When companies raise capital there are a number of rights that the investors (typically through the lead investor) will seek, such as a preference on liquidation (the right to be repaid their investment before the founders receive distributions), tag-along rights (the right, if the founders sell their stock to a third party, to participate in the sale), approval rights (the right to approve certain actions the company wishes to take) and pre-emptive rights (the right to purchase their pro-rata share of equity in future company financings.
An additional right a lead investor will often seek is to be granted a seat on the governing board of the issuer. Having a board seat gives the investor the ability to have a voice in crucial decisions, as well as access to information regarding the company the investor might not otherwise be privy to. However, sitting on a board also carries with it certain obligations, such as (i) making due inquiry into matters the board is voting on, and (ii) voting in the best interests of the company. Thus, if the company is considering signing a contract with a competitor of a board member, the board member may be obligated to approve the contract if favorable to the company, even if it is disadvantageous to the interests of the director. Further, board members are obligated to bring corporate opportunities to the companies whose boards they sit on, and sitting on a board may expose a board member to lawsuits brought by unhappy investors. Given the foregoing risks, investors might instead consider asking for the right to sit in on board meetings without actually being a board member (so called “observer rights”). Observer rights give the investor access to company information and the ability to participate in a board’s decision process, without the risks attendant to being a board member.