Who should be on the board of directors, and often whether a particular individual should be a director is a common dilemma for a start-up.

The first thing to be clear about is the role of a director versus the role of a shareholder versus the role of any employee. The three are not mutually incompatible – you can be a shareholder and an employee, or all of them at the same time. They are different, just as owning a house and living in a house are.

In order to keep this post short, I will have to keep an explanation of the three short. Bear in mind that the following is simplified.

An employee is someone who works for the company. He or she may have responsibilities. However, as an employee, he or she has no liability to anyone other than the company for the work done.

A director is someone who, along with the other directors, is responsible for the majority of decisions about the management of the company, particular those day to day ones. Directors don’t have to be make all the decisions – some can be delegated to other people within the company. But they are responsible for the outcomes.

That responsibility is to the company, which is its own person in legal status, and to the shareholders (note that there may be legal obligations to other stakeholders as well). The shareholders choose the directors and give powers to them to make certain decisions. The powers can be broad, such as to do what they think is best with regards to balancing having a competitive edge in the technology developed by the company with cost controls, or very narrow, such as to take on a loan from a specific lender.

Who should be on the board of directors is therefore an equivalent question to who are the best people to make sure that the company is run as the owners wish and that the best decisions are made when the owners don’t give specific instructions.

You may read articles on other sites that talk about having independent directors who can hold executive directors to account, or making sure that the board is diverse with committees to decide matters that might require independent thought not influenced by other board members. Those points are very valid, if and only if, your business has enough funding to employ committees of directors and it is large enough so that many directors are needed.

Keep your board small

A new company only needs a small number of directors. Most UK companies (regardless of age) have three or four. An odd number is good because it forces decisions to be made (a vote cannot be tied).

Small numbers are also good because decisions need to be made, not deliberated. Every additional director will bring opinions that have to be considered. Deadlock becomes more likely.

In the early days, all the founders should be on it

If you have started the company, you’ll probably want a say in how it is run. Of course, owners have that to some extent, but they may also want control of day to day decisions made by the board. In an early stage company, there will be many decisions that have a large impact on the future success of the business and where time is of the essence. Founders are best to be making those decisions.

By having the founders on the board, the directors are most likely to be able to run the company as the shareholders would like. There are likely to be fewer shareholder-level disputes that could disrupt the business.

If you can afford it, do bring in expertise

Some decisions require experience or knowledge or both. Founders may not have those things. You can compensate by hiring someone else, either as a non-executive director or as an advisor. The difference between them is voting rights and responsibility. The former has both, the latter does not.

When you start, you’re unlikely to need non-executive directors. They are advantageous in some circumstances, but not necessary.

Good advisors are worth their weight in whatever precious material you want to choose. There is less commitment to keeping them hired all the time; you can bring in expertise in certain areas as required; and you can still take their opinion without being bound by their opinion.

Being a director is a responsibility, not a reward

Directors have legal obligations. There is cachet in being able to say you run a company. But it isn’t all roses.

If someone wants to be a director because of position alone, decline him or her. He or she has to be able to handle the responsibility.

Someone can still make high level decisions without being a director (although be careful of shadow directorships). He or she can still have a job title that includes the word “director” or “officer”.

If you take on someone new who expects to be appointed as a director, give him or her a long probation period before agreeing to a directorship. He or she needs to be familiar with the company and its aims in order to serve successfully as a director. The other directors need to know that the skills he or she brings are those that are needed, and that they can trust him or her to act in the interests of the shareholders and the company.

The directors are the people who the shareholders appoint to run the company on a day-to-day basis. In a private limited company, there will always be at least one.

In a start-up, it is usual for the founders to be directors as well as owners. There may be other non-director owners (such as lenders) and there may be other directors (such as advisors).

Confusingly, there is no fixed definition in law – the best we can do is say that anyone acting as a director is one.

You hopefully know if you are one – you should have accepted the position as it comes with significant legal responsibilities. If you haven’t, but think you do the job of one, be aware that you can also be a shadow director – someone who is not a director, but who still has those responsibilities because of the control over the board that he or she has.

If you do hold a directorship, it should be recorded at Companies House (along with a service address for notices). The first directors to a new company are registered at incorporation. Afterwards, the articles of association should set out the process by which new ones are appointed or removed.

Who can’t be appointed as a director?

Certain people are prohibited from holding directorships by law. These include:

• someone under the age of 16 (unless he or she has been excepted by the Secretary of State)
• an undischarged bankrupt, or someone subject to bankruptcy restrictions
• someone who has been disqualified by a court
• someone who is an auditor of the company

Additionally, the company’s articles of association may prohibit generally certain types of people. If there is one, the shareholders’ agreement may also give stricter restrictions on exactly who can be appointed.

You don’t have to be UK resident to be a director. You could live abroad.

Corporate bodies such as other companies and limited liability partnerships can hold directorships. However, the board must also include at least one natural person (a human being).

Executive and non-executive roles

Executive directors are involved in the direct management of the business.

The role of a non-executive director is still to ensure that the board meets its objectives. He or she can bring experience from other areas of business life, and a viewpoint of someone not deep into the details of the business.

Companies are advised to appoint non-executive directors to bring balance to board decisions, although small companies are not obliged to have any. External equity investors will usually insist on having them.

Employment status

Employment law rather than company law defines whether someone is an employee or not. It is not always clear whether someone is an employee or not. Generally, someone working only for the company, on the company’s terms will be an employee.

Since executive directors are those directors who do this, they will be employees and require an employment contract.

Non-executive directors tend not to be employees and are hired under a contract for services.

Executive and non-executive directors have the same duties in law. Duties are not diminished because the director does not work full time within the company.

It is therefore sometimes better not to be a director unless you need to be. With power comes responsibility, both for your own actions and those of fellow board members.

The duties of directors

Directors have responsibilities towards the company. If those responsibilities are neglected or broken, the company and/or the shareholders may suffer, and the director concerned may be liable to civil and criminal action.

The statutory duties are:

• to act within powers given by the constitution of the company and the shareholders and to exercise them only for the reasons that they were given
• to act in good faith to promote the success of the company for the shareholders as a whole body. A director must consider in his or her actions:
  • the probable consequences of his or her decisions and actions
  • the interests of the company’s employees
  • the relationships the company has with third parties that are needed for long term success – suppliers, customers and other stakeholders
  • the need to maintain the reputation of the company
• to exercise independent judgement. Advice can be sought, but decision making power cannot be allowed to be taken by someone else
• to exercise reasonable skill, care and diligence by being informed about the company and taking decisions that would be expected by someone with his or her qualifications and experience
• to avoid conflicts of interest between himself and herself and the company
• not to accept benefits as a result of position or action as a director from third parties
• to declare interests (direct and indirect) in proposed transactions and arrangements to the rest of the board

Stemming from these, directors are reasonably expected also:

• to maintain confidentiality about the company and future intentions of the company
• to consider and act in the interests of creditors as well as shareholders

A company also has legal responsibilities. These include duties under the Companies Act, and those under other laws (such as the Health and Safety Act). Because the company acts through the board of directors, the directors are also responsible for making sure that the company fulfils its duties. The most notable ones are requirements to keep accurate and complete accounting records and to file information with the Registrar of Companies, which include the financial statements.

Breaching duties

If a director breaches a duty to the company, then the company (or in limited circumstances, the shareholders together) will be able to enforce a remedy.

Remedies might be:

• restoration of company property held by the director
• damages to make good the breach (but not to punish)
• an injunction to prevent further damage
• setting aside the actions of the director

If the company breaches it duties, all the directors together are liable for fines and/or (in serious cases) imprisonment. This could happen if the company:

• fails to file documents
• is, or about to become, insolvent
• breaks certain other laws (for example, criminal proceedings can be started against a director who breaks health and safety law)

Directors cannot be relieved of liability and cannot transfer it. However, companies often seek indemnity insurance for directors as a benefit in kind so that if a director did breach his duties, costs can be covered.

Shadow directors are people who have not been appointed as directors, yet who can wield significant influence over the day to day decisions made in running the company.

The definition under the Companies Act 2006 is “a person in accordance with whose directions or instructions the directors of a company are accustomed to act”. The definition, however, excludes professional advisors such as accountants and lawyers because “a person is not deemed a shadow director by reason only that the directors act on advice given by him in a professional capacity”. To be a shadow director means to control the whole board of directors, not simply to exert influence over one, or to provide advice that the board follows.

Legislation extends to shadow directors. They are bound by many of the same duties and obligations as board members. However, they may not be aware that they need to comply with the law, and therefore may not seek to protect themselves in certain situations, for example, by taking up liability insurance.

The consequences of being a shadow director are:

• creating a liability to contribute to the company’s assets if the company becomes insolvent
• possible disqualification from being a director following insolvency (of particular trouble if the person is a board member of another company)
• possible criminal charges for breaches of directors’ duties
• personal liability for breaches of directors’ duties

People become shadow directors both intentionally and unintentionally. Intentional reasons are usually to try to circumvent the law. For example, someone who has been bankrupt cannot be a director. The bankrupt might think that he can appoint a family member as a figurehead director in his place and continue to run the company. In fact, the bankrupt would be breaking the law and open to criminal charges because he would be a shadow director.

So how does this relate to start-ups?

The first thing to be aware of as a founder is that people who control decision making in your company may be shadow directors if they are not directors. This is the unintentional.

The following are examples:

A debt investor may not take up a directorship, but may decide to exert influence over how the company is run, especially if the release of further funding is related to achieving milestones that are not well defined.

The company becomes reliant on the work of one of the first employees (perhaps a website developer or a business development executive) and that person has significant say over how his or her part of the business is controlled. He or she starts making decisions about strategy, which are voted through by the board because of the need to keep the employee on-side.

A fellow founder is bought out by an investor but continues to come into the office and influence employees as to how things should be done. He or she knows a lot about the business, so no-one questions what he or she says.

How to avoid shadow directorships

The key to avoiding a situation where a shadow director exists is to have clear, written rules about how decisions are made by the board. These should be in your articles of association or perhaps in the shareholders agreement.

First of all, you need to know on what basis decisions are made, and which ones are for directors to approve only. Appropriate action must be taken when board-level decisions are made outside board meetings.

The second thing to do is to discuss the proposal for action within a meeting. If the directors are acting with due care, both the advantages and disadvantages of the consequences of a decision should be discussed in full.

Lastly, if someone seems to be acting as a shadow director, he or she should be told that he or she faces risks and that no longer acting in this way is beneficial to him or her as well as to the company. The most persuasive risk is that if the board make a wrong decision and the directors are sued, he or she might also be sued for something he or she was never aware of. Directors may be covered by liability insurance, but any non-director would not be.

Shadow directorships are not a reason why advisors should not advise, but rather why they should not direct the board.