There is a fundamental information imbalance in the startup world that stems from the fact that most  founders are raising money for the first time, but most investors are not investing for the first time. This used to be a much bigger issue ten or fifteen years ago, but these days, it is possible for a founder to learn enough about fundraising, term sheets, board structures, etc.

There is an increased amount of transparency in the startup eco-system today than when I was trying to raise money the first time back in 1998. Fortunately, I ended up with excellent angel investors who offered very founder friendly terms. I raised $1.15M on a $2M pre-money valuation (yes, really!). The most onerous term, was that as a solo founder they wanted to make sure that the key-person risk was covered. So at the ripe old age of 23, I was worth more dead than alive — since I had a $3M life insurance policy on my head to cover the key person risk. But, I was lucky because back then I had no idea what participating preferred meant, or what a full-ratchet meant.

Although there are probably other examples that pre-date this one, but what Nivi and Naval did with VentureHacks back in the day was one of the pivotal moments for me to realize that it doesn’t always have to be this way, and that entrepreneurs *can* empower themselves with the information they need in the fundraising process.

The challenge for most founders remains that they come in with an information disadvantage. The best founders will actively seek to learn as much as possible, as quickly as possible, to make sure that they can overcome that disadvantage in a timely manner.

Since I was never “trained” as a VC and instead transitioned over from being a founder to being an investor, I’m still learning some of the “VC tricks.” And I’ve decided that in the spirit of transparency, it’s something that needs to be written about more, so that first time founders can learn and know how to respond/react to some of these. It is with that in mid that I wrote the post Watch out for the board observer request.

I’m going to attempt to document all those little things that when I heard for the first time, I felt like, “well, now that’s an interesting little trick.” So watch out VCs, your secrets are slowly going to get exposed. For today’s version of my #VCTricks post, I’m going to talk about board composition.

When you’re raising money, one of the mot important things is to consider the composition of the board. Founders who haven’t yet learnt the ropes typically think that as long as they control >50% of the stock in the company, they are in control. That’s a very limited view and often not true.

A lot of the key decisions for a company often fall in the hands of the board of directors and so it is important to make sure that you have a board that is well-balanced. And here comes the trick — sometimes you may receive a term sheet, which on the surface looks like a balanced board. It’ll say something like: “The board shall consist of 5 members, 1 seat for Shylock Ventures, 1 seat for SPECTRE Capital, 1 for the common stock holders (typically Founder 2), one for Founder 1 as the CEO of the company, and one independent.“

At first glance this looks like a pretty well-balanced board. 2 investors, 2 founders, 1 independent — cool right? Not so fast. The key is in the phrase “as the CEO of the company.” Even though the board starts out with two founders, one of the founders is actually occupying what is really a seat that is designated for the CEO of the company. What can happen in the future is that if the board decides to bring on a new CEO (this happens often and I’ll address this in a future post), then Founder 1 is effectively off the board since he/she is no longer the CEO.

Now this is not all bad — after all, the CEO of the company *should* be on the board of the company. However, it does upset the balance on the board if and when that happens. When a founder sees this construct in a term sheet, they need to understand that what has been proposed is really a structure that consists of 2 VCs, 1 Common, 1 CEO, and, 1 independent. The founders then have to then determine whether they want to argue for a different structure (perhaps, 2 investors, 2 common and 1 independent) or whether they’re comfortable keeping it as is. Ultimately, it’s a discussion and a negotiation that the founders need to have with their lead investor.

The ask for a CEO seat can also be a signal to a founder that the investor may not have full confidence in the founder’s ability to lead the company as CEO, and so the investor is trying to keep their options open. Again, this isn’t all bad and can sometime be good for the company and the founders, but it is important for founders to be able to read between the lines and then have a discussion with their investor about at least giving the founding CEO a fair chance. IMHO it’s better to have these conversations up front before you sign a term sheet.

So that’s the VC Trick — give what looks like a common/founder seat, but is really a CEO seat.

Now let’s talk about the related startup mistake. If you look carefully at the board structures proposed above, each one contemplated an independent seat as well. Well, here’s the simple thing that founders screw up — they don’t get around to filling the open independent seat!

The *only* time the independent board seat can be filled is while the founders and the investors are still within their honeymoon period. I define the honeymoon period as the first 3 months, or 6 months if you’re really lucky, during which an investor will still be very excited about the investment. During that time, the founders and the investor can potentially agree on who should be the independent board member.

Once the honeymoon is over, i.e. when the investors start to realize that there is a lot more work to be done that they initially imagined, or that the company isn’t as far along as they really thought, or when the seeds of the first contentious discussion start to brew, then it becomes much harder, and sometimes impossible, for the founders and the investors to agree on an independent board member.

At that point, each side is going to introduce someone they know and the other side is going to worry about whether that person is truly independent or whether this is an attempt to stack the board.

This is *such* a common startup mistake. As soon as the round is done founders get back to focusing on recruiting, product, customers, and all that other stuff that they should be focusing on, and the independent board seat feels like a low priority item. But once you let the honeymoon period pass, and the independent seat remains vacant, then you’ve compromised the balance of the board.

Now let me play this out in a sinister example. 5 person board. 2 VCs. 1 Common. 1 CEO, 1 independent, but the independent seat is vacant. Now it comes time for the board to vote on who should be CEO. Founder 1, who is the current CEO, becomes an interested party and so can’t vote (would appreciate it some lawyers can verify this for me). So now the CEO vote becomes 2 VCs vs. 1 Common. You can guess who wins.

So please founders, do yourselves a favor. Don’t let that independent seat sit vacant. Don’t fall victim to this incredibly common startup mistake. Think about it carefully, find the right person, who can be truly independent and can have an opinion of their own and do what’s right for the company.

 You can follow me on Twitter at @ManuKumar or @K9Ventures for just the K9 Ventures related tweets. K9 Ventures is also on Facebook and Google+.