When negotiating a term sheet for an angel or venture capital investment, there is often tension between the founders and investors with respect to allocation of control over various future company actions and decisions. There are many different ways for a founder to retain, or a new investor to obtain, control over a startup. Below is a brief, but not exhaustive, outline of some of the most typical control features found in early stage financings.
Control typically comes in two forms and at two levels:
- the standard methods of implementing control rights are blocking rights (i.e., the right to veto or stop an action from being taken) and approval rights (i.e., the right to force an action to occur); and
- these control rights can relate to board of director-level actions, shareholder-level actions or both.
This post is part one of a two-part series and will focus on board of director controls.
Board of Director Controls: Controls with respect to board-level decisions can be implemented in two ways, and often both are utilized simultaneously.
The first is the ability or right to appoint directors to a company’s board. This usually arises from one or more of the following:
- a voting agreement whereby the company’s shareholders contractually agree to vote for the director(s) designated by a specified constituency (e.g., the founders, holders of common stock, holders of a series of preferred stock, etc.);
- an express designation of a board representative elected by a specified class or series of stock set out in the company’s articles of incorporation (the “Articles”); and/or
- restrictions added to the company’s Articles or bylaws limiting the size of the board (i.e., setting a maximum number of director seats).
The second method of allocating control at the board level is by increasing the approval threshold required for various identified actions in order to provide certain parties with “blocking” rights. For example, approval of certain actions might require the agreement by a particular constituency’s board member, giving such director a veto in the event such director withholds his or her approval. Board approval can also be conditioned upon the agreement of a super-majority of the board members or even a requirement that the board vote must be unanimous. This type of increased director voting thresholds can be implemented by adding provisions to the company’s Articles or bylaws, or through a contract among the shareholders such as an investor rights agreement.
In my next post I will address typical shareholder control mechanisms.