What founders should know about veto and majority rights
From an investor perspective
A recurring theme during my almost three years at Point Nine has been that veto rights and decision-making matters are a highly sensitive topic for founders. Founders often wonder why investors (including Point Nine Capital) want a say on certain matters, even when they might only hold 20% (or even less) of the shares. Furthermore, founders may wonder why, in a financing round, corporate governance (including approval requirements and veto rights) receives so much attention. With this post, we would like to give some background and explain why certain approval rights, which are generally demanded by investors, are much less dramatic than they seem to be.
Types of Veto Rights
Veto or blocking rights of investors can broadly be classified into three groups (or at least that’s the way we see it):
- Reserved matters
- Exit veto rights
- Waiver veto rights
Those that enable investors to block a certain decision or measure what the company would like to implement are generally referred to as “reserved matters” or “approval rights.”
Then there are certain rights that allow a certain majority of investors to demand certain actions. Therefore, these go beyond a pure blocking right. These rights are generally exit-related and include the right to demand a sale of the company (“drag-along right”) or an IPO (“registration right”). As a flip side of these rights, a certain number of investors (who do not agree with a demanded sale or IPO) can block such a move (we’ll call those “exit veto rights”). The third group relates to the rights of a majority of investors to waive or surrender certain rights or privileges that they are entitled to (“waiver veto rights”). The waiver of the pro-rata right on behalf of all investors in a financing is the most prominent example of such rights.
What is the rationale behind these veto rights? Why do investors want a say on certain decisions and matters? The basic idea is that we (investors) want to achieve a certain minimum level of information on, and control of, major corporate decisions that can have a significant impact on the value of our investment. However, founders should not be intimidated: the matters where we want to have a say generally do not impact the day-to-day running of the business. On the other hand, the measures outside the ordinary course of business are the ones that investors are concerned about. Keep in mind that, at the end of the day, VC money is at risk as well and investors should be primarily focused on ensuring collaboration when it comes to major decisions.
Our idea is not:
The investor wants to control all main decisions in my company.
The investor wants to prevent that some decisions are taken lightly.
With this approach, we would like to set out some examples that should allow you to better understand what to focus on when discussing these matters with investors.
Typical examples of reserved matters are the issuance or redemption of shares, the expansion of an employee option pool (ESOP), or major corporate measures outside the ordinary course. For instance, the rationale of a blocking right on any share or option issuance lies in the implied dilution of investors and the negative impact this may have on their stakes. Taking the example of an ESOP increase, on the one hand, companies want to attract talent through the grant of shares, but on the other hand, an investor or investors want to be able to control the terms and the amount of options that may be issued.
Besides making sure that the reserved matters do not unduly interfere with the day-to-day business, founders should pay close attention that when an approval is needed, no single investor has a veto right to ensure that the company cannot be taken hostage to special interests (even if with a good investor, this is purely theoretical; founders should still push against such a veto right to avoid an unhelpful precedent).
Exit veto rights
In contrast to reserved matters, allowing an investor or a group of aligned investors (especially when moving towards later stages) to hold a veto right in relation to exit veto rights might make sense.
The prime example for this is the blocking of a drag-along decision if a certain investor or group of investors paid a higher price for their shares than other investors. With some justification, these investors will argue that they should not be dragged against their will even if they don’t hold the majority of all preferred shares, mainly because the sale would give them a much lower return than investors who invested at a lower price. Therefore, permitting a separate veto on a drag for a certain class of preferred shares might be justified and acceptable.
Waiver veto rights
From a founder’s perspective, waivers of investor rights should, of course, be allowed as much as possible, and they should not be subject to special interests (i.e. the veto of an individual investor). This logic is equally applicable to investors who should ensure that measures that benefit the business can be implemented. However, there is one caveat: the waiver must apply to all investors equally and all investors must be affected in the same way.
Let’s try to understand these rights using an example. Imagine your company is being acquired and a certain group of investors have a higher liquidation preference than others (for instance, series A over seed). If the liquidation preference rights are to be waived, investors with higher-ranked shares would clearly be more affected than investors with lower-ranking shares. Does the fact that some investors paying a higher price for their shares constitute a sufficient reason to grant them a veto on the removal of the liquidation preference for all investors? There is no obvious answer whether, in this case, a waiver should require the consent of each affected share class, but clearly an investor demanding such a veto would not act unreasonably. This is another good reason not to build a waterfall into the liquidation preference in the first place, but rather have all preferred shares on the same level (“pari passu”).
When applying the rule that no waiver that leads to a discrimination of the minority should be acceptable, there is one particular situation to keep in mind: in some jurisdictions, in particular in the U.S., it is often agreed that a waiver of the pro-rata right (meaning the right to subscribe new shares in a capital increase in order to maintain one’s shareholding) is not deemed a discrimination of certain investors even though other investors are allowed to subscribe for shares in the capital increase irrespective of the preceding waiver. This constitutes a “selective” waiver of the pro-rata right, which we at Point Nine think should be avoided unless in case of very special circumstances.
Our purpose to make VC more human
In conclusion, what matters ultimately is that investor rights protect legitimate interests and are well balanced against the need to run the business smoothly and efficiently. Founders rightfully expect their investors to keep governance manageable, which may also imply that the approval of more operational matters (e.g. business transactions above a certain value) is moved to the board (where investors are represented) when the shareholder number increases.
Also, when it comes to veto rights on reserved matters, “exceptions confirm the rule.” If a major tier-1 investor joins the cap table and invests, for instance, three times the amount of all prior rounds combined, such investor might expect that if he subsequently holds a majority of preferred shares, this is reflected in the governance. Even if, in consequence, this investor is able to exercise certain veto rights (i.e. decide alone whether to block a certain action covered by reserved matters or to waive an investor right), this might be acceptable as long as the other investors are treated equally and are not discriminated. Some additional wording in this regard in the relevant transaction documentation might do the trick, which should also help to avoid an unhelpful precedent for upcoming rounds.