Maintaining Control of Your Company: What All Founders Should Know
The original article was published in Forbes platform on Jun 23, 2019 - Maintaining Control of Your Company: What All Founders Should Know
As a founder, maintaining control of your company is paramount. It is therefore critical to focus early on issues of corporate governance, especially on how the board is constituted. This can help stack the cards in your favor before any later financing rounds when there may be far more investor interest in these issues. Failure to think ahead about corporate governance can be calamitous; for once you lose control of your board, you are unlikely to regain it.
Fortunately, founders can draw upon several legal strategies to maintain control of their boards and companies. The degree to which they deploy these strategies will depend on their familiarity with them and on their leverage during fundraising negotiations. Sometimes, lawyers managing venture rounds are junior and underexposed to these corporate governance strategies. Too often, founders focus on financing at the expense of governance. The wisest founders know to treat board composition with the same priority as deal economics.
You control your board as long as the common board seats are greater than the investor seats (often... [+]
Board Seat Management
What does it mean to control your board as a founder/CEO? You control your board as long as the common board seats are greater than the investor seats (often called preferred) plus the independent board seats.
Generally, a new investor board seat is added to the board with each new material round of funding. New investors will want representation on the board, and, ideally, their participation will add value to the company. It is essential for founders to understand that any number of common board seats may also be added during any round of funding. These seats do not need to be filled--the CEO or other founders can simply control them. This is vital and frequently misunderstood. For example, a board may start with five common seats and have two more added each round. This might seem extreme, but the key point is this: As long as founders have leverage, they should never let the number of common seats fall below the number of investor seats + independent board seats. (More on independent seats below.) Founders’ stacking common board seats in their favor is generally a wise idea -- if they can get away with it. Of course, control of these extra seats might be negotiated away in subsequent rounds, but it is better to be in a position to force new investors to request such concessions.
It is also wise to discuss board composition and earlier directors’ willingness to step off the board and relinquish board seat designation as the company scales in the future. This can be addressed through alignment + value add contributions that different investor directors provide for companies in earlier stages than growth stages.
Independent Board Members
Independent board members can offer priceless advice and add tremendous value to companies. However, they can also impact ultimate control of the board. Adding an independent board member may seem benign, but with two common seats, two investor seats and an independent one, founders risk losing control of their boards. There is a good chance that an independent board member will vote with investor board members. If founders are going to add independent board members, they should make sure to add an equal number of common seats as well in order to maintain control. It is also not a bad idea to choose an independent board member who is aligned with the founders’ vision.
Investor Unilateral Voting Rights
New investors may also try to create a separate voting class for themselves. They are not seeking super-voting rights, but will want to obtain unilateral blocking rights on such issues as Change of Control (M&A) and future investment rounds. Their argument: If they vote together with the other preferred shares, they will not hold a majority and cannot protect their interests. This concept will eventually get introduced in the life of a company, but it is important to hold it off for as long as possible. Once this line is crossed, there is almost no going back, and all future investors will likely get to block a sale of the company. The following example highlights the main argument to use with the new investors: If the founders give blocking rights now, similar rights might come back to hurt these current investors in future rounds.
Example: After your Seed round, you raise $10M on a $50M post from a Series A investor. The Series A investor will inevitably ask to have unilateral blocking rights, and let’s say you agree. Then, for your Series B, you raise $20M on a $100M post and have little choice but to also give the unilateral blocking rights to the Series B investor. For the Series C, you raise $100M on a $500M post and again your Series C investor gains the unilateral blocking right. If you then get a buyout offer of $500M, the Series A and Series B investors will likely want to sell, delivering them 10x, and 5x returns, respectively (not including option pool and other dilution events). However, the Series C investor would not get a return and with its unilateral blocking rights will likely block the transaction. In this case, the Series A and Series B investors would be better off if no investors had received unilateral blocking rights.
The best early-stage venture capitalists understand this key point and therefore prefer to work with founders/startups to minimize separate voting blocks. Accordingly, companies can request that all series of preferred stock act as a single class for voting, control and approval purposes, to mitigate risks relating to potential minority investor blocks with future financings or exit transactions.
Super Voting Rights
Companies can be structured with multiple voting classes. New investors often push to be isolated in a separate voting class to enjoy unilateral blocking rights for certain issues (see above), but founders can also create a separate class granting themselves super voting rights. Founders seeking these rights may get pushback from investors; nonetheless, they are relatively common. Airbnb, Facebook, LinkedIn, Snapchat, Square, Uber, Yelp, and Zynga all created super-voting rights. Snapchat took it a step further by creating three classes, the third of which stripped all voting rights away from public investors entirely. Over the last 20 years, more than 50 companies have IPO’ed with dual-class share structures. Generally, the founders’ super-voting class will have 10x the votes of typical investor shares. Again, founders need good leverage to execute such moves, but if they succeed, they will dramatically increase their chances of maintaining control of their companies.
Proxy Voting
Though far less common, proxy rights present another vehicle for maintaining founder control. With proxy rights, investors contractually assign the voting rights of their shares to founders. Facebook presents a good example. At one point a number of its investors, including Sean Parker, assigned over 30% of the overall voting rights of Facebook to Mark Zuckerberg via proxy. This, coupled with Zuckerberg’s greater than 20% ownership provided him with control of over 50% of Facebook shares.
The strategies mentioned here can also be combined. Continuing with the Facebook example, in addition to holding over 50% control of the voting shares via proxy, Zuckerberg also created a 10x super-voting class for himself, providing him with ultimate control of Facebook’s corporate governance. Whatever the founders’ preferred strategy, the key is to act early on these corporate governance issues. After all, proper economics of financing involves not merely an assessment of how the cash will flow but necessarily involves considerations of how corporate power may shift and flow as well.
I acknowledge the debate around unilateral founder control of a few large tech giants like Facebook causing a negative social impact by disenfranchising public shareholders. I generally support sunsetting these provisions post-IPO (and plan to discuss this in a subsequent article).
However, far more frequently than conflicts between powerful founders and the investing public, I witness an asymmetry of information between founders and their venture investors, who are likely pursuing board seats or blocking rights. Here, I aim to equip founders with knowledge of these corporate governance strategies to help bridge this divide.
This advice is aimed to help founders navigate the challenges of building an early stage company. If you are a founder or investor that has any additional advice or feedback, please leave it in the comments below or share with us on Twitter: @timy0ung@eniacvc .
The article is provided for informational purposes only, and should not be construed as legal advice on any subject matter.
