Control is a critical component of every venture capital deal.
Control can be used to dictate desired outcomes or, through “negative controls,” to block undesired outcomes. Negative controls are typically enumerated as “protective provisions” that give the venture investor the right to unilaterally block a variety of corporate actions.
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A majority of the board and a majority of the stockholders generally control the outcome of all decisions that require a vote. Venture capital funds, which typically own minority positions, rely on protective provisions in the corporate charter to block actions they do not support. There is nothing sinister about protective provisions. They are a standard part of the basic covenant the entrepreneur enters into with the venture capital investor: “thou shall not do anything that will impact my investment and financial terms without my blessing.”
Common categories covered by negative control rights are dissolution or winding up of the corporation; sale or merger of the corporation or a disposition of the corporation’s assets; amendments to the corporation’s charter; creating or issuing senior or pari passu securities; paying dividends; redeeming securities; borrowing money (often above a specified threshold); and changing the number of directors.
These protective provisions effectively give an investor a veto right to protect the investment by not allowing a majority of the board or stockholders to unilaterally undertake actions that would diminish a venture investor’s equity value or return by:
- Shutting down the company.
- Raising senior or pari passu capital, which would negatively impact the value of the investors liquidation preference or, in a low valuation scenario, create the potential for significant ownership dilution.
- Selling the company at a price that isn’t acceptable to the venture capital investor, which would limit the investors upside potential.
- Creating a debt load that would put the venture capital investor’s equity investment at risk by creating a heavy debt load and otherwise abrogating the investors liquidation preference since debt always gets paid before equity.
- Paying dividends or redeeming equity, which in both cases can amount to distributing value to the detriment of the venture capital investor.
- Altering the composition of the board, which is often a very fragile and carefully crafted balancing of competing interests over control.
There is always room for a productive conversation but it isn’t productive or useful to take offense to the inclusion of protective provisions or to try to remove them in their entirety. Appropriate areas that can be discussed start with the block on charter amendments and the issuance of senior or pari passu securities.
It isn’t unusual to discuss narrowing this protective provision to limit the blocking right to a charter amendment that will adversely affect the preferred stock issued to the venture investor in a manner that is different than other preferred stock, and to dispense with the block on the issuance of senior or pari passu securities. This means the venture investor can protect its negotiated investment terms without necessarily having a block on your ability to attract future venture capital.
Similarly, you can have a productive conversation around an M&A exit and try to agree on an exit value that will serve as a floor. Then, an M&A outcome yielding a higher value will not require your investor’s consent. That, basically, is conceding that a venture investor expects a minimum return without necessarily ceding to your investor total control over a possible exit.
Expect greater adoption of these types of compromises in earlier stage deals but these compromises are still viewed in the market as exceptions to the rule. The strength of your negotiating posture and the general disposition of your venture capital investor towards these types of provisions will ultimately dictate whether or not you will see a deviation from the market norms in your deal.
Regardless, you should always remember that covenant which binds you and your venture investor when it comes to control.
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