What are Board Observers and should you have them?
In addition to the directors some board meetings are also attended by observers. The right to appoint an observer may be a condition of an investment or sometimes a licence or other key contract. The rights of the observer may be laid down by contract but are usually enshrined in the company’s articles. This will usually say who can appoint an observer and that the observer is entitled to notice of all board meetings and to receive all the board papers. The observer has no voting rights and in the past was generally barred from speaking at board meetings however now it is very common for their rights to extend to speaking although not of course to voting.
The usual purpose of appointing an observer is to give the appointer comfort as to the progress of the company. It is common practice for a university to appoint an observer to the board of its spin outs. This can be helpful for both parties. The university does not “interfere” in the running of the company but can see that the usually inexperienced directors have the business under control and provide information such as where additional help might be sought or what other facilities of the university might be available to the start up. If they have concerns, they can take the founder aside outside the meeting and offer advice. Generally, this works well, and the university will fade into the background, with the observer attending less frequently, once the company is up and running and will usually lose its right to appoint an observer once substantial investment has been obtained.
Of potentially more concern is the appointment of an observer by an investor. With an early-stage company bringing in its first investment the investor may have similar concerns to the university and want some comfort that its money is being spent wisely and that the company is making progress. You would expect this to be handled by the appointment of an investor director however where there are multiple investors a smaller investor may accept an observer in place of the right to appoint a director if other larger investors have a right to appoint a director. Where an investor has multiple investments, they may also be uncomfortable about taking on a board seat because of the difficulty of complying with their duties towards each of the investee companies without conflicts arising.
Sometimes an investor will ask for both a seat on the board and an observer. This may be explained as a desire to have someone with technical expertise listening in to advise the investor or its director or as a training opportunity for a more junior individual that the investor hopes to use in a director’s role in the future.
The third case where you may get a request for an observer is where there is a potential conflict of interest because the appointing party is a key licensor or service provider to the company and as part of that strategic relationship is making an investment or where the nature of the collaboration is such that they feel they want to see what is going on as the project develops but because of the conflicts cannot take up a board seat.
If the observer is just sitting there and cannot vote does any of this really matter? Well, there are two major issues.
Firstly, there is the question of accountability. A director has legal responsibilities towards the company and with that potential liabilities. An observer has none and so his duty will be towards the organisation that appointed him. So, if they do speak at a board meeting in whose interest are they making the point?
Secondly, there is the question of influence and so transparency. The shareholders appoint the board and both they and third parties who interact with the company are entitled to believe that those are the decision makers. If there are observers in the room are, they influencing the decisions? If they speak, they could be influential but even if they stay silent their presence may be sufficient to swing the debate in particular directions. Even where an observer has no right to speak it is human nature that if they are in the room someone will speak to them and of course there is the question of how it looks to the outside world.
There are also issues for the observer himself. If he becomes involved in discussions and decision making could he be considered a shadow director and accidently find himself liable having failed to act in accordance with the duties laid upon directors.
What then is the best solution to a request to appoint an observer?
First of all, it is essential to understand why this is being suggested. In the case of smaller shareholders, could they be persuaded that their interests can be adequately protected through an agreed investor director? This may mean the larger shareholders making some compromise over their choice or just better communication with the smaller investor. If the issue relates to a strategic partnership would a more satisfactory solution be a joint development committee? Should the appointment be time limited if it relates to a particular matter?
If having carefully examined the request for an observer, the company feels that such an appointment is acceptable to it then it becomes critical that the person so appointed, and the board are all clear as to that person’s position and the extent to which they can and cannot be involved in board discussions.
If you would like any help looking at your board governance or have any questions relating to the involvement of observers with your company, please contact Patricia Barclay on firstname.lastname@example.org