Venture Capitalist Board Observers: An Entrepreneur's Guide

Entrepreneurs should consider the role of board observers

As an entrepreneur, you know that venture capitalists will get seats on the board of directors when they invest.  What you may not know, however, is that the VCs will often also have board observers from their firm.  What is the difference between a director and an observer?  What are the benefits and drawbacks of observers?

Board Member Vs. Board Observer

Directors have two primary fiduciary obligations to the company: the duty of care, and the duty of loyalty.  Moreover, directors vote on matters that require their approval (e.g., approving business strategy).

Sometimes, there are more parties with an ownership stake in the startup than there are board seats.  The general guideline is that early stage companies should have five to seven people on the board.  When there are many investors, not all investors will get represented.  In this case, VCs will ask for and often receive observer rights.

Observer rights are covered in either the investor rights agreement or a separate side observer rights agreement.  These rights usually include:

  1. Attend and participate in board meetings
  2. Receive the same information as directors

However, observers are not allowed to:

  1. Vote on matters
  2. Receive attorney-client privileged communications

Advantages of Board Observers to Startups

Observers can contribute to the governance of emerging companies.  First, they can mollify investors who want to participate in board meetings.  Sometimes the observer is the second representative -- an associate rather than a partner -- from a venture capital firm.  The associate gets trained through the experience.

Second, more experienced observers can add to the discussion.  These observers may be investors who have come in on a later round when the board is already at its optimal size.

Disadvantages of Board Observers to Startups

Yet, observers can also potentially cause problems for early stage ventures.  Unlike directors, observers do not have fiduciary duties to the company.  As a result, except in unusual circumstances, observers are not liable for their participation.  However, directors can be held liable for breaches of their fiduciary duty.  Only directors risk personal liability, high legal costs, and damage to their reputation for alleged breaches of fiduciary duty.

This difference in liability suggests that observers may have different incentives in how they view their service.  Since startup boards typically try to reach a consensus on important issues, board observers may exert disproportionately large influence on decisions.  Although not entitled to vote, they can greatly influence the decision making process in situations where a vote actually does occur.  This is why venture capitalist Mark Suster dislikes board observers, except for where the person is the associate of a VC partner.

Balancing The Pros And Cons

In general, I have some concerns about allowing board observers to participate without limitation meetings.  Not every investor can be on the board. Observers can attend if they are significant investors.  Their participation should be limited in some fashion though.  They certainly should not be allowed to receive attorney-client communications or certain sensitive information.  Investors who do not have a board seat may have information rights, so they do receive important information regarding their investment.  Is that enough information for them?  If they are not actively participating, and merely observing, then what are they contributing to the meeting?

Of course, allowing these non-voting individuals to attend the meeting is often an exchange for their financial support.  Observer rights are usually given to investors who might get a board seat but for the limited size of startup boards.  But that does not mean that adding the investor enhances the board's work on critical corporate governance issues.  Yet, perhaps there is not much harm done either.

The question then arises:  Should the standard for board attendance and/or participation be do no harm, or do good for the company?

In rare cases, an overzealous observer can cause problems.  The individual may disrupt the proceedings or fail to prepare properly.  If this happens, first try to negotiate the situation with the observer and his or her superior.  Then refer to the investor rights agreement or observer rights agreement to see what you can do.

Of course, now that you know that problems might occur you should negotiate the scope of the observer's rights.

What kind of experience have you had with a board observer?  Do you think an observer contributes to the conversation?

Douglas Y. Park
Twitter: @DougYPark

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