesive and complementary enough, so that the board is informed, engaged and communcating well among themselves and with management, and can act quickly and effectively when the board needs to consider matters and act.
A board’s centralized authority over a startup is checked to some degree by the authority of the stockholders of the startup. The stockholders have the authority to appoint and remove directors, and the stockholders have the right to vote on extraordinary corporate actions (e.g., venture financings, sale of business, amendments to charter, etc.). However, the stockholders, as stockholders, have little voice in the day to day business of the startup. In the context of a startup, the stockholders are typically the small group of founders (who are also, in part, the officers and directors of the startup), and often they will enter into a voting agreement to appoint one or more founders to the board of directors. As a result, there is not much of a check on the board of directors by the stockholders for an early stage startup. This check will become more meaningful when the startup brings on investors, who will have differing interests, will desire to have the right to appoint one or more board members, and will likely negotiate for a laundry-list of specific stockholder approval rights to be voted on by the investor group. At this stage, the check on the power of the board of directors becomes meaningful, and a certain amount of control over the startup will shift away from the exclusive power of the board of directors to one of shared control between the board of directors and the stockholders.
Officers of the startup control the startup’s day to day activities, but as indicated above such control is always subject to the authority and supervision of the board of directors. Due to the oversight and supervision of the board, and due to the board’s ability to remove officers, officers do not really control the startup, but they certainly control an extraordinary number of day-to-day activities and decisions that can make or break the startup. As a result, competent, experienced and trustworthy officers are key to forming and running a successful startup.
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