Term Sheets: What are Preferred Directors?
This week we continue our series on key VC financing deal terms.
This week’s question: What do I need to know about preferred directors?
Our answer: Preferred directors are board members designated by preferred stockholders typically as part of the investors’ protective rights in a financing. In a corporation, the board of directors is responsible for overseeing the company including by making key strategic decisions about fundraising, selling the company, issuing stock, and hiring and firing officers. Initially, startups typically appoint the founder but in later financing rounds, lead investors will increasingly negotiate for a board seat to have influence and oversight of your startup (and their investment) especially as it relates to business strategy, equity issuances, governance, and major decisions. Preferred director seats are highly impactful, so we recommend working closely with your startup’s counsel to negotiate the number of investors on the Board to preserve ongoing flexibility while fostering healthy and functional board dynamics.
Key Considerations
1. Number of Preferred Directors. When determining how many preferred directors should be allowed on the Board, maintaining balance is key. Typically in earlier stage companies, investors are OK with the founders largely maintaining control of the Board because investors are more concerned with oversight rather than control. However, as the company progresses, founders are commonly outnumbered on the Board by preferred directors and mutually appointed directors as investors seek more control in advance of potential exits. You should seek to maintain an ongoing balance between founders, preferred directors, and independent directors (ie. unaffiliated third-parties) so governance is not overly favored in any direction.
2. Removal Triggers. The Voting Agreement should contain provisions to remove preferred directors if the investor requests removal or if the investor falls below the threshold required to have an eligible board seat. Be sure that these are clearly implemented in the Voting Agreement to avoid any administrative burdens or conflicts in changing the Board’s composition.
3. Fiduciary Duties. Keep in mind that preferred directors owe fiduciary duties to all of the company’s stockholders, not just their specific fund, so they must make decisions in the best interest of the company. However, you should always be aware of what context the individuals serving as preferred directors are making a decision – on their fund’s behalf or the company’s – to confirm interests are properly aligned.
4. Observer Rights. If an investor wants access to the board but you or they don’t want a formal seat, then a common compromise is to provide the investor with a board observer seat. This entitles an individual from the investor to join board meetings in a non-voting capacity and grants them access to materials shared with the Board (subject to customary exclusions for highly sensitive or privileged information).
Why It Matters
Preferred director seats are a standard ask from lead investors in VC financings. However, granting these seats can reduce founder control. A well-structured board helps maintain alignment and reduce friction, but the details matter, especially number of seats and thresholds for appointment and removal. You should negotiate carefully to balance investor influence with long-term governance needs and set terms that align with both business goals and future fundraising strategy.
