By: Tyler Mills
May 2018
This blog post seeks to alert entrepreneurs to a process by which to strategically give up control to venture capitalists. Because it is inevitable that some control of the venture must be given up to institutional investors, an entrepreneur should calculate how to deliver control to venture capitalists in the most beneficial way. This post will address two common mechanisms that VCs employ to obtain control—protective provisions and board designations—and then will argue that, if given the choice, entrepreneurs should favor granting VCs board designation rights over protective provisions.
First, Why Entrepreneurs Have to Give Up Some Control to VCs
Entrepreneurs may be wondering why they have to give up some control to the VCs. Venture capitalists seek control of the startups in which they invest because of the agency problems inherent in such companies. Agency is a legal relationship where one party, the principal, grants authority to another party, the agent, to act on the principal’s behalf. In the venture capital context, the agency relationship looks like this: The VC infuses the company with capital and in return the entrepreneur acts on behalf of the VC to ensure that his/her money is being put to good use, i.e. working towards increasing the company’s value. However, information asymmetries between venture capital investors and startup entrepreneurs create agency problems, which VCs try to mitigate by securing a degree of control of the company. The agency risks of venture capital financing typically come in two flavors: adverse selection and moral hazard.
First, adverse selection risks result from hidden information. For example, venture capitalists may be unable to sufficiently determine the viability of the entrepreneur’s invention or business and the entrepreneur’s work ethic. The entrepreneur, on the other hand, is in a better position to know about these risks. Second, moral hazard risks are associated with hidden actions. For example, because an entrepreneur’s human capital is so crucial to the success of the business, an entrepreneur can threaten to quit or perform poorly, after a VC’s initial investment. This will force a VC to renegotiate terms or insert more capital. Because of the above-mentioned information asymmetries inherent in venture capital financing, venture capitalists will often seek control of the companies in which they invest. In seeking control, venture capitalists often choose between two strategies: protective provisions and board designations. Entrepreneurs should be familiar with the above-mentioned two strategies so that they can give up some control in a beneficial way.
Second, Entrepreneurs Should Know Venture Capitalists’ Strategies to Obtain Control
When investing in startups, venture capitalists will use a few common mechanisms to secure control. First, VCs will typically only invest in preferred stock because of the large contractual nature of that type of stock. When VCs contract for preferred stock, they will negotiate zealously for protective provisions, which give them veto rights over certain corporate actions, such as selling the company or raising capital. By negotiating for these protective provisions, venture capitalists are able to control the companies in which they invest in order to increase the likelihood of a return on their investment.
In addition to protective provisions, venture capitalists will typically negotiate for the right to designate one or more individuals to the company’s board of directors. The board of directors of a company establishes policies for corporate management and makes major decisions for the company. In addition, a company’s board of directors, at least in Delaware, is given great deference via the business judgment presumption and Section 141(a) of the Delaware General Corporation Law. As a result, venture capitalists can control major corporate decision making through their board designees, most importantly decisions relating to sale or initial public offering, the two preferred mechanisms for securing a return on investment.
Inherent Defect of Board Designation Strategy: Fiduciary Obligations
Members of a company’s board of directors owe fiduciary obligations to the company’s stockholders. A fiduciary obligation is “the obligation or trust imposed by law on officials of an organization making them liable for the proper use and disbursement of the organization's money, funds and property.” The main fiduciary obligations owed to stockholders by board members include the duty of loyalty, duty of care, and duty of good faith (which is typically categorized as a subset of the duty of loyalty). These duties ensure that the company’s board is acting in an informed manner and in the best interests of the company and its stockholders, rather than acting in their own self-interest.
In In re Trados, the Delaware Chancery Court dealt with the question of a board’s fiduciary obligations in the context of a VC-controlled board. In Trados, the Chancery Court held that when a preferred-controlled board favors the interests of preferred stockholders over those of common stockholders in deciding whether to enter into a transaction, the board will be left with the burden of proving that the transaction was “entirely fair” to the company. This holding tells us two things. First, a VC-controlled board owes fiduciary obligations to common and preferred stockholders alike. Second, if a VC-controlled board decides to favor the interests of preferred stockholders over those of the common, the board will lose the business judgment presumption and have to prove the entire fairness of the transaction. The entire fairness standard is Delaware’s most stringent standard of review, which seeks to determine if the process for determining whether to enter into a transaction and the price at which the transaction was entered into, were fair. As a result of this holding, entrepreneurs now have more clear safeguards against VC investors’ control via their board appointees.
A Recommendation for Entrepreneurs: If Given the Choice, Permit Board Designation Over Granting Protective Provisions
Because VC-controlled board members owe fiduciary obligations to common stockholders to not favor the interests of preferred-stockholders, this blog post recommends that if forced to choose between granting VCs board designees or conceding more protective provisions, entrepreneurs should choose to grant board control. The reason for this is because, particularly after Trados, it is clear that board members must not favor preferred stockholders’ interests over those of the common or risk having to prove the entire fairness of the transaction. This ruling gives entrepreneurs greater safeguards to protect against venture capital domination if they grant board control. On the other hand, protective provisions are contractual in nature and, as such, do not provide the same legal safeguards as the fiduciary obligations discussed above.