We touched upon it before, but now it becomes a bit more tricky. We talk about the schizophrenic position between founders, CxO and shareholder positions.
- Who Negotiates?
You as founders and your management team finalized your business plan and provided all necessary documents to the investor in your role as management board and the investor now offers a term sheet. Cool.
Who does the investor offer the term sheet to?
The shareholders. Yep. That means no. The document goes to the the representative body of the shareholders – the advisory or supervisory board. Technically in a traded stock, it’s the shareholders. Or the supervisory board would need to get shareholder consent on a material decision. But in the VC world, all those rights and duties from e.g. the common shareholdes are pooled into the boards hands. And the board – being elected by the shareholders – are the body that negotations such stuff. So the new investor gives the stuff to the board.
So what happens now has nothing to do any more with the founders as CxOs. And not as shareholders. But as board members. The board is where everything takes place now.
It is a fully reasonable assumption under common and fully objective reading of the law, that the the board has the fiduciary duty to fully represent shareholder interests. So if we assume the board is not misaligned with shareholder interests, the board negotiation is in theory a shareholder negotiation. Just not lead by all shareholders, but its elected representatives on the board.
- Who owns the negotiation?
This is where things get tricky. If the shareholders and board members don’t know the share holder agreements that regulate their body and the investment agreements that regulate their voting rights and powers in great detail or they are not very experienced in these kind of exercises, it is very likely that the strongest and most experienced board member will try to influence and own the negotiation to make it go towards its own favour.
A very informed and legally sophisticated pool of board members will typically keep things in check. Anyone that tries to further his own interests against other shareholders will immediately be called to reason and remembered of his fudiciary duty to the entire shareholder base. But if nobody understands when you can use this argument to get people back behind the line they should not cross, people will cross the line and the entire negotiation becomes one of leading influencers in the board.
That is important. If you assume nobody really knows how to call to the fudiciary duty raison, the entire board negotiation is one of power and influence play. And it requires at least a clear and aggressive view on how terms affect shareholder interests. My observation is that unsophisticated board members lose this game for several reasons: (1) they don’t get the full scope and power of the terms discussed, (2) they have little or no support from their lawyers, because they are not endowed with enough fire power or are not willing to commit the firepower, as they don’t get the risk and reward of such negotiations, or (3) they are overall so weak in the industry that the lawyers don’t play strong against the opponent to not destroy business development opportunities and relationships built with the opponent. So in the end, it is up to the board member to fully grasp the legal aspects and be very sharkish and aggressive in fighting in these discussions.
It is needless to say, unless you have a very experienced angel that coaches you as founders, you are likely to lose that game. Unless you are really really smart and well educated on this matter. This is a clear area where institutional VCs have the upper hand.
- How is the negotiation played
The negotiation has always two key components. Component one focuses on financial risk and reward. Component two focuses on control.
The financial risk can be divided into generic risk measures that define the structure of the preferred asset class – liquidation preferences, anti-dilution, etc. – and tactical financial structures such as using milestones/tranched payments, incentive design structures such as sweet equity, ESOPs.
The control part focuses on for example shuffling rights between common and preferred classes regarding board decisions. Defining the actual milestones and how specific the control on management aspects is.
That is pretty simple and there is a lot of literature on the structures. More important is how you win those negotiations.
- Control negotiations
To understand control negotiations, we have to take a step away from the legal speak and have to think about what control means.
This becomes very evident in this example:
Well, the founders are shareholders. In the beginning, they should be majority shareholders over all share classes. Makes sense that they have the full voting power on the shareholder level to do what shareholders do. For example decide on the fate of the board and building a solid board to represent them and the interests of all shareholders. Because that is what a hedge fund manager that buys a majority of shares of a publicly listed company would do,too. He would seat new folks into the board to impact the direction of the company.
Let’s assume the founders know the company and industry better than the investors. That is a reasonable assumption. And let’s assume they have the full shareholder interest in mind when composing the board. And so forth. They are perfectly capable as majority shareholders and hence their should be no control rights transfer from the common shares to the preferred shares. And the new investors only get preferred shares to protect their financial assets and preferences over the common shares. Makes sense, right
So the fully in control common shareholders have to form a solid board. In this perfect example, the new shareholders have absolutely no say, but the smart founders give their investors a board seat. Because they want their knowledge to spill over to the board and they think it is in their own and the other shareholders interest to have them sit there. They also get some additional advisors on the board. Perfect.
Now the founders are also the best managers in the world and they all sit in the management board of the company. Great! The board needs no extra control rights over the management that exceed the standard board rights. Because a supervisory board might not even exist, it is called an advisory board and it just advises the management.
Now does that look like your typical Venture Capital investment agreement? Probably no.
Investors will add their right to the advisory board. And they will have special information rights. They will also have special control rights normally not part of the deal. They might even tie their investment to company performance goals and let the advisory board supervise the meeting of these milestones. They will even think the founders cannot split their roles as shareholders, board members and management and will throw a vesting schedule for the founders and offer sweet equity tied to these performance goals. They will shuffle board rights from common shareholders to preferred share class to allow control rights to only them that the common shareholders don’t have.
Those things are always introduced as “standard terms” and “risk protection measures”, but it essentially means that control is shuffled from the ones that should in general know it better – the founders. Why? Because nobody believes that founders play all those roles correctly and founders lack the experience. They think conflict of interests are prevalent. Hardly any founder as shareholder replaces himself in the board. Probably not a single one. And hardly any founder on the board proposes to replace himself as CEO and CTO or CFO in his own company.
So that is all valid. When you think about the risk coming from founders being non-investors and inexperienced in this world. But what founders should not forget in this entire scenario – they not only reduce their risk of violating their organ duties, they lose essentially control over the direction of their own companies. Is that something they want? No. And this is something where a bad investor can really destroy value if his understanding of the potential and vision of the company is just not aligned with reality. But the same holds true on the contrary, if the founders vision and direction of the company is not superior to that of its investors, shareholder value is destroyed, too.
Now you cannot win a general control negotiation. You have to win several ones. You have to win the shareholder control negotiation. With all your shareholders out there, you must be able to be the best shareholder for all shareholders. That means you are able to fully grasp your responsibilities and you are just better at meeting your duties as a controlling shareholder than any other shareholder. You simply are a better investor and know how to direct the company by choosing the right board and management essentially and by winning the shareholders – as you grow, there will be more and more – and the shareholder majority to continue on this path. If that is the case, you will be able to keep control in the common shareclass or at least regulate control of all share classes in a way that you remain in control on shareholder level.
The next step is that you want to have a winning board. Nobody in history every said that you have to sit on the board of your company. You can easily have a trusted and more seasoned individual on the board and just kill the entire board if it fails to be loyal and aligned to your shareholder level control. Why do you have to sit on the board. You will be in the board if you are the management anyway. But let’s assume you are also the best person for chairing your board or you should at least be in the board. In this role you have to prove that you truly have the general shareholder interest in mind, and you are capable of directing the management with the resources and powers you have. You are able to implement information rights and reports that are sufficient to steer the company on board level, you have the ability to get the right management for the company and you offer the right doors for the management. You are just the best board member that a company can have. Or at least, you can sell all your shareholders that you as a board member are a more suitable candidate for representing them on the board than anyone else that wants to do the job can be. Simple.
And now comes the tricky part. When you move to the management level, you also have to show that you are the best person to manage the company. In the interest of shareholders and under full vetting of the board. Does that make any sense? Probably not. But maybe you are needed as CEO to be the visionary figure and you are able to set up an A team under you to run the company even better than Google or Apple. Then you might still win the war. But if you fail to set up an A team under you and you suck at management, you really don’t belong into this position. Period.
Now you can win this game by having a really bad shareholder base that is less experienced than you, a shitty board that you can control, etc. But the tactic here for success is different. You want a very good and diversified investor mix that gets the best board for you. You probably will not be able to pull this off. So you will have to get a lot of shareholders of tier 1 quality. And of course they will think you are not as good as investor as they are. So why would they want you to have the majority control rights? In the beginning they won’t. It’s that simple. But then you lose some control and you are still on the board with a tier one board. Now on the board level, these guys will know a lot better how to control and manage the shareholders than you can, but right now they won’t replace you in CEO position. Not just yet. Unless you fail to get the core milestones done. Let’s assume you do just that. Good. In this time, your board members will lobby the shareholders. They will represent particular interests where they can while trying to be loyal to the legal requirements on their role to represent all shareholders. But they will fail a bit in this. And your shareholders will have completely disaligned interests and will try to manipulate the board. By the time you reached your milestones and still have some control as a shareholder and board member, it is time to win over the shareholder as the one man that truly represents all shareholders interests or the the ones of the most relevant ones that further the interests of all shareholders. You role is to keep all aligned, use your understanding from the management level to drive the direction and so forth. If you do all this well, you can win the trust of shareholders and they might be willing to give back control to you in order to reduce their exposure to shareholder battles over the board. If you do just that, your standing in the board will again be stronger. Maybe now is the time to think about who to hire as a replacement or to use the combind power of shareholders and board to find new tier 1 players in your management team.
You can easily see how the dynamic plays out. The key thing is you will lose and regain control if you play the game right. You have to get the best shareholders, the best board and the best management. And you will likely move towards more board management and just giving direction and vision to your company. But that is fine.
This way you give leverage to the negotiations around control. Which you will need to fully get the value you envisioned in the beginning.
Unless you realized you were wrong and another board member or investor is having better ideas, in which case you still want control and channel that knowledge into the organization.
Since you are the founder and you have the deepest interest in the success of the company, you can always win this game.
But you have to understand it.
Turning the argument around: Now a lot of investors you will talk to also don’t master all this in perfection. Humans are all inexperienced in some form. So the question you have to ask the other way around are the same. Are they capable to handle the control they want? They want to hire and fire the management? Do they have the network to find a better management? And how can you as current shareholder that they have access to them? What are their criteria? Can you judge the choices on the control they make? Are you better or are they better? If they aren’t the best in what they do, maybe you can convince them – and the other shareholders – that maybe those rights are not the right ones for the benefit and interest of all shareholders. New investors like to overstretch and dictate terms that are common in the industry. That doesn’t mean they deserve these terms.
So going through it again:
You as shareholder and with all the other shareholders, what rights are you granting new investors? And is this aligned with capability or can you challenge it? Do you have the leverage and skill to convince and challenge unreasonable demands from investors? Without very solid angels, you might now.
You as a board member. What if your co-board members are not really good board members? How can you ensure you have enough voting power in the board to participate from their value add and to reduce exposure to risks coming from your board? What are you and the other shareholders saying if you give board power to an incompetent set of board members?
You don’t want your superior knowledge – even if you are not suited as majority shareholder – to get lost and have the board fail to maximize value because you got screwed on your board power and composition. What do you do to ensure that the board functions in its capacity?
And finally as management director, how can you ensure you can run the company efficiently in the areas where you are better than your board? How much control does your board have over your operational and management decision making? And not only you, let’s say you know you suck as managing director, how does a new hire or a replacement of you get enabled to fully add his value and not be restricted by covenants and duties set by the board level?
In a good negotiation with investors where you sit down for a few hours, you should be fully present and discuss all those aspects in detail and honestly. Talking about your own strengths and weaknesses and talking about the strengths and weaknesses of your investors and board. And use this to steer the control discussions.
- Financial Negotiations
The financial discussions and negotiations typically focus on valuation and some protective provisions and incentive design structures. That is all well understood. But still, everybody completely sucks at what this is all about.
Let’s be honest. Most negotiations are run by idiots with weird beliefs. And control and power plays a huge role. But let’s ignore the control discussion completely and the fact that valuations are also driven by investors attempt to get maximum shares and push all costs of the investment and the risk to the company by introducing structures.
If we look at this from first principles: You are not getting equity funding for moneys sake only. But you want help in getting sufficient funding to allocate that funding in a short time frame to maximize the ROE in a reasonable time frame. Investors and you in the end care about IRR and the money you get when you exit the company.
5.1. The management board impact
Everybody knows that strategy is one key aspect. What do you need to do in which time frame and how much does it cost? The what you need to do in most startups is about hiring the right people for the right positions and getting the right checkboxes checked on the way as you grow. So it is all about what needs to be done on a workstream basis, how do you get it done on a process level, what people do you need when to get those results as planned and how do you get the right people? And how do you ensure the right people doing the right things get the right results.
That is your primary job as CEO. And that strategy must be independent of the money you get offered. You must know how fast you need to grow to get market share when the market is ready and how to get the market to be ready when you are coming. That might mean you need 2 million customers in one year. How much money and hiring do you need to get there? And how can you drum up the investors that write the check in the size you want.
And on this road, you want investors and angels to help you write and craft that story and business plan that gets you this money at the right valuation. The right valuation meaning that investors believe that you can achieve the goals -by good sound strategy and execution and by indicative market signals. That is why you get investors, to find this out. Or at least to get you the people to find this out. And you being smart and experienced enough to focus these people on getting there. Again maybe getting external help from your investors and board.
If all this is right, you get enough investors rounded up to fill the ticket. You can choose a set of investors. The competition gets you the valuation you need and shifts the terms into your favour. We discussed this earlier.
But this all hingest on your ability to be a manager. And get the right people into the organization. And to focus on the right things. Without board or shareholder interference, but with good value add from shareholders and your board.
5.2. The shareholder impact
Now comes the thing that most founders forget. You are not only the management board. You are also a shareholder and member of the board. The negotiation has a new ancle once you start to enter the financials.
And there are two ancles to the negotiation.
Ancle 1: The management achieved this. But why did it not achieve more?
Ancle 2: Why this term? What is your risk/ benefit? What is my risk/benefit?
Ancle 1 is important. You can attack yourself in the management or the other board members for their past actions and use that to uncover future risks that now need to be addressed.
Let’s say the management – you – sucked completely and didn’t get the result. Good. That’s bad for you as a manager, but good for you as a shareholder and board member. Because nobody in the board replaced you as a manager, they all didn’t improve the value. Should the shareholders now via terms in the agreement be punished for the board failing to replace you as a manager?
Or equally, you can attack funding issues, or oversight terms in your last investment agreement as having blocked the initiatives in the company that lead to the shortfall in expectation – if revenues didn’t come – or in bad preparation of the growth case of the business – if no time was there to prepare the business plan. You can also say that the existing shareholders when reviewing the business plan failed to provide the input on what would have strengthened the business plan and hence the valuation and thereby they destroyed value for the shareholders. You can by this attack their integrity and attack the control rights discussion, shifting the argument towards loosening control or increasing funds raised or reducing valuations. On this level, you can attack the management, the board and the other shareholders from your shareholder position. And use their failure to argue against control and unfavourable terms from the the investment round. And if everything is sound and the world is fair, they have a fudicary duty to consider this and react on it.
In ancle two, you can again as board member or shareholder stress the rights of all shareholders against the new shareholder and ask why he gets better terms that existing shareholders did not get. And what the benefit for the shareholder value is if the new investor gets this. Of course, if you lose the financing, all suffer from this. But this is why you need deal competition to reduce that risk.
And then of course, when you start negotiating with the new investor on valuation and the business plan that underlies the valuation, you can even go the route of discreting the business plan. You can argue that the business plan is conservative and underprepared, fighting against yourself in the management position, and that the growth case and expectation of your as shareholder or board member is different one. If you have sufficient control as shareholder and not much in the board, you can even challenge the board negotiation and blame the entire board for not representing shareholder interests accurately. And use this as negotiation lever.
By being critical against the existing powers, you can show that you understand the level you sit in and you are arguing from a different perspective. Especially as a shareholder, you don’t have the need to be conservative on your estimates and you do not need to defend your optimistic assumptions. You can say you are not willing to give this share of the company for the amounts raise and demand different terms.
Most terms besides the valuation are disguised measures that lower the valuation. And from this ancle you can attack any term as lowering the valuation. You can ask what warrants the lowering of the valuation and you can ask what the term that lowers the valuation and shuffles risk profiles to the new investor is adding to the company and its valuation.
This might not always win the negotiation on better terms. But if you have a sensible feeling for this game, you can immediately see an incompetent and arrogant investor and understand his true motive in investing.