Venture capitalists (VCs) who are considering making an investment in a startup or other innovative venture are generally concerned about control provisions in order to keep an eye on their investments and comply with certain tax statutes. Although VCs normally own less than 50% of a company, they usually negotiate special control provisions to ensure that they have an adequate say in important matters or when certain things might happen to the business, such as liquidation or going public. Here are some ways that investors retain control:
When it comes time to negotiate a fundraising contract, it is not uncommon for VCs to basically demand that they receive a significant portion of the board seats. Fledgling startups may be hesitant to establish a board from the very outset, but they should not be surprised when an investor wants the company to do so before discussing, much less be willing to commit to, an investment. There is a good chance that investors will spin the establishment of a board as an excellent opportunity to have a team of dedicated experts with whom the startup founders may consult. This certainly may be true, but it is important to remember that the goal for most VCs is to exercise a good amount of control over the company’s operations. In some cases, this involvement may border on micromanagement, so it is crucial to ensure that everyone understands the objectives going forward if the founders decide to grant this VC request.
Even if the VCs do not request that a board be established or the VCs do not take a portion of the board seats, there are other ways that they may try to include terms within the contract that will allow them to exert control. An example of this is the inclusion of protective provisions. This sort of provision may allow VCs to block or override board actions. For example, the protective provision may dictate that a certain percentage of preferred stockholders must consent prior to implementing a decision of the founders or the board. There are some pretty run of the mill matters to which this veto power may relate, but some VCs may demand that it apply in a lot of additional circumstances. Depending on the scope and breadth of the provision, this could really hinder operations not to mention frustrate a lot of people.
In some cases, the preferred stockholders and/or those who own a majority of a company’s shares will want to engage in an all or nothing kind of transaction. Depending on what that action is, they may need all interested parties to participate or else the deal will not close. Thus, many VCs are keen to include drag-along rights so that they have the ability to make minority owners act in accordance with their wishes. For instance, if the majority decides it wants to sell the company, it can force minority stockholders to sell as well by virtue of these predetermined drag-along rights. Now this is not to be confused with tag-along rights, which actually give the minority holders some say as to whether they want to follow suit.
Another way that VCs may seek to preserve their investment is by demanding the right to convert preferred stock to common stock. This may occur by virtue of a liquidation preference, but it can also occur if the investors want to convert because there is a rise in the share price. Thus, they have the option to take advantage of gains while also having protection in the event that there is a drop in the price. These various control measures essentially afford VCs the right to have their cake and eat it too. This may be off-putting for individuals new to the startup or VC world, but when so much money is at stake and considering that more startups fail than succeed, it is certainly understandable. Ultimately, startup founders just need to understand the nature of the provisions requested and really consider how they may impact the business in the long run before agreeing to them.