How VCs can control your company

6 minutes, 1 links

How VCs can control your company

The goals of founders and their investors don’t always align. VCs aspire to return 3X their fund for their LPs, but what founders want is less straightforward and can change over time. When these goals get out of line—and they do—things can get ugly fast. Investors can remove founders, block the sale of the company, or hold the threat of these things over founders’ heads in order to strongarm the founders into certain decisions.

How does this happen? Despite the belief of many founders that the best defense to VC control is maintaining greater than a 50% ownership in their company, VCs can control a company via two other powerful mechanisms:

  1. Privileges granted to preferred stockholders in protective provisions that are agreed upon in the investment term sheet.

  2. Seats on the company’s board.

danger The idea that total control of a company comes from maintaining ownership of more than 50% of it is a pervasive myth that is dangerous for founders. This myth comes from a fundamental misunderstanding of how voting rights work for stockholders in companies that grant preferred stock to investors.

Somehow, somewhere, people got the idea that founders and investors all received the same kind of stock. After all, why would there be different kinds of stock, and what would that even mean? Ownership is ownership, right? Wrong.

Investors get preferred stock, and founders almost always hold common stock. (We’ll discuss these classes of stock in greater detail later in our primer on ownership.) During an investment negotiation, investors frequently negotiate special privileges for preferred stockholders called protective provisions.

Definition Protective provisions grant preferred stockholders—usually venture capital firms—veto power over certain decisions that could adversely affect their investment. They are different from regular voting rights because, in the case of protective provisions, preferred stockholders get to vote separately from common stockholders. Decisions subject to protective provisions must be mutually agreed upon, but generally fall into one of two categories: highly consequential decisions like acquiring another company, and/or decisions that could materially affect the value of preferred stock.

Protective provisions require a majority of the preferred stockholders to vote on certain decisions that could impact the value of their shares.

danger After a company has granted protective provisions to preferred stockholders, investors with even 1% of a company’s overall stock could block a decision to sell the company for a profit to another company, because they want the founders to work for a few more years on the company so they can sell it for a larger return. While this happens, it is an edge case and would be the direct result of a poor negotiation on the founders’ and other investors’ part—as well as evidence the company’s lawyer was not paying attention.

Delaware corporate law (which covers the majority of startups established as C corporations) states that C corporations have to be supervised by a board of directors.

Definition A board of directors (board or BOD) is a group of people who oversee an organization, including by guiding and supervising the organization’s officers, and have legal obligations to act in the organization’s best interest. For a corporate board of directors, this includes ensuring that the company serves the best interests of its shareholders. All corporations are legally required to have a board of directors. The board typically consists of a mix of individuals representing different interests. An inside director is any founder, executive, or individual investor on the board. An outside director is not an employee of or existing investor in the company, and they are recruited to the board to provide specific expertise. Individuals on the board are referred to as board members. A board member is said to have a board seat at the company.

When a company incorporates, the board is usually made up only of one, some, or all of its founders. Under Delaware corporate law, boards have the authority to control the day-to-day matters in a company. You should always defer to your legal counsel when determining what decisions need a board vote, but in our section on protective provisions, we cover the decisions that almost always require a board vote.

It’s rare for an investor to negotiate a board seat at the seed stage unless they’re writing a large check ($750K+). Boards of directors usually meet quarterly for meetings that can be as long as three hours; they’re a big commitment, and investors usually don’t want to sit on too many boards. But at some point beyond the seed stage, you’ll have to give up board seats to investors, and that means you’ll need the support of any investors with a board seat when making major decisions.

Between protective provisions granted to preferred stockholders and board seats, every founder needs to know what they’re giving up in a deal with investors. Some investors, like Mark Suster, are transparent regarding how they think about working with founders when incentives change. Going into a working relationship with an investor with your eyes open about the risks is certainly preferable to putting years of your life into a business only to be surprised by your investors’ decision to block an acquisition or replace you as CEO. Understanding a term sheet and carefully negotiating the terms that are important to you can help you stay protected—and at least know what you’re getting into.

If you found this post worthwhile, please share!
Read six complete sections of this book for free.
Get six free sections of The Holloway Guide to Raising Venture Capital in your inbox over the next 2 weeks.
Emails may include promotional content from Holloway. You may opt out at any time.
The Holloway Guide toRaising Venture Capital