Business investors, like venture capital funds, angels and other investors, typically receive minority ownership interests. The resulting lack of voting control and limited influence on management control requires these investors to use other means to protect their interests and have a voice in key business decisions. Minority investors should consider and negotiate for the types of protections outlined in this post. It is equally critical for start-ups to understand what an investor might ask for and why.
This is a two part post. Although not an exhaustive list, the following are common means used to protect investors with minority ownership interests:
1. Board Participation:
Despite the lack of ability to control the board, it is common for minority investors to require some degree of participation to not only remain current on company affairs, but to obtain the ability to influence and persuade other board members on key decisions. Although board participation is appealing, remember that board members have fiduciary duties and therefore may be accepting additional risks. As such, minority investors with board appointment rights should require the company to obtain suitable D&O insurance coverage as a condition to the investment. Board observer status is an alternative way to have input and be informed without the downsides of being a board member.
2. Consent Rights:
In addition to board representation, minority investors often request investor-level consent or veto rights on certain key actions. These may include materially changing the venture’s business plan, entering into a sale of the venture, commencing an equity or debt transaction, approving distributions, increasing the stock option pool, changing senior executive compensation or dissolving the venture. Although consent and veto rights are appealing to a minority investor as they guarantee a say with regards to certain matters, it is worth noting that the parties may disagree down the road on what was meant and a long list can be burdensome on the minority investor if it is constantly asked for consent. Further, consent rights can lead to a deadlock if the parties cannot come to an agreement on an issue that requires unanimous consent.
3. Affirmative Covenants:
A minority investor may want to seek affirmative covenants (contractual agreements from the venture about how it will operate and act) in order to stay sufficiently informed and keep the business in line with expectations. Common affirmative covenants include requiring the venture to provide the minority investor with periodic financial statements, annual business plans, progress reports regarding specific goals, access to books and records, and notices and correspondence with material third parties.
4. Pre-Emptive Rights:
To avoid dilution of its equity ownership, a minority investor will often seek pre-emptive rights, that is, the right to purchase the investor’s pro rata share of any future equity issuances. Startups sometimes regret granting pre-emptive rights which can slow down future investment rounds since big VC investors rarely want a small prior round investor to participate, and it makes good governance sense to provide a majority block of the investors with the right to waive pre-emptive rights so that new investors are allowed in.
5. Price Anti-Dilution:
Price anti-dilution rights provide that any issuance of new equity at a lower price per share than paid by the minority investor will result in the issuance of additional equity to the minority investor (upon conversion of their preferred equity into common equity) so the minority investor’s per share price is effectively lowered. A “full-ratchet” adjustment effectively reduces the per share price paid by the earlier investors to the price paid by the new investors. A “weighted-average” adjustment (most commonly used) is a formula that results in a partial lowering of the per share price paid by the earlier investors, but not fully-adjusted to the per share price of the newly issued shares. Obviously, these rights mean that founders are disproportionately diluted in down rounds.
6. Restrictions on Self-Dealing:
To avoid self-dealing and conflicts of interest, the minority investor should consider requiring that any arrangement between the majority investor and the venture be subject to the approval of the minority investor, and that the arrangement be entered into on arm’s length terms.
7. Rights of First Offer:
A right of first offer requires an investor selling its interests in the venture to offer such interests to the other investors before selling to a third party. This would allow a minority investor to prevent a third party from obtaining ownership interests in the venture. Start-up founders need to consider whether they are willing to be bound by this type of restriction.
8. Rights of First Refusal:
A right of first refusal is similar to a right of first offer, but the investor selling its interests only offers to sell its interests to the other investors in the venture after receiving a bona fide offer from a third party, and such offer must be on substantially the same terms as the bona fide offer.