Term Sheets: Control Terms
The control terms are the provisions that enable investors to exercise control over the company to protect their investment and to comply with fiduciary duties the investors owe to the LPs of their venture fund.
Although Series A investors typically purchase about 20% equity, the percentage of ownership does not equal the percentage of control. There is an old VC saying that the art of venture investing is "structuring the deal to have 20% of the equity with 80% of the control." When VCs purchase less than 50% of the startup, they almost always require the control provisions outlined below.
Information rights give the investors rights to certain financial statements from the company. Reporting requirements are usually quarterly and annually (or as soon as practicable in those cycles). Although, monthly reporting may be requested. Financial statements usually do not need to be audited by an independent third party or conform to GAAP.
The right to financial information should be limited to major investors and non-competitors of the company. Major investors are usually determined by number of shares purchased. Corporate investors could become competitors (e.g., corporate funds owned by Intel, Google, Salesforce, etc.). Competitors may include VCs that invest in competing startups in the same industry. The more limited the information rights are, the less likely it is that the information will fall into the wrong hands.
Note: Be ware of pre-Series A convertible notes or edited SAFEs that give investors these information rights (at the purchase of the note or SAFE or post-Series A).
In a Series A round, the lead investor will typically require a board seat. An odd number of directors is best to prevent a deadlock (tie vote) on an important matter which would prevent the company from taking action. The most common composition of the board at this stage will be 3 directors or 5 directors. At this stage, it is best to keep the board as small as possible for efficiency and for the founders/common stock holders to remain the majority directors. The makeup of the Series A board sets the precedent for the Series B board.
For example, a board with 3 directors usually consists of either:
2 common stockholders (usually the founders) and the lead Series A investor (best case); or
the founder/CEO (who represents the common stock); a director elected by the lead Series A investor (who represents the preferred stock), and an independent director (who can break ties and votes in the best interest of the company).
Drag Along Right
The drag along right requires that every shareholder vote a certain way once a minimum threshold vote is achieved. The right to "drag along" other shareholders usually applies to a vote for a change of control (sale of the company).
There are 2 types of drag along scenarios: An affirmative vote of a majority of the preferred holders and a majority of the common holders, each voting separately as a class is required. The minority shareholders of each class are "dragged along" with the vote of the majority in their class. This prevents minority shareholders in either class from holding up company decisions (which can happen because either the shareholder wants to gain leverage by not agreeing or because the shareholder cannot be located to vote on the matter). Having each class vote separately ensures that each class is adequately represented in the decision. In this case, the common holder vote should not include preferred shares that have converted to common shares or preferred holders will convert just to change the outcome of the common holder vote.
The other scenario is where preferred holders have the right to drag along the common holders. This effectively gives the investors the ability to force all of the other investors and the founders tell sell the company.
Pro Rata Right
The pro rata right gives the investor the right to participate in future investment rounds on the same terms offered to other investors in that round. Pro rata rights often first show up in the seed round (convertible instruments). Usually the investor can invest up to its current percentage of the company.
Occasionally, investors will negotiate for "super pro rata rights" which allows them to invest 2+ times their current ownership or for a specific percentage of the next financing. The company generally doesn't care about pro rata rights because it wants investors to participate in future rounds. But, the right sometimes causes issues with new large investors in later rounds because they do not want to have to share the investment round with prior/smaller investors and this could become a point of negotiation. Thus, the right should be limited to the largest investors in the round.
Protective provisions give the investors the right to veto a list of certain corporate actions/transactions. At the very least, investors will want to have a say in actions that will impact the company's financials. Standard protective provisions include: amending the certificate or bylaws, altering the size of the board or voting procedures, creating new or additional common stock, issuing stock that is senior or equal to the existing preferred stock, altering the rights of the existing preferred stock, buying back stock, declaring a dividend, taking on debt, acquiring other companies, exclusively licensing technology, or selling all/substantially all of the company's assets.
The company will want few protective provisions, while the investors will generally want as many as possible.
The investors should not have veto power over the day-to-day operations of the company (e.g., hiring/firing employees, or salaries or other compensation). The amount of debt that requires approval is negotiable and usually depends on the stage of the company.
Founders should negotiate a minimum threshold of preferred shares outstanding for this veto right to continue to apply. Otherwise, the preferred holders can effectively control the company into perpetuity even if there are very little preferred shareholders left (e.g., the protective provisions apply "so long as 10% of the originally issued Series A Preferred remains outstanding.")
Note: A VC director will have conflicting fiduciary duties to the VC fund's LPs and the company. VCs must act in the best interest of the VC fund, but those interests do not always align with the startup's.
The investors always have a right to convert their preferred shares into common shares at any time. This option is standard and likely non-negotiable. In practice, preferred holders would only convert into common if it would be more beneficial (e.g., a higher payout than their liquidation preference, or to control the vote of the common shareholders).