Start-ups with one founder rarely have or need a board of directors. In fact, such a board would seem out of place in a one person company. As soon as any outside money is ingested into the corporation, others have a vested and legal interest in the behavior of officers entrusted with the best use of funds. Money from friends and family usually is offered in a casual manner with much less restriction than professional investors, so that a formal board is a logical step but not often created upon this event. Then along comes either money or contracts from strategic or financial investors or partners. The operations of the corporation become more complex. Ownership is spread among several classes of investors. The number of employees grows. Bank loans with restrictive covenants are taken on. These events, one or all, usually are triggers for the founders to seek to create a board for oversight and guidance.
Once created, it is logical to follow the standard practice in the creation of two standing committees composed of outside board members (not employees or executives) – the compensation committee and the audit committee. Compensation’s charter is to approve stock option grants for any employee, no matter how small the grant, and all salary and benefits for at least the CEO if not the next level down, to avoid conflict of interest with the CEO. All actions of the committee are in the form of recommendations to the full board for vote, and are not binding until that event.
[Email readers continue here…] Second, the audit committee is responsible for hiring an outside auditor as appropriate, reviewing the accounting practices of the corporation and making sure that laws are followed relating to recognition of revenues and expenses. Good audit committees also review the corporation’s insurance portfolio, risk protection policies such as email and computer use, disaster response and recovery policies and any other area where the corporation’s very life could be at risk from inattention.
Let me tell you the story of a company on whose board I sat for several years. The CEO insisted that between husband and wife, over half the stock always be in their hands, refusing new offerings or any other form of dilution, and controlling the majority of board seats in the process. After replacing two board members with two other friends who were a bit less independent, during that first meeting with all present including the two new board members, I suggested that the corporation then form the two committees – audit and compensation. “Never!” was the single word as I recall the CEO’s immediate outburst. I made a motion to bring it to a vote. The corporate attorney was present, recommending this as a relatively safe move for the CEO. I called the question after a drifting discussion. You can guess that the three friends voted down the measure, perhaps as a sign of unison, since this was the first vote by the two new members. It was the final nail for me. I engineered the extraction of the outside investors, even at a near total loss. At least the investors could then take the loss against ordinary income under rule 1244 of the IRS code, worth something to each, rather than being locked into what was a slowly failing lifestyle business with no effective oversight.
