Recordkeeping can be a hassle: it costs money and time to maintain records. But it is a necessary and crucial part of every company. The failure to maintain proper records can have detrimental consequences on the validity of a company’s actions, particularly when that failure is the failure to properly document board approval of key company decisions.
Every company that has a board of directors or board of managers – regardless of the company’s size, maturity or industry – has a list of company actions and decisions that require the board’s approval. This list is often found in organizational documents or is required by law.
Examples of actions that commonly require board approval include:
- Amending or waiving any provisions of a certificate of incorporation or bylaws
- Issuing stock options or warrants
- Undergoing a round of equity or note financing
- Entering into a merger transaction or an acquisition
- Increasing or decreasing the authorized size of the board or any committee thereof
- Declaring or paying dividends
- Approving or materially amending an annual budget or business plan.
In order for any such actions to be valid and effective, the company must first obtain the prior approval of the board through resolutions in a unanimous written consent or at a meeting of the board that reflects the approved resolutions in the minutes of the meeting. Only after such approval is obtained can companies comfortably proceed with the authorized action.
What actions do companies most commonly fail to obtain board approval for?
When it comes to early stage start-ups, there are often trends in the types of actions companies most commonly fail to authorize in board consents or at a board meeting as reflected in the meeting minutes. The following list sets forth a few such actions companies often forget to have the board approve.
Stock option grants
Whenever a company grants stock options to any employee, consultant or director of the company, the grant must be authorized in board consents or at a meeting of the board as reflected in meeting minutes. Typically, board resolutions authorizing the grant of stock options would contain the following:
- The company has had an independent third-party professional appraiser perform a detailed analysis of the fair market value of the company’s common stock, and the board has determined the value of the company’s common stock based on a variety of factors, including the independent appraisal. This third-party independent appraisal of the company’s common stock is referred to as a 409A valuation, which is a reference to Section 409A of the Internal Revenue Code.
- The details of each individual option grant, including the name of the grantee, the number of shares to be issued, the date of the grant, the vesting commencement date, the exercise price (which typically cannot be lower than the fair market value of the company’s common stock), the vesting schedule and whether the stock option is an incentive stock option or non-qualified stock option.
- If necessary, an amendment of the company’s stock incentive plan to increase the number of authorized shares of common stock available for issuance under the plan and a corresponding amendment to the company’s certificate of incorporation to increase the number of authorized shares of common stock.
Other issuances of securities
Other security issuances that companies often fail to authorize in board resolutions include issuances of warrants, convertible notes, common stock and preferred stock. Whenever any security is issued to any person, such issuance must be authorized by the board.
Changes in officers
The bylaws or operating agreement of a company typically requires any changes in some or all of the company’s executive officers be authorized by the board. This means that whenever a company removes an officer and another individual is appointed in said officer’s place to fill the resulting vacancy, both the removal from office and the appointment to office must be documented in board consents or board minutes as actions authorized by the board.
Approval of prior minutes
As a matter of good corporate governance, prior minutes of the meetings of the board should be reviewed by the board and approved at the next board meeting or through resolutions in a board consent. Upon approval of the minutes, the board directs the secretary of such meetings to execute the minutes and to cause them to be filed with the minutes of the meetings of the board.
What are the consequences of failing to obtain board approval?
The failure to obtain board approval for the grant or issuance of stock options, capital stock, warrants and the like can have significant implications for a company. First, the grant or issuance of such security may be invalid, so the security holder may not have ownership rights in the security, or the security holder may not have the right to receive the return of the holder’s investment in the company’s equity.
Second, the failure to properly document security issuances by a company can result in a significant loss of confidence in the company by not only existing investors, but also prospective investors that become aware of such documentation and approval failures.
In particular, often when a company undergoes a round of preferred stock financing, the investors conduct a detailed review of the capitalization table as part of their due diligence review of the company. This capitalization table review, which is referred to as ‘cap table tie out’, involves a careful review of the company’s capitalization table against the company’s board consents, board minutes, stock option grant awards, restricted common stock purchase agreements and other such documentation. This is to confirm that the capitalization table reflects the number of securities that are issued and outstanding and the number of shares of stock options available for issuance.
In order to maintain the prospective investor’s confidence in the company’s recordkeeping, it is vital that the capitalization table set forth an accurate list of the company’s outstanding shares of capital stock as well as any outstanding securities that are convertible into or exercisable for common stock, including stock options. Furthermore, the exact number of shares outstanding before the financing is of critical importance to investors because the number is a key part of the formula used to determine the price at which the new preferred stock will be sold by the company in the financing.
The failure to document the election of an officer, on the other hand, means any action taken by such officer prior to formal board approval may be deemed void. Board approval of the election of officers is a means through which officers are granted signing authority on behalf of a company. Thus, if an individual has signed documents in his or her capacity as an officer of the company before the individual was formally appointed to that office by the board, the individual’s signature on the documents could be deemed to be invalid and any document that contains the invalid signature would be deemed to be ineffective.
What can a company do if it fails to document board approval for a company action?
All is not lost! In the event a company fails to record resolutions approving certain actions of the company in a board consent or board minutes, ratification could be the solution. In practice, this means the company can draft a board consent after the fact that ratifies past actions of the company and its officers.
In the case of prior board meeting minutes that have not been approved by the board, the board can approve such minutes at its next board meeting or in a separate board consent. In most cases, ratification of the matter by the board is sufficient to reflect the board’s approval of the matter.
Jullia Park is an associate in the emerging companies and venture capital practice group at Morrison & Foerster, and John Rafferty is a partner in the practice.