Voting rights—and veto rights, in particular—are one of the most critical terms you will negotiate when raising capital. Let’s take a closer look at shareholder veto rights and board-member veto rights. Then we’ll talk about how to negotiate them and what to look out for.
In recent posts we’ve talked about other things that may come up when you’re raising capital—things like down rounds and liquidation preferences. The liquidation-preference post ended with a scenario that sets up the voting issue nicely.
To recap: facing significant liquidation preferences, a company had to choose between being acquired and going public. In an acquisition, the liquidation preferences would wipe out the common stockholders—the founders and employees. In an IPO, the liquidation preference would disappear, preferred stock would automatically convert to common stock, and the founders, employees, and early investors would all get rich—while the late-stage investors would take a bath.
The cliffhanger question was: how does the company decide—and who inside the company decides—whether to take the deal or go public?
In a similar real-life example, Instacart went public and its preferred holders converted to common. Some of them lost a lot of money.
What happens more often is investors block the IPO and force a sale.
How?
That’s where veto rights come in.
Veto Rights
In venture deals, investors negotiate for two kinds of veto rights:
- Board Veto Rights
- Shareholder Veto Rights
As a refresher, shareholders are the owners of a company. Shareholders elect directors as their agents to oversee company operations. Day to day operations are managed by the CEO and subordinate employees, all of whom serve at the pleasure of the board of directors who in turn serve at the pleasure of the shareholders.
As agents, directors owe fiduciary duties to the shareholders. Fiduciary duties keep agents honest.
Shareholders are principals. Shareholders do not (typically) owe fiduciary duties to one another or to the company.
By law, most major decisions a company makes must be approved by an affirmative vote of the board. A few decisions must be determined by a vote of the shareholders.
These are the default rules.
Venture terms layer on top of these rules.
Board Veto Rights
When the board acts, it does so as a body. Directors do not act individually.
Venture terms typically give one or more individual directors veto rights over specific company actions. These are big things, like selling the company, creating new classes of stock, and borrowing large amounts of money.
This veto right is a powerful tool for oversight and control. But it comes with limitations.
Specifically, each director is individually bound by fiduciary duties owed to the company and all shareholders equally—duties of care and loyalty. That’s true even if the director was appointed by a single VC (under a Voting Rights Agreement) and given a veto right.
The duty of loyalty requires each director to act in the best interest of the company and the stockholders equally, without giving preference to any class of stockholders.
As a result, fiduciary duties constrain veto rights.
That’s not the case with shareholder vetoes.
Shareholder Veto Rights
Venture terms also give one or more shareholders or classes of shareholders veto rights over a similar list of major actions—selling the company, creating new stock, borrowing money, and so on.
Unlike directors, shareholders typically do not owe fiduciary duties to the company or to their fellow shareholders. (In limited situations, a controlling shareholder may owe fiduciary duties to the company and the other shareholders. This is the exception.) That frees shareholders up to make self-interested decisions.
When a VC is able to veto an action in its capacity as a shareholder it will generally be free to do so in a self-interest way, at the expense of common shareholders and other investors.
In fact, because VCs are managing money for their own investors (the limited partners who invested in their fund), the VCs will often owe fiduciary duties to their limited partners. Those duties may require them to act in their own self-interest and against the interest of common.
What’s the Takeaway?
If you’re a founder, you should take away a few things.
First, avoid veto rights if you can. Since you probably can’t, fight to limit them to director vetoes. Not only is the director bound by fiduciary duties to act in the best interests of the company and shareholders, but the director has to look you in the eye and vote. Shareholder groups are more amorphous and can cast contentious votes in writing without having to see you face to face.
That seems to be what happened with Instacart where the late-stage investors had their preferences wiped out. The company negotiated terms at the peak of the market and had the foresight—and the leverage—to avoid any sort of shareholder blocking rights over an IPO.
Second, get the specific list of veto rights in the term sheet. You’ll never have more leverage than you do when negotiating a term sheet. Don’t settle for the “usual and customary” veto rights. List them out. Narrow them down. Be specific.
Finally: valuation isn’t everything. Unless you have a hot startup in a hot market, you will make tradeoffs. It is worth giving a little on valuation—and selling more of your company—to get better control terms. You will always be subject to some level of investor oversight. But if you’re careful and smart about it, you can maintain flexibility to take advantage of whatever comes along in the future, without always needing investor permission.