This article is the final part of a three-part series explaining the key terms you’ll need to negotiate when raising money.
To recap, Part One covered the economics behind a term sheet and introduced you to key concepts and Part Two covered repurchase agreements and founder vesting - two passionately negotiated terms. This is the final article in the series and will discuss terms relating to control. My advice relating to the importance of a well-chosen board as well as how best to managing founder fallouts can all be found right here.
Passion and control
Having reviewed hundreds of term sheets throughout my time as COO, it never surprises me how passionate founders are about control of their business. In fact, it is one of the most critical topics a founder is concerned about. As a founder, doing your life’s work, giving up so much to create your dream and pouring your heart and soul into your company, it makes perfect sense why you would be passionate about control. In this article I will explain what things to look out for and recommend times to pick and choose your battles when you’re at the negotiating table.
The board is the key focus of control and one of the most important elements to get right when setting up your company and going through investment rounds.
In addition, there are special board and shareholder decisions where a higher voting threshold above a majority vote will be requested by investors for better governance. Both board and shareholder decisions cover similar principles so I have discussed in the context of the board.
The Board of Directors
The board should be a terrific resource for the founder if constituted thoughtfully. The board provide valuable strategic and planning advice and should be a pillar of support for the founder. I can’t emphasise enough how important it is to choose your board members carefully.
Typically, the lead investor in each funding round will request a board position. This can become unworkable as the company grows and continues to raise capital and before you know it the board is too large and cumbersome. To avoid this, at Square Peg, we try to make sure that board rights aren’t entrenched and that board members can be removed if their ownership drops below a prescribed percentage. If a board member is truly adding value, there is always room to add a seat for that person.
Voting rights and behaviours
The key control issue is how the board votes. We often see founders wanting to maintain control of their board, and so they will constitute the board with majority founder board members vis a vis investor and independent members.
If this happens, you can guarantee there will be a list of key decisions that the investor will require a veto on. A form of this may be, “decisions on A, B or C, are passed by the majority vote of the board, including the vote of at least one investor director”. The list should be limited to only those decisions where there may be misalignment. An example is where the founder and ordinary shareholders have invested at a much lower valuation than the preferred investors. In this case, you can expect that the preferred investors will want a veto on the sale of the company below a prescribed value. A great resource can be found here that outlines the various decisions requiring the approval of Required Resolution (decisions requiring a higher than majority vote). Each founder and investor will have slightly different matters that they focus on, so the list of key issues can vary between companies but is a great guide to those that are typically included.
It goes without saying that veto rights are fantastic for the party that it protects, either the founder or the investor, but potentially dangerous for the rest of the shareholders. So, where we can, we ensure that a single party doesn’t have the right to veto a decision. Provided there is alignment amongst those that are voting, and you have a rational board, if the majority vote in favour of a resolution, then the resolution should be adopted. As a founder of a high growth company, you need to make sure that the board and the company can work effectively and at speed and avoid terms that make it difficult for you to achieve the company’s goals.
We have just finished a negotiation with a fantastic company who we are very excited to welcome into our portfolio family. The founders had a prior negative board experience where the board ousted the founder. Although it was likely that this was in the best interests of the company, understandably they didn’t like it. When negotiating terms, they argued strongly that if a resolution was to be put to remove a founder from the board or the company, the majority of founders were required to vote in favour of the resolution. Although I empathise with the founders, this is terrible corporate governance. The board has a fiduciary duty to act in the best interests of the company and you should trust that the board will do exactly that. If you choose your board carefully and thoughtfully you should have the confidence, they will.
Fortunately, in this case, the founder recognized that the best position for the company was to give up on this founder veto right. This is a great story of partnership and trust, but it doesn’t always go this way.
In conclusion, a rational, aligned and well-functioning board who can guide and support you cannot be overstated. If the board is not working for you, act quickly and make changes. Spend the time when you are negotiating your shareholders agreement to work through the board provisions to give you the flexibility you need to appoint and remove board members at the appropriate time and avoid single party veto rights where you can.
If this article has helped you get a grasp on the important terms you can subscribe to All Signal, where we share long-form content and insights. In case you missed the previous articles on terms, here you can find Part One and Part Two.