Why do startups have Boards of Directors?
Do they just exist to make VC's feel good, or is there an actual purpose?
Two weeks ago, Sam Altman was fired as the CEO of Open AI by his own Board of Directors… before being hired back less than a week later. For all the chaos that ensued during that one week, the Board itself was completely reconstructed, with only one person (Adam D’Angelo) surviving the carnage. Of note, there are now zero OpenAI employees on the board (not even Sam himself).
While OpenAI has a unique ownership structure that creates an odd relationship between the Board and the for-profit entity, the chaos has shined a new light on why startups have boards in the first place. Why does any company have a Board? Let’s dig into it.
The basics: public company boards
Starting from the top, publicly traded companies must have a board of directors that looks out for shareholders. They exist as a check and balance against management teams or CEO’s to prevent decisions being made at the expense of shareholders.
For example, a management team could theoretically make the decision to dividend out all of the cash on a company’s balance sheet to themselves as a one-time bonus, rewarding themselves handsomely while destroying significant value for shareholders. Even if management owns some equity in the company (whether it be common stock, RSU’s, or options), their incentives will never be perfectly aligned with common shareholders as they’re an employees themselves, and others own more than they do.
In most cases, common shareholders are made up of the people in the general public who own shares directly, or via some sort of money management fund. A publicly traded board exists to protect these shareholders, who don’t have the ability to police management teams directly. Oftentimes, it’s hard for shareholders to really understand what’s going on inside of a company in which they have a very small holding, as they only see quarterly reports and don’t speak directly to management. Boards are set up to help reduce the risk of this information asymmetry.
While there are some administrative tasks that are left up to a Board (e.g., determining management compensation), their main job is to hire and fire the CEO. If the CEO is doing a bad job, the Board fires them. If the CEO is fired, the Board leads the search for a replacement.
Even more boring boards: private equity boards
Unlike in a public markets context, where a very large number of people own the majority of a Company, in the private equity world most “portfolio companies” are owned by a single firm. As a private equity firm actually does have significant insight into the inner workings of their Companies, this Board doesn’t have to solve the information asymmetry problem.
While there are usually outside board directors brought on to aid in tactical decision making in board meetings, the board is really just an extension of the private equity firm itself. At the end of the day, the firm as a whole will make major decisions about their companies: the literal board members are really just messengers and point people to communicate with management.
The wild west of boards: startup boards
Unlike the above scenarios in which the investors own / control a company, startups are usually controlled by their own founders (certainly at the beginning). Assuming normal dilution standards by stage, most founders still control ~half the company even after raising a Series B (heavily simplified example below):
Given that founders still own the majority (or close to it) of the company, they in turn are expected to control the board (after all: the board exists to protect their own interests as owners).
In turn with this, we typically see founder controlled boards up until around this stage. If there are fewer founders than outside investor leads, founders will often get multiple board seats to maintain control. Sometimes, founders are even able to maintain board control for several rounds after they’ve lost the voting majority.
Furthermore, the vast majority of VC’s (ourselves included) never want to replace the CEO of an early stage company. At the early stage of investing, you’re investing in people, not companies. If you replace the CEO, the company effectively ceases to exist… and the investors lose their money.
So the natural question becomes, if an early stage board can’t overrule management and has no interest in replacing CEO’s, why even have a board of directors? If a board is already controlled by the founders / management, isn’t having a board just an annoying administrative distraction from building a business?
In short, I don’t think so.
The benefits of startup boards
Even without the ability to outvote founders on any topic, creating a board even at the earliest stages of a startup is an example of good governance, and leads to better outcomes for everyone. We often encourage companies to create boards beginning at the Seed stage.
A few benefits of having a board at a startup include:
Having board meetings forces founders to step back a few times a year and look at the bigger picture: when you pull out from the detail, what do third parties think about our progress? What strategic decisions need to be made from here?
While time consuming, pulling together board materials (even brief ones!) helps to crystallize all that’s happened in a quarter, and what’s next
What problems are we running into that others have already solved? Having board members who have worked with a large number of companies increases the probability that they’ve seen this before: what shortcuts can we take?
How are we doing? As a Founder, it’s incredibly hard to get honest feedback from prospective investors, customers, or employees who sugar coat everything until it’s too late. It’s a board’s job to be as honest as possible with founders
How is the market doing? Investors on your board are assessing this company every single day, and going to be closer to macro conditions than any single startup. How should these macro conditions inform our micro decisions?
In challenging markets, inside investors are far more likely to fund an extension / flat round than external parties. This is both to protect their own capital, but also because they already have a relationship with you in which you’ve built trust
Building trust and relationships with board members can turn them into your biggest advocates and references when looking to raise future funding rounds, or close key employee hires: the more people who sing your praises, the better
Lastly, being a founder can be lonely: you can’t vent frustrations or fears with employees for fear of derailing internal culture. Other than co-founders, board members can be the sounding board for founders when things aren’t going well
The most important part of board meetings is simply for both sides to be honest with one another and solve problems together. Constructing a strong board in which everyone trusts each other and is willing to go the extra mile to help the company is critical to a startups success.
Building a startup is hard enough as it is: there’s no need to be fighting battles inside of a board room when there are always more than enough to be fought outside of it.