Do Founders Really Control Their Company With 51% Ownership?

24 March 2015 Innovative Technology Insights Blog

Founders are often focused on maintaining at least 51% ownership of their companies. With 51%, they will be able to control the Company, and their destiny. At least that’s what they thought. In reality, the 51% control premium is often contracted away in the world of preferred stock venture financings.

In a typical venture financing, venture capital (VC) investors may end up with 25% of the Company, leaving 75% in the hands of the founders. However, the VCs will require that the Company enter into various contracts with them as a condition to the financing that shift control away from the founders and towards to the investors.

The Amended and Restated Certificate of Incorporation

The VC investors will require that the Company amend and restate its certificate of incorporation to create special preferred provisions for their stock only – such as “protective provisions” that require the Company to obtain the consent of the preferred holders for certain major actions – like sale of the Company, paying dividends, or issuing debt. The amended certificate will also contain anti-dilution provisions that adjust the preferred holders percentage ownership in the Company if the Company sells new shares at a lower price than those that were sold to the VCs. It will often contain redemption provisions that allow the preferred (VC) holder to require the Company to redeem all of their shares after 5 years at the original purchase price, and often with accrued dividends.

The Voting Agreement

They will require a voting agreement, that guarantees the VCs certain Board of Director seats. Typically after the first VC round, the Board will be re-set at 5 members, with the preferred (VC) holders getting 2 seats, the founders getting 2, and an independent holding the fifth seat (and swing vote). The voting agreement will also often have a “drag along” provision that obligates founders to agree to vote in favor of a Company sale if it is approved by the Board and the VCs.

The Right of First Refusal and Co-Sale Agreement

They will require a right of first refusal agreement obligating the founders to agree to offer their shares first to the Company and second to the VCs if they want to sell their shares to a 3rd party. The VCs will also have a “tag along” right allowing them to sell their shares along with the founder’s shares to the 3rd party buyer that is corralled by the founder.

The Investors’ Right’s Agreement

Finally, the preferred (VC) holders will require an investor rights agreement, providing them with the right to cause the Company to file for an IPO, rights to have their preferred shares registered for subsequent sales to the public, rights to receive monthly, quarterly and annual financial statements, rights to inspect the Company’s premises, and rights to participate in future financings in order to maintain their ownership percentage. The investor rights agreement will also contain numerous covenants pursuant to which the Company agrees that it will not do certain things without the approval of the VC directors, such as changing the compensation for executive officers, entering into new lines of business, or making an investment that is inconsistent with its Board approved investment policy.

The typical VC investor understands that control of a company is not purely a function of the stockholder’s percentage ownership. Instead, control, or at least blocking rights, can be gained through contract provisions that are often found in their preferred stock investment documents. Accordingly, and in the world of preferred stock investments, 51% ownership by founders does not provide the level of security and control that is often desired.

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