Chapter 3 Legal Characteristics

      A board is a legal construct with a well-defined set of requirements and responsibilities that fall under the term “corporate governance.” The board's formal duties include the legal concepts of duty of care and duty of loyalty. Boards also have smaller working groups, including audit, compensation, and nominating committees. While startup boards should be agile, it's useful to understand the formal requirements.

      As a startup grows, the number of stakeholders increases. In the beginning, a startup has a small team, often just the founders. A few early employees are added and given stock options. The company raises a small amount of money, adding a few angel investors and possibly a VC. The company releases its product, gaining customers and suppliers who become stakeholders in the startup. More employees are added, and, if it's a venture-backed company, the company raises a VC round. Soon, you'll have a lot of divergent interests among the stakeholders. The board is ultimately responsible for navigating any conflicts that arise.

It's essential to put a structure in place early to ensure the board and leadership team minimize conflicts of interest and understand how to navigate them. Good boards invite counsel to participate in meetings to help the company follow best practices. While entrepreneurs are rightfully concerned about racking up legal fees in such situations, Eric Jensen (Cooley, Partner) states, “Just as a VC is focused on building the company using best practices, a good attorney does not focus just on legal aspects. We act as advisors first, sitting in board meetings for free and alerting the CEO to any warning signs we spot in these board meetings.”

A Board Member's Legal Duties

      The state laws in which the company is incorporated, and the company's charter documents (the Articles of Incorporation and Bylaws) establish the legal duties of a board member. Federal securities laws and the Securities and Exchange Commission (SEC) add bonus rules for public companies.

      A fiduciary duty is an obligation to act in the best interest of another party and is the highest standard of care the law can impose on someone. A fiduciary is expected to be completely loyal to the person or entity they owe the duty, who is also called the “principal.” Specifically, the fiduciary mustn't put their interests before the interests of the principal and must not profit from their position as a fiduciary unless the principal consents. Every board member has a fiduciary duty to the shareholders unless the company is a Public Benefit Corporation (PBC), where, under Delaware law, the fiduciary duty is to the stakeholders as defined in the company's charter.

      My attitude when I'm on a board is to be supportive of management teams, to be a sounding board, and to offer constructive criticism at times. The board shares the responsibility to the company and the shareholders and we're not just cheerleaders—there are legal and fiduciary responsibilities that are often cut-and-dried. For instance, our board was contacted by an employee who said, “I'm quitting, and I want you to know that some of the numbers that you're being shown at the board meetings aren't really accurate.” As a board we need to get to the truth of that; is it a parting shot from a disgruntled employee or do we have a management team that isn't representing things accurately? We hired an internal audit firm to look at the books and tried to understand how it added up to what we were being shown. It turned out that the numbers were accurate, but that situation was cut-and-dried: we were given information that we had to investigate.

      Legal and fiduciary responsibilities to me are in some ways easy, but the more difficult decisions for a board are the ones that are not legal or fiduciary, but ethically important. For example, we had a member of a firm where we were investors post comments that were homophobic on Twitter. That's not a legal or fiduciary issue, but we asked if we could coach that person. Being on a board is more than legal and fiduciary responsibilities but also involves ethical responsibilities. You need to make sure that the right thing happens.

      Rebecca Kaden, Union Square Ventures, Partner

The duty of care and the duty of loyalty primarily define board members' fiduciary duties.

      VC board members, especially when they are major shareholders, are also focused on making a financial return for their fund, which can generate a conflict of interest in certain situations. Jon Callaghan (True Ventures, Managing Partner) says, “As long as you are a board member, you have to focus on what is best for all shareholders. This can be difficult for VCs. Afterward, you can go home and fret all you want about your fund not making a better return.” In actual conflict situations, a VC should explain the conflict and either recuse themselves or honor their fiduciary duty to the company in a board vote, while reserving the right to vote differently as a shareholder.

      Additional legal obligations include the duty of confidentiality and the duty of disclosure. While linked to the duty of care and duty of loyalty, they're just as important.

      While these duties may sound conceptually straightforward, in practice, they're subject to judgment and interpretation based on the specific situation. In legal disputes over board action, courts apply a legal construct, called the business judgment rule, which gives deference to the decisions of boards where the directors acted in good faith and in an informed manner. Courts generally apply the business judgment rule and uphold the decisions of boards if:

      This rule helps protect a director from personal liability for bad business decisions by essentially shifting the burden of proof to a plaintiff to demonstrate that the director didn't satisfy this test. On the other hand, if directors have an interest in the decision or fail to adequately inform themselves about the decision to be made, courts may apply a more rigorous standard to the board's conduct.

Addressing Conflicting Duties

Conflicts between