A shareholder who is a founder and/or CEO may wish to entrench their decision-making powers as a company takes on more capital and dilutes the ownership. Whether such an entrenchment should be allowed will depend on the perspective. The desire for a locked-in vote is natural from the perspective of the founder/CEO who puts in blood, sweat and tears to try to make their company survive, often at personal sacrifice.
In Part I, we discussed the obligations around confirming your company’s board of directors. In Part II, we discuss how a company’s CEO and/or founders can maintain a seat on the board of directors. We will first consider the mechanism by which such “entrenchment” occurs. Then let’s dig into this a little more deeply to understand the various perspectives for a locked in board nomination.
Directors and Replacement of Directors
In the absence of specific shareholders’ agreement rules on who is permitted to make decisions, a company’s decisions are made by the board of directors on a simple majority rule (in most cases), and the voting requirements are set out in the corporate statute. This is often modified by the company who will create special rules for special shareholders. Such rules can become quite convoluted in a shareholders’ agreement, with certain decisions that may be voted on by some shareholders, and certain decisions requiring the vote of a minimum number of directors. Deciding on what the rules should be can be case-specific but as a general rule, the simpler the better, with a view to addressing the needs of the various perspectives set out below. Setting the rules is a good idea in advance, as these rules are closely scrutinized in the event of inter-shareholder disputes.
A helpful resource to consider the various permutations of management voting rights is the Clausehound Small Business Law Library for shareholder management rights and the appointment of board members found here. By reading through the variety of clauses offered, you will get a sense for the levers and considerations that stakeholders will have when negotiating this provision.
For example, you can include language that states:
The Board of Directors will be comprised of a maximum of five (5) directors including the CEO, two Founder representatives, and two independent directors to be nominated at all times by a majority of the Shareholders. The Board of Directors shall initially consist of the following persons: [Insert name 1]; and [Insert name 2], or their replacement nominees as appointed from time to time. If a Director resigns or is removed by a majority of the shareholders, such vacancy may be filled by the election of a new Director nominated by the remaining Directors and elected by majority of the shareholders, pursuant to the nomination rules of this provision, within fourteen (14) days of such vacancy.Perspective of the CEO: Considering the suggested clause above, above, the current CEO will have a voice in company decisions, but no right of nomination.
Perspective of Founders: From the perspective of the Founders, the suggested clause above entrenches the CEO and two board members nominated by the founder into decision-making seats, which ensures that, so long as the founders and CEO are aligned, a ⅗ majority vote on all decisions. A rogue CEO could cause issues for the founders by voting with the independent board members.Perspective of Investors: In the suggested clause above the remaining board seats are held by independent board members, which could be defined as a non-shareholder who is possibly an industry expert or a professional board member, and is someone who understands that the role of the board is to protect the shareholders. The right to appoint independent board members is the approach that might be taken by a passive investor who is investing in many companies. This approach gives the company room to move, or possibly swing vote with the CEO. A more active investor would likely require one or more board seats to be held by that investor rather than by an independent party.Three or five board seats, or more
Limiting the number of board seats to three creates risk for the legacy shareholders because new investors will want to hold one or more seats. To make sure that the voices at a board meeting have a fair chance of being heard, the founders, CEO and/or early investors will want to increase the size of the board, and may also propose adding “board observer” (non-voting) seats to give even more voices an opportunity to be heard.
While one-size does not fit all, either in board size or voting rules, stakeholders will need to consider what rules, arrangements make the most sense for the dynamics of their owners, investors and management.
To read Part I of our series, click here!