The Case of the Infallible Founder

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HEIDI: Welcome to The Startup Solution and "The Case of the Infallible Founder." I'm Heidi Roizen from Threshold Ventures.

With the recent drama at OpenAI, founders are now paying a lot of attention to their corporate governance – like this early-stage entrepreneur I'll call Chester.

. . .

CHESTER: Hi Heidi, I had a question for you about boards. So, I got my first term sheet recently, and the VC is requiring a board seat. The truth is I've been worried after what happened to Sam Altman recently getting fired by his board. I wouldn't want that to ever happen to me. So, my question for you is – could I set up my board so that they can't fire me? Or make any other decisions that I might not agree with? Let me know when you have a minute to speak. Thank you.

. . .

HEIDI: Now, I'm not surprised by Chester's question. But I actually don't think it's in his best interest to set up non-functional governance. I just need to help Chester understand why.

So, why did I call this episode "The Case of the Infallible Founder?" Well, as esteemed professor Noam Wasserman quotes in his piece on FTX, "Monarchy is the greatest method of decision-making in the world – as long as the monarch is infallible." So, I'm being a bit cheeky here, but in my many decades working with founders, I've yet to meet an infallible one – including myself. And it's a good bet that Chester's not infallible either.

So, instead of helping him build a monarchy, I'm going to explain to Chester why good governance is good for his company – and good for him, too.

. . .

Let's start with some basics.

Most entrepreneurs who intend to raise outside capital structure their companies as C-corps. C-corps are considered separate legal entities from their owners, which allows there to be protection between the owners' personal assets and the creditors of the company. A C-corp can also have multiple owners and multiple classes of stock. In fact, many VC funds are limited to only investing in C-corps because of governance and tax consequences. And that's why most entrepreneurs choose C-corps as their form of structure.

Every C-corp must have a board of directors – this is actually required in every state law of incorporation. The board is responsible for things like appointing the officers who will run the business, and approving things like capital raises or company acquisitions.  

Now, it's possible to have a board with only a single board member. And, in fact, that's often the case when a startup is first founded, with the founder holding that seat.

But at some point, the company will likely look for investment capital. And once other people's money is at stake, it's typical for those people to want some form of proper governance and board representation. 

Why? Well, the initial reason a VC asks for a board seat is to have better visibility – and some sway – in how that money is subsequently used by the entrepreneur. As I've said, we VCs are fiduciaries who are often investing the money of other entities. And we've usually raised that money with some form of commitment that we'll monitor what we've invested in. It's all part of the financial construct that makes venture capital even possible. And without it, there'd be less money for entrepreneurs. And that wouldn't be a good thing.

However, I can see why this argument is not that compelling to any individual entrepreneur. At this point, my argument might seem like governance is just a "necessary evil" to get the cash.

. . .

But I don't see it that way. Governance, when done right, will help your company be more successful, and maybe equally important, keep you out of trouble.

Let me explain how.

The first thing I want to highlight is the amount of help a board member can provide you. In my experience, the best investor board members are like high-level employees that you don't even have to pay. 

Now, you could, of course, ask investors for help even if they aren't on your board. And entrepreneurs should try to get help from any investor they have, even if the investments are small and there's no board seat involved. But a board seat conveys extra obligations to the person who holds the seat. Board seats, even for investor directors, require what's called "duty of care" and "duty of loyalty." These are obligations they must fulfill on behalf of ALL your shareholders – not just the shares that the investor owns.

. . .

These are important legal concepts in governance, so let me go a bit deeper here. Duty of care means all directors will actually give time and attention to your company – be aware of what's happening, read the documents, show up prepared at board meetings. And duty of loyalty means that all directors will put the interests of the company ahead of other interests that may be in conflict with it – including the potentially competing interests of the particular stock they own.

This is a very critical point. We investor directors wear two hats: one as a director, with duties of care and loyalty to your company and all its shareholders, and another hat as an investor looking out for our own shareholdings. And sometimes those can be at odds.

For example, in a prior episode, "The Case of the Carveout Conundrum," I talked about a situation where – as a board member – I voted for an acquisition to take place. Yet when it came time to ratify the deal the board approved, by voting as shareholders, our fund threatened to vote against the deal. We did that in order to pressure everyone else into paying for the carveout ratably instead of our fund footing the whole bill, which was how the initial proposal would have worked. With our share-voting rights in the balance, we said that voting for the acquisition was conditional on fixing this unfair allocation. That got done, and the deal went through. But that should give you some idea of how investor directors can end up with competing interests.  

The topic of investor voting rights is a big, hairy one and worthy of a lot of discussion. But we'll save that for a future episode, and for now, just focus on directors. Suffice it to say that even if your investor director is wearing two hats, in matters of board consideration, they have to put the duties of care and loyalty to your company ahead of their own investment priorities when deciding issues and voting as a board member. That is a legal requirement that comes with the job of being in a board seat.

Your board should be operating with those goals in mind, and that should, in turn, be helpful to you. For any big decision like M&A or a fundraise, having a number of people following good governance processes, including good documentation of those processes, means that you should not only be making the best decisions but also have a strong defense if things get questioned in the future. And, if you find yourself facing a wind-down, using proper governance procedures can help you avoid both legal liability and reputational damage.  

. . .

There can also be management issues, like HR situations that rise to the board level. It can be super helpful to have a fiduciary body that's not you or your management team to resolve issues like that.  

In short, it pays to have a board on the hook to both practically and legally bear the burden of all these responsibilities with you.

Now, boards in turn do hold company leadership accountable – that's part of their job. And maybe that doesn't sound desirable to you. But I'd argue that being held accountable is part of the 'growing up' a startup and its leadership need to do in order to, ultimately, become a big success.  

Accountability and transparency have value. Employees want to work for a place they can trust and can benefit financially from through equity. Investors want to put their money where it won't be misused. Customers want to buy from a company they can depend on. And, if your goal is an IPO, governance and accountability are going to be essential to achieving that.  

. . .

On the other hand, when there's no governance or oversight, I've seen bad things happen. I've seen founders lose sight of the bigger picture and make decisions that may be personally good for them, but not so good for the company. I've seen some use company resources for personal gain or vanity projects that really don't build any value. These types of things can lead to a lower return, or maybe something worse. And governance can help prevent that.

Well-governed companies use standard accounting, good legal counsel, and checks and balances that help to surface inaccurate or questionable actions. Good controls and reporting act as early warning signals, allowing companies to course-correct before small issues become big disasters. And, as I said in my last episode, "The Case of the Fraudulent Founder," the news is full of founders who took advantage of a lack of oversight until it landed them in very hot water.  

In fact, as I was finishing writing this episode, the news came in that Sam Bankman-Fried was sentenced to 25 years in prison. I'm sure he and FTX are going to be a literal textbook case as to how lack of governance, among other things, led to disaster.

. . .

From what I've seen, working through difficult issues with your board members is healthy for you and your company. I've been on boards where all the control is concentrated in one person, and I just don't think it works that well. Sure, the leader remains in charge, but as that leader continues down paths that others don't agree with, many of the key people tend to vote with their feet and simply leave. And the current investors may give up, too, not investing in future rounds and creating a pretty negative signal in the market that will probably concern new investors as well.   

And there are still more advantages to having a strong board. In his excellent piece on startup governance, Ryan Shannon, who's an investor at Radical Ventures, points out that board meetings force a founder to pull away from the details and look at the bigger picture. He suggests that board members who have worked with a lot of other companies may bring interesting ideas to the table that have worked elsewhere. He also says that board members can have good insights into the macro conditions that may not be obvious to the founder.   

Ryan also brings up something that I would underscore as a key benefit of having good directors. He points out that directors are inside the tent with you, and privy to your issues. They can be great, honest sounding boards about things you can't talk to anybody else about.

And ultimately, having transparent, trusted relationships with your investor directors should make them more likely to be good references for you, and also, hopefully, make them more inclined to participate in future rounds.

. . .

So, let's get back to Chester and revisit his desire for a company with no governance other than himself. Even though I don't advise it, if he's hell-bent on having sole control, well, there are ways he can try to make that happen.

For one, he can simply not raise any money. He can bootstrap his company as sole proprietor and be beholden to no one. Of course, depending on the kind of company he wants to start, like a capital-intensive one that makes a complicated hardware product, this may be impossible. And it might be hard to attract employees if there's no shot at equity rewards for anyone else, and probably not a great work environment either if Chester insists on calling every shot. This structure might even end up limiting Chester's own financial success. As Noam Wasserman laid out in his excellent article, The Founder's Dilemma, you can be rich, or you can be king, but it's hard to be both – and he presents a whole bunch of evidence to support that. I've posted a link to his article in the show notes, and I highly encourage you to check it out.

Chester could instead try structuring his company such that he holds the only board seat and controls all the voting stock and tell investors that they can buy stock, but it won't come with board representation or voting rights. This is a construct that has sometimes flown, particularly when the founder has been extremely successful in the past.  

But Chester's not that person, so that's not going to happen. And it hasn't actually worked out so well for at least some of the founders who did get that, as I've already pointed out.

For Chester, it comes down to the simple calculus that if he wants investment capital, he's going to have to agree to governance. So, he may as well make the best of it.

. . .

After Chester and I talked through all this, he decided to accept the VC's requirement of a board seat, given it would be virtually impossible to raise money without it. He decided to lean in on the positive aspects of governance that we talked about to increase his chances of building a more successful company. However, he did go back to the VC with an additional ask that I'd also suggested. He asked that instead of his board being just himself and the VC, he wanted to add a third seat for an independent director, who would be mutually decided on by the two of them. I think independent directors are great additions to boards, and I'm going to unpack why in the next episode, so I hope you'll join me for that!

But for now, let's close with what you can take away from The Case of the Infallible Founder.

First, governance is often required by investors, so you as a founder may have to deal with it regardless of how you feel about that.

Second, and to make you feel better about it, governance and accountability can actually lead to more successful outcomes.

Third, board members have a fiduciary obligation to pay attention to your company and put its interests ahead of their own. This makes them super valuable helpers and advisors, especially at key inflection points like fundraising or M&A.

And finally, good governance can keep you out of trouble and make you a more attractive employer, supplier, and investment – leading to a higher chance of success. And isn't that the ultimate goal?

. . .

HEIDI: And that concludes "The Case of the Infallible Founder." For the record, this situation is real, but Chester is a composite. And no startups were harmed in the making of this podcast. 

Thanks for listening to "The Startup Solution." We hope you've enjoyed this episode, and if you have, please pass it along to someone who could use it. I'm Heidi Roizen from Threshold Ventures.

Further Reading

As I mentioned, Ryan Shannon has a great article about the benefits of a startup board.

And,  here is Noam Wasserman’s seminal piece, The Founder’s Dilemma, and his more recent piece on Unchecked Founder Power that focuses on the recent example of FTX.

VC and Harvard lecturer Jeffrey Bussgang builds on Noam Wasserman’s work in this piece, Why Startups Should Embrace Radical Transparency.

This post by Samer Hamadeh, who is both an entrepreneur and board member, and Adam Dinow, who is an attorney at Wilson Sonsini, has a lot of practical advice about boards for entrepreneurs: What you need to know about startup boards 

In that vein, here’s another comprehensive and pragmatic piece about how to create and manage a board. 

And finally, on the topic of founder control, here’s an interesting perspective from Rick Fleming, an Investor Advocate at the SEC, about the dangers of a dual-class share structure. 

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