The third post in Brad Feld's excellent series on venture capital term sheets explores the board of directors, easily the most important control feature of any important portfolio company. Unless, of course, you don't hold a majority of the seats, in which case you had better contract for some protective provisions (negative covenants).
The board provision in most venture capital deals allocates some seats to the common stockholders, some seats to the preferred stockholders, and some seats to be selected by all of the stockholders voting together as a single class. Brad offers this awkward language from a term sheet to capture this last concept: "the remaining directors will be ... mutually agreed upon by the Common and Preferred, voting together as a single class." Notice the problem? Just because the common and preferred are "voting together as a single class" doesn't mean that they mutually agree. If they are voting together as a single class, whoever holds a majority of the shares wins a disputed election.
Brad also suggests this alternative: "the remaining directors will be ... chosen by the mutual consent of the Board of Directors." This is exceedingly rare in the deals that I have seen, and I might even argue that such a provision is illegal -- at least for a Delaware corporation -- unless the corporation is formed under the close corporation statute. After all, Section 211(b) of the Delaware Code states, "an annual meeting of stockholders shall be held for the election of directors." The only stated exception is when "directors are elected by written consent in lieu of an annual meeting." As you can see, stockholders elect directors regardless.
Consider also Chancellor Allen's ode to the annual meeting (while the Delaware legislature subsequently overrode Chancellor Allen's holding that required an annual meeting, not just written consents, the legislature did not undermine the central role of stockholders):
The obligation to hold an annual meeting at which directors are to be elected, either for one year or for staggered terms, as the charter may provide, is one of the very few mandatory features of Delaware corporation law. Delaware courts have long recognized the central role of annual meetings in the scheme of corporate governance.... The critical importance of shareholder voting both to the theory and to the reality of corporate governance, ... may be thought to justify the mandatory nature of the obligation to call and hold an annual meeting.
While I have seen Brad's provision for director-controlled elections in form books, I do not know of any cases deciding their validity outside of the close corporation context. And the idea of a self-perpetuating board outside of that context is very unappealing to me.
Posted by Gordon at January 14, 2005 12:33 AM | TrackBack