CEOs Gone Wild

The recent ouster by American Apparel of its CEO and cofounder, Dov Charney, is turning into an excellent model of what to do (and not to do) with respect to sexual harassment and corporate governance. There have been rumors for years about whether Charney sexually harassed and engaged in other inappropriate behavior with employees. Those rumors have been fueled by the sexually suggestive images that permeate the company’s website and advertisements. Numerous cases of harassment had been filed over the past ten years, but invariably were settled through mandatory arbitration, with findings kept secret. The problem with keeping the details of cases and their resolution secret, however, is that it makes it difficult to bring pressure to bear on repeated wrongdoers. This issue is compounded when the focus of multiple complaints is someone as high up as the CEO. A lower-level employee or manager might be dismissed after the first complaint, and certainly after the second or third. It’s much harder to dismiss the CEO however. The pressure of public disapproval is often needed, but when the details are kept secret, bringing pressure to bear becomes quite difficult. Even in this case, with years of complaints and rumors of seedy behavior, the board still didn’t feel it had the ability to take action until the company’s financial situation and results took a downward turn.
That brings us to the corporate governance aspect of the story. According to a story in today’s New York Times, American Apparel had a leadership vacuum at the higher levels of management:

“Yet another layer of anxiety inside the company stemmed from Mr. Charney’s management style. Current and former executives described him as relentlessly controlling and pointed to a power vacuum growing in the retailer’s upper ranks.

Analysts said the company had developed a reputation as a place where talented people did not want to work. And during the past year, Mr. Charney forced out important company executives, including the general counsel, Glenn A. Weinman. A company with about 10,000 employees was left with only one lawyer in the United States.”

The absence of strong executives meant there was nobody to influence the CEO and act as a check on his troublesome behavior. At the risk of sounding self-serving, having no general counsel meant there was nobody in place with the specific role of identifying and dealing with legal risks in an appropriate manner.

The composition of the board of directors was another problem. The New York Times article described the board as “handpicked” by Charney. That in itself isn’t uncommon in corporate America, but good governance principles require that the board of directors have a degree of independence, and the ability (and willingness) to properly oversee management’s performance. Far too many corporate boards fall short in this regard. Also troubling was this:

“Few if any board members had experience in retailing or major public companies, things that helped enable Mr. Charney to keep them at a distance and to keep board meetings infrequent.”

While diverse experience and views are valuable assets on a corporate board, there should also be expertise and knowledge of the industry in which the company operates. If the company is a public company, as is American Apparel, board members require a level of knowledge and sophistication appropriate to a public company. Morever, the board should meet frequently, in order to adequately ensure that the company is on the right track. The board of directors’ obligation is to the shareholders, not the CEO. As events have shown, it took far too long for American Apparel’s board to remember that.Follow me on Twitter @PaulHSpitz

Anatomy of a Termsheet 5 — Voting Rights

Welcome back to the fifth installment of my series on the Anatomy of a Term Sheet. In this series, I am going through the model term sheet provided by the National Venture Capital Association, which you can find here.

In previous posts, I discussed provisions such as pre-money valuation, the option pool issue, dividend terms, and the liquidation preference. Today we are going to look at voting rights.    

Here is what the sample voting rights term looks like:

The Series A Preferred shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except 

(i) [so long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding,] the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the “Series A Directors”), and 

(ii) as required by law.  

The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock.

There are a few things going on with this term. First, it gives the Series A investors, which hold preferred stock, the ability to vote alongside common stockholders, as if their preferred shares had been converted to common stock. In addition, the Series A investors have the power to elect one or more directors, giving them an important voice in the management of the startup. Investors are naturally going to want control of the board, even if they don’t hold a majority of the stock on an as-converted basis, to protect their substantial investment. This is a negotiation point. It is still possible for the founders to maintain board control if other factors are at play, for example if the startup is particularly hot and there is more than one VC fund eager to invest. A possible fallback that might be acceptable for both sides is for the founders and investors to each select an equal number of board members, and for those existing board members to then choose an additional member. For example, if there is a five-person board, the founders and investors each choose two directors, and those four directors choose a fifth.

Finally, there is a provision that the number of authorized shares can be changed only by a majority vote of the preferred stockholders and the common stockholders voting together as a class. It takes away the right of the common stockholders to vote separately as a class on changing the authorized number of shares. Note that if the company is incorporated in California, it cannot opt out of the statutory requirement that the common stockholders vote separately as a class to authorize shares of common stock. If the company is incorporated in Delaware, on the other hand, it can opt out from the separate class vote requirement under Delaware General Corporation Law Section 242(b)(2), and this clause in the Term Sheet exercises that opt-out right.

Thanks for reading, and I hope this has been informative. Next time, we look at protective provisions.

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Startup Checklist

In previous posts, I have provided a lot of information on various aspects of getting a startup company established. I thought it would be useful to put a lot of that information in one post, as a startup checklist. So here we go…

1. Review your employment agreement – before doing any substantial development work, founders who are maintaining their day jobs should review their employment agreements (and this could include employee handbooks, etc.) to ensure that there are no conflicts with the startup. In particular, a startup founder wants to make sure that any IP she develops will belong to her startup, and not to her day job. It’s a good idea to have a lawyer take a careful look at employment agreements and policy statements.

2. Decide how you will split the equity among the founders – while equal shares might seem easy and uncontroversial, it may not be the best, fairest way of splitting the equity.

3. Form a corporation – if you have any aspirations of seeking angel investments or venture capital funding, form a corporation, not an LLC. And form it in Delaware. You might think forming an LLC is cheaper or easier, and you will be wrong. You will end up needing a corporation anyway, and will waste time and money fixing things that should have been done right the first time.

4. Adopt bylaws – once you have filed your certificate of incorporation, you will need to adopt bylaws to govern the management of your new company.

5. Appoint a Board of Directors – You will need one or more directors to oversee management of your company. The directors can now approve various resolutions to get the company operating.

6. Enter into a shareholders agreement with vesting and buyout provisions, and issue stock – you will want to have vesting provisions in place from the start, in case any founders leave the startup. Otherwise, you will have an ex-founder wandering around outside the company with fully-vested shares. Also, make sure each founder receiving shares files an 83(b) election with the IRS at the time you issue shares. Let me repeat that in boldface, because it is really important: make sure each founder receiving shares files an 83(b) election at the time you issue shares.

7. Assign IP to the company – at the time of issuing shares, make sure that all founders assign to the startup any IP they are creating. This will be part or all of the payment for their shares, depending on the situation.

8. Qualify to do business – You will need to qualify to do business in whatever state your principal location is located in, unless you are located in Delaware (see number 3). This is fairly easy to do; you just file some paperwork and pay the state a fee.

9. Stock options – do not issue stock options until you have a proper stock option plan in place, approved by the board of directors, with a Section 409(A) valuation of the stock options. This doesn’t necessarily have to be done at the outset, but there are advantages to doing it before entering into negotiations with VC’s over a Series A round.

10. Employment/consulting agreements — if you are going to hire employees or use outside developers, make sure they sign agreements specifying that any work they do for the startup is the property of the startup.

11. Comply with securities laws – just because you are not a public company does not mean that you are exempt from the securities laws. This is a complex area, with many risks and pitfalls. Definitely consult a knowledgeable lawyer in advance, and preferably each step of the way. Only seek funding from accredited investors; it will make your life much easier. There are no friends-and-family exemptions from the securities laws.

All of the above items are essential to making sure that your startup has a smooth path to growth. If you omit any of the above items, you jeopardize the well-being of the startup, and create many headaches and costs downstream.

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