Venture Hacks

Summary: Control is a one way street that runs towards investors. Control doesn’t run backwards toward founders or common stockholders. In each round of financing, the percentage of investor board seats goes up (or stays the same). Once the investors have more board seats than the common, you’ve lost control of the board and you’re never getting it back. Your best bet is to be stingy with board seats and hope you never have to raise a round without good leverage.

An interesting idea came up in a meeting with Mike Speiser last week:

Control is a one way street.

In startups, control is a one way street that runs towards investors. Control doesn’t run backwards toward founders or common stockholders (unless you create dual-class stock when you IPO).

Types of control.

Here’s how control shifts to investors with each round of financing:

The Board: In each round of financing, the percentage of investor board seats goes up (or stays the same). And the percentage of common board seats goes down (or stays the same). In each round, the common can only hope to maintain their percentage of board seats.

Protective Provisions and Class votes: In each round of financing, the number of investors who participate in protective provisions and class votes goes up (or stays the same). That means you’ll have to ask more investors for their consent to do things like sell the company.

Shareholders: In each round of financing, the percentage of company shares held by investors goes up (obviously).

Class votes, shareholder votes, and the exercise of protective provisions are rare compared to board actions. The board meets about once a month to approve management decisions—so let’s take a closer look at the board.

An example.

Here’s an example of how board control shifts to investors with each round:

Founding: The founders have all the board seats. Let’s say the board consists of 2 founders.

Seed: The founders keep all the board seats.

Series A: The investors gain two board seats, an independent joins the board, and the founders don’t gain any board seats. Let’s say the board is now 2 investors, 2 founders, and 1 independent.

Series B: The company has a tough time raising money so the investors gain one more board seat but the founders don’t. The board is now 3 investors, 1 independent, and 2 founders. The investors now control the board.

In each round of financing, the percentage of common board seats stayed the same or went down. Don’t count independent directors when you’re calculating the percentage of common board seats—you don’t know how the independent director will vote.

Facts about investor board seats.

Here are some facts to consider when you’re giving board seats to investors:

1. In every round of financing, you will have to give board seats to investors. (There are two exceptions: (1) many seed rounds don’t give board seats to investors, and (2) some later-stage rounds don’t give board seats to investors if the company has a lot of leverage or the new investor has a lot of experience following an existing investor.)
2. If you give a board seat to an investor, you’re never getting that board seat back.
3. Every time the percentage of common board seats goes down, you’re stepping towards losing control of the board. (Don’t count independents when you’re calculating the percentage of common board seats.)
4. If you ever raise a round with poor leverage, the investors will gain control of the board.
5. Once the investors have more board seats than the common, you’ve lost control of the board and you’re never getting it back.

How to structure your board.

Your best bet is to be stingy with board seats and hope you never have to raise a round without good leverage:

1. Build a great company with good traction so you have a lot of leverage when you raise money.
2. Exploit your traction by creating a market for your shares when you raise money. You need alternatives to get good terms.
3. Create a board that reflects the ownership of the company. Some investors argue that a board that has an equal number of investor seats and common seats (not counting independents) is “balanced”. But this board is actually “investor-leaning”. In bad times, investors will take over this board. But, in good times, the common doesn’t take over the board.
4. Don’t let your investors control the board through an independent board seat.
5. Create a new board seat for a new CEO. Don’t give him one of the common seats.

Control is a one way street. You have to go down the road to raise money—but be wise about how far you go.