Episode 16 culminates with a disastrous end to the Intersite bake-off, and highlights an issue that’s cropped up in several episodes:  troublesome or under-performing board members.  To recap, Pied Piper is competing against nemesis Endframe in a “bake-off” to win a $15 million contract with Intersite.  In the course of the bake-off, Pied Piper’s (formerly) billionaire investor and board member, Russ Hanneman, unknowingly sets a tequila bottle on the delete key of Richard’s laptop causing the deletion of 9,000 hours of Intersite’s premium content, and Pied Piper loses the bake-off.

Russ has been problematic since he first rolled into Richard’s and Pied Piper’s life—spending Pied Piper’s money on billboards and useless swag (Episodes 11 and 12), installing his girlfriend on the board and poaching Pied Piper’s employee for another of Russ’s companies (Episode 12), demanding that Pied Piper change its business model solely to make him more money and then pulling his funding and trying to force Pied Piper into a merger with Endframe (Episode 15), etc.  The guy’s a menace, but he is also Pied Piper’s biggest investor—having pledged, but not delivered, $5 mil in funding.  But how did he get on Pied Piper’s board?  How did his girlfriend get there?  And could Pied Piper have avoided it?

As Pied Piper’s major investor, it is not surprising that Russ, or his designee, would wind up on Pied Piper’s board.  Members of the board of directors of Pied Piper (or any company), are elected by the stockholders.  Prior to Russ’s investment, the major stockholders of Pied Piper were Richard, Erlich and Raviga (Peter Gregory’s firm), and the board was composed of Richard, Erlich and Monica, as Raviga’s designee.  A major new investor (like Russ or a VC fund) may ask for a board seat as part of the bundle of rights in exchange for their investment.  Typically, at the time of the new investment, the investors will require the existing stockholders to sign a voting agreement, in which the existing stockholders agree to vote their shares in favor of the investors’ designee.  When the investor is a VC firm, the designee is usually the venture partner who sourced and championed the deal within his or her fund.  In Russ’s case, it is likely that he was his own “designee” and Pied Piper’s existing stockholders (Erlich, Richard, and Raviga) were required to vote for him by the terms of the voting agreement.  In addition, Russ appears to have obtained the right to designate two board members, himself his girlfriend.

This clearly isn’t ideal for Pied Piper.  They are stuck with Russ being disruptive and erratic, and his girlfriend who appears not to do much except vote with Russ.  Could Pied Piper have done anything to avoid this situation?  After all, as an early stage startup, Pied Piper really needs these designees to be value added board members, with connections and industry insights to provide useful advice and help Pied Piper grow.

The number of board seats and board composition are key terms of any investment negotiation and can often be overlooked in favor of issues around valuation and liquidation preference.  Before agreeing to a board seat term, founders should be up to speed on how board voting works, blocking rights (the right to block an action) and overall composition, but knowing the basics is not always enough.  Monica advised the guys that if she, Richard and Erlich all voted together, they’d be ok even with Russ and girlfriend on the board.  But it only took about 30 seconds for the pact to fall apart with Russ and Monica voting against Erilich and in favor of extending an offer to the cyborg, and Erilich retaliating by voting in favor of Russ’s swag.  Rather than trying to deal with a problem director after the fact this way, a better approach is to avoid getting a lemon in the first place by doing advance homework on potential board members:  looking at their other portfolio companies, their past work experience and their connections.  Even a board member that is not actively harmful, but is just a bit of a dud—like Russ’s girlfriend—can put drag on a board, slowing down board actions and/or forcing consideration of issues that the board would otherwise not spend time on.  On the other hand, a board member who is knowledgeable, engaged and connected can really help take a startup to the next level.

Given that Pied Piper was pretty desperate for Russ’s money, they likely couldn’t have refused to accept Russ on the board.  Could they have done something about his girlfriend?  Pied Piper could have resisted giving Russ the right to designate two seats.  If that didn’t work, the original board members could have required that Russ’s second designee be an individual that is reasonably acceptable to the other investors.  Inserting a normalizing requirement like this into the voting agreement would give Monica, Elrich and Richard some ammunition to confront Richard on who fills the fifth seat.  (But even then, they could have ended up with a rep from the McLaren dealership. . .)

With thanks to Stephanie Zeppa, Corporate Partner, for her insights.