Investor Levers of Control
Just as I was zeroing in on the closing of my first equity investment in a startup I had co-founded, my corporate attorney said, “Once this investment is closed, they can fire you.” What? The investors won’t own more than half of my Company. How can that be?
Startup founders/CEOs worry about losing control of their startups to investors, but, when starting out, few understand that owning more than 50% of the shares does not give you control in a venture-backed company. The levers of control that venture capitalists and other startup investors can exercise are more subtle than that.
Before we dive into details, I want to note that some of the following levers only really come into play when you raise an equity round like a Series Seed or Series A because that is when you are selling shares in your Company to investors. However, some of these levers can even come into play when you are doing a SAFE or convertible note, depending on how the terms of the raise are structured because some of these levers do not depend on capitalization table voting rights. If you aren’t sure, get advice from a CEO who has fundraised multiple rounds, preferably in multiple companies, or explore these questions with your corporate attorney.
So, what are some of the significant levers of control to be aware of? Note that these are all areas you should pay close attention to when negotiating the terms for an investment in your early-stage Company.
Ownership Percentage
Ultimately, the stockholders who own shares in a corporation have a voice in how it is managed by exercising their (limited) voting opportunities. Practically, only investors who own a “significant” percentage of the Company are really in a position to influence the Company’s decisions by voting their shares. While the math here is pretty straightforward, note that sometimes investors will exercise their votes in concert with one another. This is often the case when investors come into a company together, so while no one investor may have a major stake, they can wield much more significant power when a group of investors coordinate.
Board of Directors
One of the most critical shareholder vote actions is the election of representatives on the Board of Directors. In public companies, there will sometimes be news stories about proxy fights as a group of activist investors attempts to raise support for a new slate of Board members. In privately held, venture-backed companies, this is much more likely to be a topic negotiated as part of an investment.
Typically, as part of the term sheet for an investment round, the number of seats on the Board of Directors is often specified, along with which stockholders (e.g., preferred stockholders or common stockholders) get to elect which Board members. In fact, it is commonly determined before closing the round who specifically will hold those Board seats. And, unless things get very out-of-alignment, it will often be the case that the founders/CEO will not have much (if any) of a voice in who the investors specify as their representative(s) on the Board of Directors. To illustrate, on one of my Boards, one of our Series C investors changed which of their team was on our Board three different times – and I, as CEO, was only informed that they were changing their representative.
One aspect to keep in mind as a CEO leading a Board of Directors is to be informed and disciplined about what matters to inform the Board about versus what matters require Board approval. This helps keep the appropriate lines between Board members and management. At the same time, Board members often bring tremendous experience to bear and they should be exercising their fiduciary responsibilities to act in the Company’s best interests, so definitely listen to them and take advantage of what expertise they have to offer.
Protective Provisions
Included in the legal investment agreements, protective provisions require the Company to get the approval of its investors (via a shareholder vote), the investors’ representative(s) on the Board of Directors, or a majority vote of the Board of Directors to take certain actions. These provisions are “protective” of the investor-shareholder interests. Typical protective provisions include anything that touches the capitalization table of the Company. Examples are raising additional capital (equity or debt), changing the Certificate of Incorporation or Bylaws in a way adverse to the investors, paying dividends, or merging, selling, or dissolving the Company. Other examples may include authorizing stock options, making certain high-dollar operating actions, hiring/firing/changing the compensation of company executives, or changing the Company’s principal business.
As you can see, if investors have the right to approve or veto such actions, this gives them significant control over important decisions for the Company. All is well if everyone is aligned, but things can get quite sticky if problems emerge. Be sure you know when you need your investors’ approval for specific actions – and remember that it is reasonable for them to negotiate being involved in such pivotal decisions that involve their resources and what they believed they were investing in when they handed over their capital.
The Need for Additional Capital
Last but certainly not least, your investors can exercise tremendous control by refusing to support the startup when it needs to raise more money unless you do it on terms they are comfortable with. This is a sneaky one because it does not appear on the term sheet of your present round, but remember that until your Company is cash-flow positive and no longer needs regular infusions of investor cash to keep operating, your investors can and often will be in a position to force management to comply with their wishes to get their support for raising additional funds.
You may think you can just go round up another investor syndicate to give you the capital you need – and sometimes you might be right. However, remember those protective provisions. Also, keep in mind that new incoming investors like to see that the existing investors are continuing to support the Company. A lack of support from existing investors is a “red flag” because “What do the existing investors know that I don’t?” or “I don’t want to get into a situation filled with friction right out of the gate!” This reality gives existing investors a strong hand in shaping new investment rounds.
If you really want to retain total control of your startup, find a way to grow your business without raising venture capital. Venture capital is expensive, invites your investors to influence and sometimes control the direction of your Company, and can mean unexpected changes in executive management. However, venture capital can also be a huge enabler of massive growth. Sometimes it is absolutely the right thing to do. And sometimes it isn’t. Think carefully about whether your startup is a good fit for venture capital before blindly going down that road. And, if you go down that road, be mindful that you are giving up significant control to get the capital.
