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Prosper planet pulse
Home»Startups»Navigating control mechanisms in startups | Paul Hastings Law Office
Startups

Navigating control mechanisms in startups | Paul Hastings Law Office

prosperplanetpulse.comBy prosperplanetpulse.comApril 3, 2024No Comments8 Mins Read0 Views
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Control issues are extremely important for startups and their investors. Startup founders naturally want influence over the company’s direction, but the control dynamics often change when outside investors come in.

Founders typically retain control of the company’s direction and day-to-day activities before raising capital from outside investors. However, if a third-party investor arrives, a key point of negotiation is how much control the founders will give to the investor. It is almost inevitable that founders/management and investors will have different aspirations and interests. This article outlines the mechanisms most often used by founders to maintain control and the tools investors employ to counter that power.

dual class shares

One of the most powerful and controversial tools for founders is the institution of dual-class shares with a super voting mechanism. Dual-class share structures can give founders voting rights that exceed their economic ownership in the company. Under the dual-class structure, the company’s common stock is divided into two sub-series. (i) Super Voting Series held exclusively by one or more founders (and possibly other initial shareholders); (ii) a series of ordinary shares in which he has one vote per share (the specific multiple may vary significantly); and (ii) a series of ordinary shares in which he has one vote per share. The primary effect of a dual-class structure is to give the founders the right to vote on any matter that requires a vote of a majority of the company’s outstanding capital stock (for Delaware corporations, this includes mergers or substantive including the sale of all capital). company assets). Generally, preferred stock purchased by an investor is converted into a series of common shares with each share giving him one vote.

Venture capital investors are resistant to dual-class structures and only use dual-class structures when the founders are serial entrepreneurs with a track record of successful exits or IPOs, or when there is very large demand for a particular investment. They tend to embrace class structure. Investors want to understand scenarios in which founders are expected to rely on their significant voting rights and assess whether they are comfortable with the way founders vote in such scenarios . In some cases, investors oppose dual-class structures in a company’s early preferred stock financing rounds, but may become more supportive as the company establishes a strong growth trajectory and approaches an IPO. In many cases, dual-class structures are introduced to maintain early shareholder control over management and the business after the company’s shares have become public and subject to shareholder activism. Introduced just before his IPO of the company.

Investors who are tolerant of dual-class structures often seek to impose guardrails on such structures. The most common guardrail is to end super voting upon the occurrence of a triggering event. For example, (i) a founder leaves his or her current role, (ii) the founder transfers stock to an entity over which he or she does not have full control, or (iii) time passes without the company achieving a liquidity event. or (iv) immediately prior to the completion of an IPO (less than one-third of U.S.-listed companies in 2023 held more than one stock – class inventory).

board control

Control of a company’s board of directors can also be highly contentious. Founders can retain the right to vote on key decisions in the company’s lifecycle by constituting or retaining the right to nominate a majority of board members. This control is always tempered to some degree by the fact that directors of Delaware corporations, when acting in their capacity as directors, are subject to fiduciary duties, including a duty of care and a duty of loyalty (requiring best conduct). . interests of the company and its shareholders). This includes ensuring that all directors, including founder directors and investor directors, use their board positions to serve the interests of the company and its shareholders (rather than a narrower constituency such as the founding team or preferred shareholders); That is required.

Board size typically increases over time to accommodate the appointment of investor nominees, industry experts, and other independent directors. Once the founding team no longer has a majority on the board, there are a number of tools available to the founder to give himself and his nominees continued control over board votes. For example, founders may agree to add board seats for investors and independents, but may negotiate the right to vote on board vacancies or to cast tie-breaking votes in the event of an impasse. do not have. Another strategy is to give founders multiple votes per seat, either blocking them outright or giving them more power to sway votes. Founders may also seek passive consent rights. This would require the vote of one of her founder directors to carry out certain actions, such as an exit event or firing a member of the founder group. Such negative consent rights may also be implemented at the shareholder level, in which case such action would require holders of a certain numerical threshold (e.g., a majority) of founder shares or common shares. Consent is required.

More mature emerging growth companies often have one or more seats on their boards for so-called “independent directors,” who are usually industry experts. On a “balanced” board, where there is an even number of founder and investor nominees, independent directors can cast tie-breaking votes. From both the founder and investor perspective, it is important to carefully research proposed independent directors and understand what kind of backers they are likely to work with. Additionally, all parties should carefully consider the proposed rules governing the removal of directors and the appointment of replacements. For example, the founding team may be satisfied with the original independent director, but if preferred shareholders have the right to appoint and remove independent directors, they may replace that director with a director who is less aligned with management’s views. there is a possibility.

Founders and investors should also familiarize themselves with the provisions in company articles of incorporation and voting agreements that provide for the removal of directors for cause (and should carefully consider the definition of “for cause”) ). Under Delaware law, shareholders can remove directors for “cause,” even if there is no such provision in the company’s bylaws or voting agreement. Under Delaware case law, grounds for a finding of cause include willful breach of fiduciary duty and other wrongdoing, including fraud, misappropriation of company funds, and failure to properly disclose disputes. Masu.

investor protection

Investor perspectives on founder protection are nuanced and vary depending on the situation. When considering the founder protection structures summarized above, investors typically want to ensure that (i) they maintain the ability to replace incompetent management teams if necessary, and (ii) ensure that founders do so in a disciplined and responsible manner. Concerned about imposing basic safeguards to ensure business operations. (iii) preventing founders from blocking major lifecycle events in the company (e.g., vetoing a sale in hopes of exiting at a higher value in the future); and (iv) Limiting “dead hand” control (founders retain profits, giving them extraordinary control after they leave the company). As mentioned above, investors are often more likely to give additional control to an experienced founding team that they believe will succeed in scaling the business. Founding teams also have more bargaining power to seek protective terms in founder-friendly market cycles or if the company operates in a growing market segment.

First, investors can limit founder control by rejecting or relaxing the founder protection structures summarized above. Additionally, investors should negotiate negative consent rights to prevent mismanagement (e.g., budget approval rights) and prevent large-scale transactions (e.g., M&A or future financing) from taking place without consent. I can. Investors can also use the drag-along rights provided in the National Venture Capital Association’s proxy voting agreement form to prevent holdout founders from blocking a proposed sale of the company. (Assuming that the sale cannot be prevented by other means). such founders would be required to vote in favor of the proposed sale (e.g., through a board- or shareholder-level veto). Additionally, investors can limit dead-hand control by tying a founder’s board nomination rights and a founder’s block on exercising drag-along mechanisms to the founder’s continued provision of services to the company. You can try. Investors can also minimize dead-hand control by vesting (or re-vesting, if the founder is fully vested) the founder’s shares. As a result, founders who leave the company before they are fully vested will have fewer shares to vote.

conclusion

The protection mechanisms summarized above are not “off-the-shelf” solutions that can be deployed regardless of the situation. Rather, founders must carefully choose the appropriate mechanism considering the dynamics of the transaction. Furthermore, none of the tools mentioned above should be considered in isolation. Rather, parties are advised to analyze the full set of founder and investor controls, both at the board and shareholder level, in parallel with the company’s capital statement. This comprehensive analysis enables founders and prospective investors to explore dual-class voting structures, board controls, and negative consent in the most relevant specific scenarios (including, among other things, future capital raisings). Understand the practical implications of rights. events, liquidity events, termination of members of the management team, etc.). Additionally, most venture-backed startups have an overall balance of control between founders and outside investors, making more exotic protection structures (such as super voting) the exception rather than the rule. I will also pay attention.



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