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June 14, 2022 | By Patrick T. McCloskey
Angel investors are sometimes invited to join a startup’s board of directors. On the surface this is a win-win: the startup gains strategic insight from someone with experience and connections in the industry and the angel gets a seat at the table to monitor his or her investment. Despite this congruence, angel investors should be aware that board service can result in personal liability. Thankfully, there are measures that can mitigate this risk.
Directors of a corporation owe fiduciary duties to the corporation and its stockholders. While the law varies by jurisdiction, if the corporation becomes insolvent director duties can shift from stockholders to creditors. Fiduciary duties generally fall into two categories: the duty of care and the duty of loyalty. Directors can be sued personally for breaching these duties and the damages sought can be substantial.
Directors can also have personal liability for authorizing dividends or stock repurchases in violation of state law. While startups do not typically pay cash dividends, redemption rights are sometimes negotiated as part of an equity financing transaction. Even if a startup repurchases stock in response to an investor’s exercise of a redemption right, the authorizing directors can have personal liability to creditors if the repurchase impairs capital in violation of state law.
Another source of potential personal liability for directors is “control person” liability under the federal securities laws. Pursuant to Section 15(a) of the 1933 Act and Section 20(a) of the 1934 Act, a director can, under certain circumstances, have personal liability for a startup’s primary violation.
This is by no means an exhaustive list of sources of potential personal liability for startup directors. If a board seat is accepted, an angel should encourage the startup to engage an experienced corporate attorney to counsel the board on compliance, especially related to the matters referenced above. While an angel is unlikely to have a decisive board vote, since founders are typically directors themselves during the early stages, they should be aligned on avoiding personal liability.
Many corporations, including most startups, agree to indemnify their directors for claims against them in their capacities as such. These provisions are often lengthy and complex, but angels considering a directorship should make sure the indemnification rights include a critical feature: advancement of expenses that is mandatory, not permissive.
Since most startups have limited cash, indemnification protection against a large damage award is usually pie in the sky. While venture capital board designees frequently have a backstop indemnity from a well-heeled fund, angels who accept a board seat will usually need to shoulder the startup’s credit risk in this context. Since the costs of defending a claim are more likely to be within the financial reach of a startup, the right to be advanced expenses as incurred becomes especially important for an angel director. Advancement rights are typically conditioned upon the director’s written agreement to return the funds if it is ultimately determined that his or her conduct did not warrant indemnification, but the absence of advancement will require the director to go out-of-pocket to defend the claim until the case is adjudicated. As the expression goes, the wheels of justice turn slowly, so the right to be advanced expenses can be a godsend for an angel director.
Angels considering a board seat should make sure the operative provisions state that the corporation “shall, to the fullest extent permitted by applicable law” indemnify and advance expenses. While there are circumstances where a director’s conduct will ultimately disqualify him or her from protection under applicable law, use of the word “may” instead of “shall” gives the corporation discretion to deny coverage outright. In Delaware, corporations must indemnify directors who are ultimately successful in defending certain claims,1 but there is no statutory obligation for a corporation to advance expenses,2 so a mandatory advancement provision is crucial.
Most states, including Delaware, permit a corporation to include language in its charter exculpating the directors from personal liability for monetary damages. While there are limits to this protection,3 angels considering a board seat should insist that such an exculpation provision be included in the charter. Ideally, the provision should include the magic language “to the fullest extent permitted by applicable law.”
Certain jurisdictions, including Delaware and New Jersey,4 allow a corporation to include a charter provision renouncing any interest or expectation in certain corporate opportunities that are presented to its directors. While pushing for this might raise the eyebrows of a startup’s founding team, the inclusion of such a provision will give angels who are active in a particular industry or segment some protection against a claim that they breached a duty by pursuing an opportunity with another company the angel has invested in.
Since startups are usually cash-strapped at the time of an angel investment, affording D&O liability insurance is frequently an issue. That said, an angel considering a board seat can still push for it. As mentioned above, founders should be aligned in mitigating personal liability risk.
Angels who remain squeamish about personal liability despite the above referenced mitigation measures can consider a board advisor role instead. As an advisor, the angel can still provide strategic insight with much less personal liability risk. An advisor does not owe fiduciary duties in such capacity, and since an advisor does not vote as a director or have the authority to bind the corporation, an angel should not be deemed to be a control person by virtue of this role. Most advisor positions are governed by a written agreement, so the angel would still have potential personal liability for any breach of the contract. Since there is no statutory indemnification protection for non-directors in the absence of an agreement, an angel should push for mandatory indemnification and advancement rights in the contract governing the arrangement.
Each of the measures referenced above should be addressed before an angel funds the investment, not after. Some measures will require an amendment to the charter, which needs to be authorized by the board, approved by the stockholders and then filed with the secretary of state.
Once a startup receives the investment proceeds, the founding team will be less motivated to address the issues. For this reason, angels should be cautious about relying on handshake assurances that the measures will be implemented post-closing. While the founding team may have good intentions, it is human nature for their focus to shift to the business plan initiatives that will put the angel’s investment proceeds to work.
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This post is for general informational purposes only and does not constitute legal advice. No one should rely on the information in this blog post without seeking appropriate legal, accounting, tax or other appropriate advice from an attorney, accountant or other professional properly licensed in the applicable jurisdiction(s).
1See Section 145(c) of the Delaware General Corporation Law (“DGCL”).
2See DGCL § 145(d) (“Expenses (including attorneys’ fees) incurred by an officer or director in defending any civil, criminal, administrative or investigative action, suit or proceeding may be paid by the corporation in advance of the final disposition of such action . . .”) Italics added.
3In Delaware, liability for breaches of the duty of loyalty, intentional misconduct, knowing violations of law and liability for improper dividends and stock repurchases cannot be eliminated. See DGCL § 102(b)(7).
4See DGCL § 122(17); Section 14A:3-1 of the New Jersey Business Corporation Act.
