Protective Provisions Posts

Control is a one way street

Nivi · June 2nd, 2008

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.

speiser1.jpgAn 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.

Trust, but verify: Why investors want control

Nivi · January 30th, 2008

“Trust, but verify.”

– Ronald Reagan

Summary: Investors trust the entrepreneurs they back. But they verify their expectations with contracts and control. You should do the same—with the same tools investors use: contracts and control.

Why do investors want to control their investments through board seats and protective provisions? Shouldn’t they just give entrepreneurs bags of money and trust them to do the right thing?

David Hornik has the answer in Venture Capital in China:

“One investor with whom I met on my [China] trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur.

“In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.

“…the legal structures needed to support a vibrant startup economy [in China] are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system.”

Investors trust, but verify.

Investors trust the entrepreneurs they back. They wouldn’t invest if they didn’t. Their trust is an expectation that entrepreneurs will:

  1. Do what they say they’re going to do in anticipated situations.
  2. Consider the investor’s interests in unanticipated situations.

Investors have been playing this game long enough to anticipate certain situations. So they use contracts and courts to enforce their expectations in those situations:

Investors trust entrepreneurs to stay at the company for 4 years, and they verify it with a vesting schedule.

Investors trust entrepreneurs to pay the investors first when the company exits, and they verify it with a liquidation preference.

Investors trust entrepreneurs to consider their interests in an acquisition, and they verify it with protective provisions and board seats.

Investors have been playing this game long enough to also know that you can’t anticipate every situation. So they use control to dispose the company towards the investor’s interests in unanticipated situations.

Verify your expectations.

China doesn’t seem to have a legal system that lets investors and entrepreneurs verify their expectations. They have trust, but no verification.

But U.S. investors can trust and verify. And you should do the same—with the same tools investors use: contracts and control.

If you trust your investors to let you stick around long enough to vest all your shares, accelerate your vesting upon termination.

If you trust your investors to let the board make the call on acquisition offers, automatically suspend protective provisions when the offer is big enough (e.g. a 3x return).

If you trust your investors to let the founders run the company, control the board.

Writing a contract doesn’t mean you don’t trust the other guy. It just means you want to document and verify your trust.

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What's the biggest mistake entrepreneurs make?

Nivi · October 14th, 2007

Q: What’s the biggest mistake entrepreneurs make when they’re raising money?

Entrepreneurs focus on valuation when they should be focusing on controlling the company through board control and limited protective provisions.

Valuation is temporary, control is forever. For example, the valuation of your company is irrelevant if the board terminates you and you lose your unvested stock.

The easiest way to maintain control of a startup is to create good alternatives while you’re raising money. If you’re not willing to walk away from a deal, you won’t get a good deal. Great alternatives make it easy to walk away.

Create alternatives by focusing on fund-raising: pitch and negotiate with all of your prospective investors at once. This may seem obvious but entrepreneurs often meet investors one-after-another, instead of all-at-once.

Focusing on fund-raising creates the scarcity and social proof that close deals. Focus also yields a quick yes or no from investors so entrepreneurs can avoid perpetually raising capital.

Q: What’s the biggest mistake VCs make?

The biggest opportunity for venture firms is differentiation. VCs compete for deals, and differentiation is the only way to compete.

Most firms offer the same product: a bundle of money plus the promise of value-add. And the few firms that are differentiated don’t communicate their differentiation to entrepreneurs. Y Combinator is an example of differentiated capital with excellent marketing communications.

Venture firms that thrive by investing in game-changing businesses have barely begun to differentiate themselves, let alone changed the rules of their own game.

Note: These excellent questions are adapted from Ashkan Karbasfrooshans’s Venture Hacks interview.

Image Source: Despair.

Why do investors want protective provisions?

Nivi · August 2nd, 2007

“AOL almost sold to Compuserve in 1991 for $60M. The VCs wanted to sell. [Steve] Case won by 1 vote. 10 years later, [AOL was] worth $100 billion.”

– Mark Pincus

Summary: Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. They protect the preferred, who are minority shareholders, from unfair actions by the common majority. However, the preferred shouldn’t use protective provisions to serve their other interests.

Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. Roughly, they state that

“The Company requires the consent of the holders of at least X% of the Company’s Series A Preferred to (i) effect a sale or merger of the company, (ii) sell Series B Preferred with rights senior to or on parity with the Series A, (iii) et cetera…”

To understand why investors want protective provisions, you first need to understand how the preferred and common classes control the company.

The board mostly controls the company.

The common and preferred classes control the company through

  1. Board seats, which require each board member to serve the interests of the company as a whole. Board members cannot simply serve the interests of their particular class of stock.
  2. Shareholder votes, where the preferred vote as if they held common shares. In legal-speak, the preferred vote on an as-converted-to-common basis. The preferred usually gets one as-converted-to-common share for each of their preferred shares. The preferred and common use shareholder votes to serve their own interests.
  3. Class votes, which require a majority of the preferred and a majority of the common. We will cover this mind-numbing topic in a future hack. The preferred and common use class votes to serve their own interests.
  4. Protective provisions, which allow the preferred to veto certain actions, such as selling the company or raising capital. In some companies, each series (Series A, Series B…) has their own protective provisions. In other companies, all of the series exercise their protective provisions as a class.

After the common and preferred classes select their representatives on the board, the board takes it from there. The board, not the shareholders, usually approve management decisions. (We previously showed you how to hack the allocation of seats on the board.)

However, some major actions require shareholder votes and class votes in addition to board votes. For example, Delaware corporations require a shareholder vote to sell the company or raise money.

Protective provisions protect the preferred minority from the common majority.

The preferred usually owns 20%-40% of the company after the Series A. If the common is united, the preferred can’t influence shareholder votes—they don’t own enough shares. Nor can they influence board votes if a united common controls the board (e.g., the board consists of two common seats, one preferred seat, and no independents).

If the common controls a Delaware corporation’s stock and board, the preferred need protective provisions to stop the common from:

  • Selling the company to the founder’s cousin for $1 and wiping out the preferred stock.
  • Selling $1M of the founder’s shares to the company so he can get a great haircut.
  • Issuing a bazillion shares to the founders and diluting the preferred to nothingness.

Protective provisions protect the Series A minority from unfair actions by the common majority. That’s why they’re called protective provisions. In future rounds, protective provisions can also protect each series of preferred stock from the other series of preferred stock.

Investors argue that protective provisions encourage good governance.

Some investors claim that they need protective provisions because they can’t use their board seat to serve their own interests. They correctly argue that board members have to serve the interests of the company as a whole, not the interests of their class of stock.

These investors will claim that protective provisions let them serve their interests as investors, so they can serve the interests of the company through their board seat:

Say the company receives an offer to acquire the business. Management thinks it’s in the company’s interest to sell. The board defers to management since management is doing a good job running the company. But the investors think the company is the home run in their portfolio—they don’t want to sell the company now. So the investors use their board seat to vote for the sale and use their protective provisions to veto the sale.

Investors should use protective provisions to protect themselves, not to serve their interests.

We don’t agree that investors need protective provisions to serve on the board without succumbing to their own interests.

In fact, any investor who makes that argument is raising a big red flag. They’re implying that they can’t fulfill their duty as board members without additional veto powers. They’re implying that the interests of their fund can outweigh the interests of the company.

Your response to this argument goes like this:

“I don’t think you mean that you can’t serve the interests of the company without these additional protective provisions. I’m sure you will use your board seat to do the right thing for the company, always.

“You control the company through (1) board votes where you serve the interest of the company and (2) share and class votes where you serve your own interests.

“Protective provisions protect you against the common majority. But they’re not a tool to serve the interests of your fund at the expense of the company.”

They're called protective provisions, not mis-alignment provisions!

We would rather have an “evil” investor who uses his board seat to serve his interests, than an investor who planned to use protective provisions to do anything other than protect himself. At least the “evil” investor’s power as a board member is in proportion to his share of board seats—his protective provisions give him a blanket veto that is wildly out of proportion with his ownership of stock and allocation of board seats!

The next few hacks will show you how to attenuate the protective provisions, reduce this mis-alignment, and leave enough protective provisions in place to protect the preferred.

Image Source: Jennifer Juniper (License)

What are supra pro rata rights?

Nivi · June 17th, 2007

I read, like, and regularly disagree with a great blog called Ask the VC . They recently answered a question about supra pro rata rights—here are our thoughts on the topic.

Q: Can you explain what supra pro-rata is? It seems to be showing up in some VC term sheets now. What’s the impact on the entrepreneur? How hard should one try to negotiate it out? If a VC insists on this term, should the entrepreneur walk away?

A: First, read Ask the VC’s response—we agree with them. Here are our additional thoughts.

An investor with supra pro rata rights wants the option of increasing his percent ownership in the next round. He probably told you “We like this company so much we might want to buy more of it!”

Investors who want to increase their ownership drive down your valuation.

Investors who want to increase their percent ownership try to drive down the next round’s valuation. Whether or not they have supra pro rata rights.

They are at odds with the founders and management who are trying to increase the next round’s valuation. These investors can exercise their protective provisions to veto everything but the lowest valuation offer. Or they can signal the “correct” valuation to new investors:

If the current investors want to increase their percent ownership, the valuation is too low. If they don’t want to increase their percent ownership, the valuation is too high. This makes it harder to get a high valuation since the new investors often believe the current investors have a better sense for the right valuation.

You want investors who maintain their percent ownership.

You prefer investors who make it a policy of maintaining their percent ownership in the next round. This incents them to increase the next round’s valuation.

These investors don’t try to increase their percent ownership because they know it puts them at odds with the founders and management. They know it incents them to use their protective provisions to veto good offers. They know it forces them to signal their sense of the correct valuation.

Your response to supra pro-rata rights is:

“Everybody around the table should be working together to get a high valuation in the next round. Investors and management shouldn’t be at odds with each other in the next financing—let’s create alignment, not mis-alignment.”

Investors who try to decrease their percent ownership in the next round are also bad news. They signal that the valuation is too high. (Angels and seed stage funds are an exception. They’re not necessarily expected to maintain their percent ownership since they may not have a lot of capital.)

What are your experiences with supra pro rata rights?

Use the comments to share your experiences and questions about supra pro rata rights—we’ll discuss the most interesting ones in a future article.