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Venture Capital Financing. Forming a board of directors

legal updates
12 / 02 / 2024
In the venture capital industry, there is a popular saying that the main things to worry about in venture capital deals are money and control. Whereas money implies issues concerning the valuation of a company and the amount of investment, the issue of control is mainly resolved through the appropriate formation of a board of directors. In this issue, we discuss the principles underlying the negotiation of the best model of the board of directors in technology companies.

The board of directors and the principles of its formation

First and foremost, we must note that the discussion below mainly refers to deals structured in common law jurisdictions (such as Cyprus, the UK and USA), i.e. when companies are established in these jurisdictions. In these jurisdictions, it is the board of directors that is the principal source of power in a corporation. For example, according to paragraph 141 (а) of the Delaware General Corporation Law, the main issues of the company’s operation and existence are managed by the board of directors. As is well known, in continental law countries, including Russia, the main role in the governance is given to the general meeting of shareholders (participants) and the sole or collective executive body, while the board of directors mainly performs a controlling function.

Therefore, in common law governed deals, it is important to pay special attention to the composition and powers of the board of directors.

In contrast to JV or private equity deals, in venture capital deals, the board of directors is a dynamic structure. In other words, each new round almost always brings a change to the composition of the board of directors, and the principles of its formation may also change.

The reasons for this are as follows:

  • First, as the company develops, seats on the board of directors are taken by representatives of those investors whose experience is more valuable for the company at that certain stage of its development.

    Usually, according to the term sheet, the round’s leading investor (or group of investors) gets a board seat. This gives the investor an opportunity to receive more information on the company’s activities, participate in the discussion of strategy issues and often gains a right to block certain decisions.

    As funds are raised, the company grows and develops, the roles of investors and leading investors change as well as the composition of the board of directors. While the representatives of pre-seed and seed round investors may play a special role at the earlier rounds, with the growth of the company they may be replaced on the board by investors of the more recent rounds. This is because investors focusing on the more recent rounds, as a rule, are more experienced in business scaling; therefore, with the growth of the company they have more value for the company, while the early round investors may be not as useful as they once were.

  • Second, as the company grows, the number of members on the board of directors usually increases. While at the early stages the majority of seats on the board of directors is usually held by the company founders, at later stages the majority may be held by the investors.

    Therefore, as business raises more investment and scales, its founders may lose control of the board of directors. There is no definite answer to the question as to at what round it would be acceptable for the founders to lose control of strategy decisions. Therefore, this issue is usually a matter of discussion that must take account of the commercial prospects for business and arrangements with investors. Of course, the founders usually want to drag out this moment and it is obvious that one should not lose a control right after the pre-seed or post-seed rounds.

Guarantees for early round investors and founders

As the value of early round investors for the company may decrease with time, transaction documents usually stipulate that after round A and above, early round investors lose their right to appoint their representatives to the board of directors (in whole or in part).

Sometimes, early round investors keep this right, but it is linked to a certain shareholding threshold. For example, if an investor exercises its pro rata right (which we spoke of in the previous issue) and maintains its shareholding, it keeps the right to appoint a representative to the board of directors.

Often, instead of the forfeited right to appoint a member to the board of directors, the investor is granted the right to appoint a so-called “observer” to the board. The observer does not have a right to vote, but it has a right to attend meetings and receive information.
Usually, business founders also strive to provide guarantees for retaining control of the board for themselves, for example, if they comply with the established shareholding threshold and continue working for the company. If the founders have sufficient negotiating power, they may provide for a tie-breaking vote in the term sheet. In other words, when there is a tie vote in the board of directors on a certain matter, the founder has a right to ultimately resolve the matter.

Number of members on the board of directors

Usually, the issue on the number of members on the board is also among the key terms when you negotiate a deal. On the one hand, it is desirable that all project founders should be on the board of directors. These, for example, include the CTO, CEO and a number of key founders. On the other hand, as noted above, a round’s leading investor almost always asks for a seat on the board.

Keeping the same composition of the board as it was at the early stages of the company’s development when moving forward to subsequent investment rounds leads to an increase in the number of board members, which does not seem reasonable. When the company is actively growing, board meetings occur quite often and matters requiring immediate attention rise even more often than, for example, in public companies. To resolve such matters promptly, it is desirable to maintain an interest-balanced and optimally sized board of directors.

Usually, even with just six to eight members on the board, some decisions may be taken less effectively and less promptly. This is exactly why it is common practice in the venture capital industry, as we wrote above, for earlier round investors to give away their seats on the board of directors to the more recent and valuable investors. In addition, as the company grows, some founders may lose their seats on the board of directors. This is done specifically to give new investors an opportunity to participate in the company’s activities, but at the same time keep the number of board members at an optimum level to retain its efficiency.

Independent board members

Independent board members are “third-party” representatives. Sometimes, when a company needs scientific support or a person with the relevant job experience, a seat on the board is given to advisers. However, the practice of inviting such “third-party” members to the board of directors is not common. Generally, in a company which has not yet come close to an IPO, independent board members are not appointed; the board of directors is usually made up of founders and investors, i.e. those who invested their capital in the establishment and development of the company.

Liability of board members

You may remember that board members carry a fiduciary duty in relation to the company. In simple terms this means that in their role they must act reasonably, in good faith and in the best interests of the company. A breach of this duty may result in claims for damages being brought against board members in connection with damages suffered by the company. If a board member is appointed by an investor who has competing projects in its portfolio, this risk will be especially relevant for it. As the amount of damages in the case of an indirect claim may be substantial, D&O insurance is not uncommon.
Such claims are often insufficiently substantiated and are brought to put pressure on board members. It is, therefore, common practice to enter into indemnification agreements with board members appointed by investors. This agreement provides that in the case of an unsubstantiated claim, the company undertakes to compensate the relevant board member for costs and expenses. A model agreement to be entered into with a board member who is an investor’s representative was devised by the National Venture Capital Association (NVCA) and is freely available on the website


The number of board members is usually captured in the constitutional documents of the company. The mechanics of electing members to the board of directors and the composition of the board are, in turn, generally determined:

  • in a voting agreement if we are referring to deals governed by the law of Delaware, or
  • in a shareholders agreement (SHA), with the relevant provisions to be reiterated in the constituent documents, if we are referring to deals in other common law countries.
Basic provisions:

  • The logic of the voting agreement or of the relevant provisions of the SHA is generally as follows: shareholders must vote in such a manner to ensure such composition of the board as is described in the agreement.
  • It may also establish criteria for voting for candidates nominated by this or that party. It may be stipulated, for example, that shareholders must vote for a board member nominated by an A round investor until this investor maintains a stake in the company’s capital on a certain level (on an as-converted basis).
  • In practice, sometimes there may be restrictions in respect of the candidates nominated by founders. Such as, for example, that the shareholders must vote for such candidate while this person remains an employee of the company and holds a certain amount of stock.
  • Now it is quite often stipulated in documents that the nominated candidate may not be a sanctioned person.
Until recently, you would seldom find a board of directors in growing companies in Russia (especially at the early stages) that would be structured at the level of a Russian company. Now the practice of forming such a board is becoming more common. However, as has already been noted, in continental law countries the role of the board of directors in the life of the company differs from the role that is typical of common law jurisdictions.

In addition to this, a problem relevant for Russian law is that of the liability of board members. Unfortunately, the absence of a doctrinal position on fiduciary duties has led to a situation where, until about 2012, the liability of the management was ephemeral and there were almost no cases when board members were held seriously liable. After 2012 the practice swung the other way and cases began to appear where multi-million damages were recovered from the management.

The lack of stability and predictability in law enforcement does not contribute to the normal operation of the institution of the board of directors in practice. This is especially relevant for fast-growing technology companies where quick and risky decisions need to be made when standard ways of evaluating the reasonableness of the board’s decisions may not work.

In the next issue we will tell you about how the right of first refusal and co-sale right work. This is the most vital instrument for investors as it allows them to ensure the liquidity of their investment in the company as they can either purchase shares of other shareholders offered for sale or join a favourable deal and lock in a return on their investment.