Whenever I talk to entrepreneurs about corporate governance I get the same response. This topic is right up there with Audit Committee on the list of “10 Most Boring Topics for Early Stage Companies”. However, setting up the right investor base and board at the time of investment is critical for a company’s success. What many founders don’t realize is that even though they are selling a minority of their company to the VCs, the VCs will have a lot of control over the business.
The National Venture Capital Association has a set of template documents on their website that most VCs use. These documents have been around for a long time, dating back to when the venture business was a lot smaller than it is today. Every entrepreneur should take the time to read these documents before they raise money.
The standard venture capital documents include a number of control provisions, which allow the investors voting together as a class to influence the following things:
Issuing additional stock (i.e. future financings)
Hiring and firing the CEO
Selling the company
Approving the operating budget
Changing the Board of Directors
The list is longer but you get the gist.
Back in the early 1990s, when most venture capital investments were widely syndicated, a company would have a few investors that held these controls together. Depending on the make-up of the syndicate it could require two or three different investors to trigger a change. Today, venture capital firms have gotten larger and many have eschewed syndication as a result of their fund sizes. This means that the blocking rights can be consolidated in a single firm.
Most venture firms are not intentionally malicious, but in the last ten years I have heard countless stories about VC firms that blocked the sale of a company because they thought a CEO was selling too early. Or they blocked a follow-on financing because they didn’t like the terms. These decisions can backfire and then the company never gets sold or goes out of business because better terms were not available.
My advice to entrepreneurs is to follow a syndicated approach to investment. This avoids the bad apple problem where one partner has a unilateral block. If you need a second reason, syndication also gets more value out of your investors. There is a lot of research on the topic already for those that are interested (for example: Josh Lerner, Raffi Amit). It is one area of finance that has been analyzed and proven to drive better returns for both VCs and entrepreneurs.