Do you fear losing control to investors?
Most founders do. You’re not alone!
Over the last month, I’ve been asked a couple of times about how founders can protect themselves from losing control of their startup. Generally, the fear is of incoming investors wrenching the company from their grip and casting them aside.
It’s a common concern. And it does happen. Most infamously, Steve Jobs was sacked by the board of Apple in 1985, a story made famous by his subsequent return when Apple was on the brink of bankruptcy, only for him to turn it around to become the most valuable company in the world.
The bad news is that you can’t always prevent loss of control but the good news is that you can take some simple steps which will offer you protection. And the better news is that losing control isn’t all that bad!
So, how can you navigate the control problem?
This article takes a look at what control means, what protections are available to founders but also why you shouldn’t get too obsessed about control.
What do we mean by control?
Most new founders consider control to mean collectively owning (amongst themselves and connected parties such as family, friends etc) more than 50% of the company’s issued shares (strictly speaking, this should be ‘voting shares’ since it is not uncommon for companies to issue non-voting shares – see below). Thus, they typically wish to ensure they are never diluted down to less than 51% ownership.
Unfortunately, this thinking is flawed and control is never absolute.
A 51% level of share ownership certainly allows the controlling group to pass what is referred to as ‘ordinary resolutions’. Examples of ordinary resolution include creating a new class of share and declaring dividends.
However, there are other matters, called ‘special resolutions’ that require 75% of more of the shareholder vote to agree including:
- Changing the company name
- Changing the articles (the rules by which the company must be run)
- Granting directors the right to issue shares without offering them first to existing shareholders (known as pre-emption rights)
So, if you really want to have complete control, you actually need to maintain 75% or more of the voting shares.
Although not impossible, it’s much rarer for founders of investment driven businesses to end up with this level of share ownership beyond the seed investment round. In practice, even if nothing else happens, you may need to seek the occasional permission from your major shareholders if you want to pass special resolutions.
However, even if you are fortunate enough to have maintained control over more than 75% of voting shares, you still don’t have absolute control to do anything you want. As a director, you have a legal responsibility to act in the best interest of the company as a whole to promote its long-term success. Amongst other responsibilities, this means that you generally cannot make decisions that prejudice your minority shareholders and, if you do, they can take you to court.
The take-away point is that there are degrees of control even in the simplest of situations.
Is control all about your shareholding?
Actually, irrespective of your overall shareholding, if you continue to take anything more than seed investment, you’re likely to end up ceding control. That’s because most professional and institutional investors are highly likely to mandate you sign a “Shareholders Agreement” (SA) as part of any deal.
As it suggests, this is an agreement amongst the shareholders as individuals. It is normal for it to be signed by all the shareholders or at least all the significant ones (it can only be binding on those who have signed).
Unlike the company’s Articles of Association, which are public, the SA is a private agreement.
Typically, the SA required by an investor will cover one or more of the following areas relating to control:
- Rights to appoint and remove directors (including founders)
- Directors that must attend to make a board meeting quorate (typically at least one investor director)
- Deciding votes if the board is not in full agreement
- Restricted matters requiring explicit permission by the investors
The list of restricted matters is normally long and likely to include changes to the articles, creating a new class of share, any issuance of new shares, taking on debt, selling any assets of the company, material changes in the nature of the business, hiring or firing of key staff, director’s pay, significant deviations from the business plan etc. They can be quite intimidating on first read although on reflection they can all be seen as ways to protect the investors’ interests.
The key point is that the SA is likely to have a much larger impact upon your control than your voting power as a shareholder.
Is there anything you can do about this?
Like any agreement, the SA and the list of restricted matters are negotiable depending on the strength of your hand. If you’ve managed to get to cash positive and the investment is to fund growth, you’re likely to be able to negotiate much better terms than if you’ve run out of money and are desperate for a life-line.
It’s a good reason to delay going for big cash for as long as you can.
For example, when Innocent Drinks (the smoothie maker) received an investment of £30 million from Coca-Cola in 2009 for an 18% stake, they were able to announce that their deal left them with complete control. Apparently, at that time they had more than 15 potential investors and according to Dan Germain, the company’s head of creative at the time, “of all the people we spoke to, they [Coca-Cola] guaranteed a hands-off approach. We will continue to make the decisions.” (see “Slaughter of the Innocent”, Independent, April 2009). Presumably, this guarantee reflected very few restrictive matters in their agreement.
(Then again, maybe Coca-Cola knew how to get a foot in the door since they subsequently completely took over Innocent in subsequent investment deals.)
Nevertheless, you should see the SA as a two-way street. Just because an investor insists on certain rights when they make their investment doesn’t mean they should keep them forever. If an investor doesn’t continue to “follow their money” by taking part in subsequent investment rounds or decides to sell most of their stake, the board shouldn’t be encumbered by rights held by a minority investor. So, it’s worth negotiating some clauses about when their rights fall away, for example if their overall holding of voting shares drops below a certain percentage.
Are Shareholder Agreements Always Bad News?
Founders may consider signing a simple SA amongst themselves before any investment comes in. A good reason to do this is to agree what happens to a founder’s shareholding should they leave or (in the worst case) die.
Let’s take an example of co-founders, a CEO and CTO, who start with a 50/50 split of the company’s equity. Without an SA, if the CTO decides to leave, the CEO now only controls 50% of the voting shares. That can be difficult if the CTO left following a dispute. Incoming investors will be extremely nervous of that level of shareholding being controlled by a potentially hostile agent. On top of that, it’s likely that the CEO will need to find another CTO and incentivise them using shares, diluting everyone in the process.
In another scenario, if the CEO should die or otherwise become incapacitated, the business may find the CEO’s shares being owned or controlled by his spouse. The spouse may quite understandably wish to hold on to them because of the potential value but it leaves 50% of the company’s shares being owned by a non-participant with potentially no ability or willingness to help the business.
There are variations on these themes: what if one of the founders needs to be dismissed for negligence, gross incompetence or even fraud?
A Shareholders’ Agreement provides a vehicle for founders to agree what should happen to their shares under these different scenarios, often referred to as ‘good leaver’ and ‘bad leaver’ clauses.
A ‘good leaver’ is normally defined as someone who dies, becomes medically incapacitated, is made redundant or is unfairly dismissed. Lawyers like to make sure there are no grey areas so a ‘bad leaver’ is normally defined as anyone leaving who is not a good leaver. That definition of bad leaver can be quite draconian and circumstances may reasonably occur that force someone to leave without them strictly falling under the definition of good leaver, so it’s usual to allow the remaining board members to have the discretion to treat someone as a good leaver.
Normally, bad leavers are obliged to give up their shares (or maybe sell them to the company or other founders at a very low price, such as nominal value).
A range of options might be open for dealing with good leavers:
- Keep all of their shares
- Sell some or all of their shares back to the company, or other nominated shareholder(s), at fair market value
- Convert their remaining shares (if any) into non-voting shares
- Keep a reasonable proportion of their shares and sell the others to the company, or other nominated shareholder(s), at a very low price
Option 1 doesn’t protect the company from some of the scenarios noted above but may work for relatively minor shareholders.
Option 2 makes more sense once the company is established and you have good investment coming on board. After all, if you’re just setting out, what is ‘fair market value’ and could the company or other shareholders afford to pay it even if you could agree? If you’re going for clauses like this as they relate to a founder, you probably want to get ‘Shareholder Protection Insurance’ in place, which would provide the funds to enact the necessary payments. Again, this is probably not a burden you want in the early days.
Option 3 requires some legal expense since you’d have to create a new class of share and then undertake the conversion, potentially with some tax implications. Once again, it’s more likely to be an option for an established company.
Option 4 is the probably the most sensible for founders to consider setting up amongst themselves in the early days. For example, you may allow a good leaver to retain no more than 5% of the company’s issued shares at the time of their leaving and be obliged to sell the remainder to the other founding shareholders at nominal value. The agreement can then be superseded by a more comprehensive Shareholders’ Agreement later once the company is established.
Of course, you may find yourself being the ‘good leaver’ if the board ultimately decides the company will be better off without you, so it’s worth spending some time on these clauses!
Is losing control something to worry about?
In my opinion, creating a company is a little like deciding to become a parent. You’re creating something that is its own legal entity (not how I describe my kids by the way). It starts off completely dependent upon you but over time will hopefully grow to be less and less dependent. It may continue to look up to you but it may outgrow you and find others to follow. As long as it’s successful, it’s no bad thing.
Yes, if you’re starting a business which is looking for investment to grow, you will cede levels of control. And, yes, that could ultimately lead to you being replaced. Again, if you’ve got good value for your time and contributions, is that a bad thing?
What you need to realise is that investors really don’t want to replace founders. It’s painful, expensive, risky and time consuming. That’s why they spend so much time looking at the team as part of their investment decision. However, if the company is struggling for lack of management know-how, then it is right for everyone (including yourself and the value of your shares) that new management should be brought in. Just because you’ve done a great job being the CEO of a startup, it doesn’t mean you’re the right person to be CEO of a growing company.
In particular, institutional investors are financial instruments and are judged by the returns they provide to their own investors. They will thus be under much greater pressure to make management changes if things are not going well.
The best protection
With all the above said, the best protection you can have as a founder is to pick the right investors.
I encourage founders to think of control not in terms of their shareholding or rights but in terms of the board’s control. What startups need is an effective board that is capable of making good decisions and is empowered to see them through. Thus, planning investment whereby the board ends up maintaining control of 75% of more of the voting shares is smart. And the board is very likely going to be made up of the founders and your key investors, who should be the primary participants in any Shareholders’ Agreement.
This does mean that picking the right investors is a control risk but it’s also a great opportunity to bring in ‘smart money’. (I cover how to avoid the wrong types and pick the right type of investors in my book “Start Smart”).
The key takeaways are:
- If you’re seeking investment, you will end up losing some control. Accept it!
- Pick your main investors very carefully, you will need to share control with them.
- Delaying investments for as long as possible will allow you to keep more control.
- Focus on maintaining board control rather than founders’ control.
- Consider an early Shareholders’ Agreement amongst the founders to avoid loss of control if one of you leaves or dies.