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Photo: iStock

The value of letting observers into Indian boardrooms

Done with clear rules, it could overcome a scarcity of board seats and also aid a firm’s governance

More and more start-ups in the US and Europe have board observers, but we hardly see many in Asia, perhaps because regulatory clarity is in short supply. Yet, as large enterprises try to imbibe the culture of start-ups in this era of covid disruption, they too could benefit from board observers as a way to drive growth.

Regulatory obstacles, if any, should be set aside to induct observers along with board directors in the larger interests of all stakeholders. This could also help solve various hassles between investors and promoters.

An observer is just that special someone who is allowed to participate in board meetings with full access to all the information, including the minutes of previous meetings, that is available to directors, but she or he has no vote. Typically we see this in startups, and the rights of observers are specified in a shareholder agreement and separate non-disclosure pact, the kind typically signed by private equity and venture capital investors or significant minority shareholders. An observer can also be brought in for specific strategic purposes.

When there are a multitude of investors with comparable investments, and insufficient board seats, observers could be drafted as a way to strengthen investor confidence. Big established companies don’t usually need this, but they may be well served by doing it for their independent subsidiaries in sunrise and high-risk businesses. It could also help prepare the next rung of executives for board roles .

Usually, the right to become an observer is given to a substantial investor who insists on one or more board seats. This is especially helpful in the case of start-ups. As and when more investment flows in from multiple venture capitalists, observers can be taken on. But it’s not just to satisfy all key investors with seats that observers act as a solution. Such appointees could also guide the company on matters critical to its success, just as directors do.

Board observers can provide new perspectives on business strategy and bring in fresh thinking for the company’s apex body of governance to gain from. Moreover, when a start-up has a representative of an investor group as an observer, it tends to find it easier to go for the next level of fund infusion. What better way to raise funds than from the same set of investors? It sure beats going about hunting for fresh ones.

Experts may argue that since an observer has no fiduciary responsibility, he or she can’t be trusted with the confidential data of a company. This shall be resolved with a firm agreement that binds them to the same confidentiality and non-disclosure clauses as regular board members. Besides, observers can be excluded from board meetings on issues that could have conflicts of interest, or when sensitive discussions must be held on, say, litigation, etc.

One of the tech services companies we were involved with was in talks with a private equity (PE) firm for funding. For the promoter-technocrat who had set up this firm, this was a big move. He even agreed to board representation for the PE firm, but the latter also asked for a board observer right. He was a bit disturbed and sought our advice on how it could work. This is a typical of issue faced by most entrepreneurs.

Investment firms usually seek a set level of formal board representation, but occasionally, they also want their observers to attend board meetings, receive information, and take part in discussions. Part of their objective is to bring in expertise and train own executives in specific functional roles. While this seems harmless enough, in the small boardroom of a start-up, an observer can punch above his weight, as they say in boxing. If a private board has an informal air about it, then proceedings do not always depend on strict voting numbers; a split vote is often seen as a bad sign. What matters more is a business leader’s ability to direct discussions. An observer may be able to dominate at this, and that too, without the personal liability or fiduciary fetters of an actual director.

The best bet for the aforesaid promoter, faced with an investor insistent on observer rights, was to hold out for clearly written rules on what the observer could and could not do. There are several observer rights one can chart out, but a firm agreement should address the following: Who the parties to such an agreement are; the specific names of observers (rather than allowing ad hoc rotation); meeting notification norms (so neither side can claim the other is trying to freeze one out); restrictions if any (particular board meetings or items of business when observer attendance is either barred or mandated); information rights (what material the observe gets); protections for and the liability status of an observer; and, last but not least, well-drafted confidentiality clauses.

Crucially, entrepreneurs must manage personal egos and control the influence that observers could have on board members with voting rights. It may be true that more minds formulate better strategies, but this also adds to management complexity. More numbers also mean more schedule clashes and need for coordination. Good observers are usually ready to adjust their schedules to suit those of most directors.

Many seasoned executives advocate fewer investors on a company’s board (and that includes observers) because it risks a loss of entrepreneurial focus. We don’t subscribe to this argument, as we believe that observers can be trained in their roles and could add significant value to an enterprise.

M. Muneer & Ralph Ward are, respectively, co-founder and chief evangelist at Medici Institute, and publisher of Boardroom Insider.

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