“At some stage in the growth of a start-up, the founder entrepreneurs of a company will realise their need for venture capital money in order to grow the company.
The task will be to attract such money while still maintaining a certain level of founder control and protection. Achieving such a balance necessitates understanding the terms that venture capitalists will try to negotiate to wrestle control of the Company.
First, and foremost, a venture capitalist will attempt to obtain more control by negotiating the valuation of the start-up company. In essence, this is a discussion of price: how much will the venture capitalist pay for what percentage of the company?
Negotiations will ensue on the price. A venture capitalist may ask what valuation the company is seeking or may volunteer a ballpark figure for pricing. The lower the valuation, the more shares (and hence more control) the venture capitalist gets for his investment. Venture capitalists will often base their valuation on other deals done which are favourable in valuation to them.
As a founder entrepreneur, obtaining information on comparable companies that have received venture capital financing will be critical in negotiating. At the end of the day, a fair, reasonable valuation needs to be negotiated.
Once the valuation is agreed, venture capitalists will likely focus on the rights attached to the shares that he or she is to receive. The more the rights, the more control the venture capitalist has over the company. Some of the super rights that venture capitalists desire in order to exert greater control over a company are protective voting rights, liquidation preference and board seats.
Protective Voting Rights
In many cases, protective voting rights mean that the venture capitalists has a veto over (i.e. can prevent): issuance of any better shares than those issued to the venture capitalist; changes in the number of directors; incurring a certain level of debt; exceeding certain level of expenditures; or investing in other businesses.
Generally, founders should vigorously resist many of such protective voting rights. Instead, a founder should argue that the company should rely on the board of directors to do what is prudent, rather than forcing such matters to be delayed by a shareholder vote.
Simply put, the liquidation preference provides that upon liquidation or dissolution of the company, the venture capitalists’ shares must be paid some amount of money (i.e. payout on an exit event) before the other shareholders are paid anything. The definition of liquidation is generally broad enough to include any sale of the business or sale of substantially all of the company’s assets.
In addition to the prejudicial financial implications for founders, the higher the payout negotiated by a venture capitalist on a liquidation event, the more control the venture capitalist may attempt to exert to treat the company as a speculative investment to be sold quickly to realise a short term return, with less consideration for longer term growth prospects and opportunities. As a result, founders should carefully negotiate the liquidation preference.
Generally, venture capitalists will expect an increasing number of board seats with subsequent financings in order to exert more control over board decisions and processes. To counter this, an entrepreneur may wish to establish at the outset that he wants to be able to look to the board as a repository of business experience and advice.
To this end, the founder entrepreneur group may decide to limit itself to just two founders on the board, with one or two seats reserved for venture investors, and two or three seats reserved for industry leaders. With this type of board, no one group controls the board and the board can focus on the best interests of the company, as opposed to those of a specific group.
Venture capitalists bring smart money to the table for founders and their companies. However, the demands of venture capitalists for company control must be balanced against founder control (and the company’s best interests) to increase the chances of business success.”
Shahram Safai practices venture capital law and represents venture capitalists, investors and entrepreneurs. Shahram is also a professional engineer and has previously worked in Silicon Valley, California, practicing venture capital law, mergers, and acquisitions. He is a partner at law firm Afridi & Angell.For all the latest business news from the UAE and Gulf countries, follow us on Twitter and Linkedin, like us on Facebook and subscribe to our YouTube page, which is updated daily.
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