Boards (III) With Don Alexander and Barry Buzogany, GeneCoda
Boards are a major player in the governance of most firms. In this series, we will be discussing the functions of the two major types of boards: corporate and advisory boards, including the legal and practical differences between them, as well as the pros and cons of each.
In part 3, we’ll discuss how to form a board and the criterion for selecting board members.
How are Boards Created?
As we stated earlier, forming a statutory board for an incorporated company is required by state law. The shareholders of a company (at this stage, usually the Founder and CEO or investors) first file articles of incorporation with the Secretary of State. An initial board of directors is appointed or elected. Bylaws are created that detail the rules of governance for the board’s activities, structure, and the roles and responsibilities of its members.
On the other hand, the formation of an advisory board is totally discretionary on the part of the CEO or statutory board chairman. Because its creation is not required by law, the structure and operation of an advisory board is much more informal. An advisory board is generally formed with the company entering into an Advisory Board Agreement with each member. This document should outline each member’s roles and responsibilities and will often contain terms such as a confidentiality clause and a non-compete agreement. Some companies may also draft an advisory board charter which is a document similar to the bylaws of a statutory board that outlines the purpose, mission and general operating principles of the board as a whole.
How Are Board Members Chosen?
The key criterion that one should consider when selecting board members can vary widely depending on factors such as the type of company the board will operate in, how it is organized, whether it is public, private, or a non-profit.
In an early-stage company, the interview and initial selection of board members is typically performed by the CEO in conjunction with existing shareholders, if any. A board chairman is selected. Thereafter, when the initial board has been formed, additional board members are selected by the sitting board with shareholder approval. Note that state laws generally permit the CEO or founder of a start-up company to fulfill the requirement that a board of directors be formed. We will examine the criteria for selecting an “independent” director which means a non-employee director, i.e., one who does not have an employment or other material relationship with the company.
Due to the broad scope of responsibility and the strategic-minded skills required of independent corporate board members, they are typically persons with senior or high-level business experience. The ideal board candidate is often a talented professional who has one or more of the following qualities: prior board experience; C-level or equivalent experience in a relevant industry or field of practice; a thought leader in the space; a track record of raising capital or accessing capital markets, and/or a major investor in the company.
Advisory board members may very well share some of the above attributes as well. But their primary role is to offer direct support to company management or staff at a more tactical or operational level. They do so by bringing a potentially narrow but deep domain knowledge to a discipline that company personnel may be lacking at any given point in time.
A given CEO or chairman-of-the-board who wants to form an advisory group should perform a gap analysis to determine what knowledge, experience, or domain expertise his current team may lack. For example, depending on the type of company and its industry, the CEO may have a specific need for specialized expertise such as science, finance, clinical, medical, or other such specialty fields.
In recruiting a new independent director, it is also important to consider how closely the candidate identifies with the company’s mission statement and to validate that the teaming vision of the candidate aligns well with that of the company—and that he/she is comfortable with its governance practices.
It’s not uncommon to find a company’s investors as members of its statutory board. When major investors are represented on a board, they usually have an acute awareness of the need for good corporate governance. However, whether also shareholder or not, each board member is charged with making decisions that are deemed in the best interest of shareholders collectively. Board directors report to the shareholders and have a fiduciary duty, legal exposure, and a duty of care and loyalty to the company. As a best practice, they should ensure that the board creates an appropriate committee structure, e.g., audit, compensation, finance, or other committees as appropriate, in order to remain in compliance with applicable laws and regulations.
By contrast, advisory boards members (including advisors who may also be investors or venture capitalists by trade) are operating in a more informal, less regulated environment. They do not have a fiduciary duty to the company. Again, the formation of an advisory board is discretionary, i.e., it is not required by state law. Thus, the obligation of each advisor is simply to fulfill the contractual role prescribed to him/her by the CEO.
Size Guidelines for Boards
The number of members of statutory and non-profit boards of directors is set forth in the company’s bylaws. By contrast, the size of an advisory board is determined by the CEO or chairman, and thus it can vary widely. For companies who are considering forming and/or modifying the size of boards over time, here are some prototypical guidelines for choosing the appropriate size.
Keep It Small
It is important to keep a working corporate board relatively small to keep its members focused on their responsibilities and accountabilities they have to the shareholders of the company. Three, five, or seven directors is a typical range for many early stage and small cap companies.
Uneven Is Better
It is always wise to maintain an odd number of board directors. Boards make binding decisions by vote and must have a quorum for a binding result. Having an odd number of directors helps avoid standoffs like those that would occur if a critical and/or controverted issue came before an even-numbered board and half voted ‘for’ and the other half ‘against’.
Unlike in the case of a statutory board, the number of advisory board members can vary widely depending on how many knowledge or experience “gaps” exist within the company at any given time. For example, a company might need seven or eight advisors initially and may desire to expand or reduce that number over time, whereas another company may require up to twenty board advisors. A typical working size for smaller companies is perhaps five or six members. We find, however, that larger companies as well as large non-profit organizations may require 15-20 board members.
Our next article in this series will cover how to determine appropriate compensation for members of the board of directors and advisory board.