As a founder, you have an idea that you believe has real commercial potential and could make a significant impact on the world. But launching and running a successful startup requires more than just a vision of success. 

Founders are often so busy developing an innovative product or seeking funding that they don't put as much thought into how that business will actually function on a day-to-day basis or where the decision-making power for the company actually lies. 

Corporate governance for startups is the framework that dictates how these decisions are made. When founders treat startup governance as an afterthought, they risk ceding too much control of their company to investors or partners. 

Founders don't necessarily need a complex corporate governance model from day one, but they do need to understand the role that a board of directors, investors, and other strategic partners play in how company decisions are made. 

What Is Corporate Governance for Startups?

Startups often begin with a few founders and a small team built around them. While the team is small, founders can make important company decisions informally or without much outside input. But as the company begins to grow and serious investors start getting involved, decision-making needs to become more structured. 

Corporate governance for startups is what gives the organization its decision-making structure. Establishing corporate governance serves three important purposes for startups. 

First, it allows a company to establish decision-making authority. Imagine a startup has two founders. One wants to accept an acquisition offer, but the other wants to remain independent. Who gets to decide depends on the company's governing documents, board composition, applicable law, and the approvals required for a proposed transaction. 

Second, corporate governance creates accountability. A CEO may oversee day to day operations, but a board of directors can oversee their decisions. This helps prevent a single person from making significant decisions without appropriate oversight.

Lastly, startup governance gives investors confidence that the organization is being managed responsibly. Potential investors will want to examine corporate records, cap tables, board approvals, stock issuances, and other documents before agreeing to invest in a startup. 

Investors often have certain criteria and expectations for a potential investment. For example, many venture capital firms prefer to invest in Delaware C corporations, rather than LLCs. A startup with an entity structure that doesn't meet investor requirements, disorganized corporate records, or unresolved governance issues, may struggle to attract investors. 

Poor corporate governance raises red flags that can create delays at best, or even cause investors to walk away from a deal at worst. 

How Corporate Governance and a Startup's Board of Directors Work

At its earliest stage, corporate governance begins taking shape when founders establish a business entity.

Many startups planning to raise venture capital choose to form Delaware C corporations, though an LLC can also be appropriate for some businesses. 

For corporations, the certificate of incorporation establishes its legal identity, while corporate bylaws create rules for board and shareholder meetings, officer appointments, and other internal procedures. 

Corporations generally must appoint a board of directors. The board is responsible for overseeing the company's management and exercising its corporate authority, according to its governing documents and applicable laws. 

While founders and executives typically handle day-to-day operations, the board oversees management and exercises authority over major corporate decisions, including financing arrangements, stock issuances, and other matters requiring board approval.

An early stage company might have a single founder/director. As the company grows and gains funding, its board of directors may grow to include the company's founders, representatives of its investors, and independent directors who have been selected for their experience and expertise. 

Board members are typically elected by a company's shareholders, although different companies can have different procedures depending on their corporation's charter and bylaws. 

Can Founders Lose Control Over Their Own Startup?

Founders shouldn't assume that because they started a company that they will always be 100% in control of it. Founders can, and do, sometimes lose control over their company. 

When founders enter fundraising, their biggest bargaining chip is equity in their company. In other words, they exchange a portion of ownership in their company for funding. In addition to equity, investors may negotiate a stake in governance, often through board representation or approval rights over major corporate decisions. 

Through subsequent equity financing rounds, founders may experience dilution of their own ownership, while investors negotiate more seats on the board or other governance rights. If the board eventually has enough votes, and the desire, they can potentially remove a founder from their role as CEO. This can happen even if the founder still owns a substantial percentage of equity themselves. 

This is worth mentioning because it highlights an important distinction: ownership and control are two different things. That makes it all the more important for founders to understand startup corporate governance, board composition, and voting arrangements before seeking investment. 

Understanding the Fiduciary Duties of Directors

Members of a company's board of directors have certain legal and fiduciary duties that they must honor as they exercise their authority on behalf of the corporation. The two principal fiduciary duties of directors are the duty of care and duty of loyalty.

Duty of Care

Board members are expected to exercise a “duty of care” throughout their decision-making processes. 

Imagine a startup is considering a $10 million acquisition of a competitor. A board of directors that reviews relevant financial information, considers the potential risks of the transaction against the benefits, and deliberates before making a final decision could be said to have exercised its duty of care. 

In contrast, a board that hastily approves a major transaction without taking the time to adequately research and deliberate the opportunity may have breached its duty of care. 

An unfavorable business outcome doesn't necessarily mean directors breached their duty of care. Under Delaware law, the business judgment rule generally protects directors from legal liability for business decisions that were made with adequate information and in good faith.

Duty of Loyalty

The other major duty of board members is the duty of loyalty to the corporation's interests, rather than their own personal interests. 

Consider a founder who serves on the board of directors of his startup. The founder also owns a separate consulting company. If the founder retains his consulting company using startup funds at an above-market rate, that could potentially constitute a conflict of interest and raise concerns over a breach of duty of loyalty. 

A lot depends on the specific circumstances, but as part of the fiduciary duties of directors, directors appointed to represent investors cannot simply prioritize the investor's interests over their legal obligations to the corporation. 

Bad decisions don't automatically mean there has been a breach of fiduciary duty. But depending on the circumstances, a breach of fiduciary duties can potentially expose board members to lawsuits.

The Common Corporate Governance Mistakes That Put Startups at Risk 

Startups that fail to put adequate corporate governance policies in place can find their organizations exposed to significant risks. Below are some of the most common risks startups with poor corporate governance face.

Failure to Establish Clear Decision-Making Authority

Disagreements between co-founders about major decisions are common. Without proper decision-making mechanisms in place, these disagreements can be extremely challenging to resolve. The result can be deadlocked decisions that disrupt or delay operations. In the most extreme cases, it can lead to litigation between founders. 

Giving Investors More Control Than Intended

Accepting outside investment often means giving up a portion of equity. Investors may also try to negotiate board representation or approval rights over major corporate decisions. Founders who accept investment without understanding the impact of these decisions can inadvertently give more power to investors than they intended, and potentially restrict future decision-making ability.

Some protective provisions may require that certain financing transactions, securities issuances, or company sales be subject to investor approval. That can lead to a situation where an investor blocks a proposed financing opportunity because the company needs preferred shareholder approval.

Improperly Authorized Equity Issuances

Many startups use equity as a powerful recruiting tool. However, if the company promises shares to employees without the necessary corporate approval, it can create questions during investor due diligence about who actually owns stock or company equity. 

That can create a situation where significant corrective corporate action is needed to complete a financing round, which can delay or even jeopardize the deal.

Failure to Address Conflicts of Interest

Directors who engage in transactions involving their own financial interests without properly disclosing and addressing potential conflicts can expose themselves and the company to legal challenges.

Neglecting Corporate Records

Accurate recordkeeping is an essential component of startup governance. Major decisions made informally, missing documentation for board appointments or shareholder approvals can raise questions during fundraising periods or during an acquisition. 

This can cause delays while necessary corrective actions are taken, and even jeopardize the deal itself. 

Inadequate Board Oversight

One of the main benefits of corporate governance is creating oversight in a company's decision-making process. When the board fails to establish appropriate mechanisms for legal and compliance oversight, the company may face exposure to misconduct, regulatory violations, and potential legal disputes. 

Each of these mistakes can have a significant negative impact on a young startup: delayed fundraising, disputes, legal expenses, loss of decision-making control, and potential legal liability are all possible consequences when startup governance is neglected or mismanaged. 

Correcting corporate governance problems after a startup has grown can be significantly more expensive and time-consuming than establishing the right structure from the beginning. 

A relatively simple process during incorporation can require an extensive amount of legal work to correct once the company has issued shares, brought in investors, and expanded its board of directors. 

When It Makes Sense to Hire a Corporate Governance Lawyer

Startups shouldn't wait until they're ready to seek funding to address governance. There are several key milestones where the guidance of an experienced corporate governance attorney can help you put in place the framework for successful startup governance.

When You Begin the Process of Incorporating Your Business

A corporate governance attorney can help you assess an appropriate governance structure based on your startup's size, ownership, and future growth plans. They can also help you prepare a charter and bylaws, appoint the initial directors, and properly authorize and document founder equity issuances. 

Before You Bring In Co-Founders, Directors, or Outside Investment

As your company grows, a corporate governance lawyer can help you bring on co-founders, establish voting arrangements, and help negotiate financing agreements and investor control rights. An attorney can also help review board seats, protective provisions, shareholder rights, and equity distribution. Professional legal guidance during this period is extremely helpful in preventing founders from giving away too much control of their company. 

You don't necessarily need a large board of directors and complex governance agreements from day one, but you do need to establish a clear decision-making authority from an early stage. 

Before you incorporate your startup, consider consulting with an experienced corporate governance attorney. Even an early consultation can help you choose the right corporate structure and avoid the costly mistakes that only become more difficult and expensive to correct as your company grows. 

Need Help With Corporate Governance for Your Startup? Contact SVTech

Corporate governance may not be the first thing on your mind when you're getting your startup off the ground, but it is one of the most consequential early decisions you can make. How you address startup governance now will affect how your company makes major financial and operational decisions, holds leadership accountable, and balances the interests of founders, directors, and investors.

Without these systems in place, your company can face delays in funding, potential legal action due to conflicts of interest, and even jeopardize deals altogether.

SVTech can help. We are a technology-focused law firm, helping startups in and around Silicon Valley establish corporate governance structures that set their organizations up for long-term success. 

Contact SVTech today to discuss the systems that will keep your startup organized, accountable, and ready for the next phase.