Moving up and making room
So far in this short series, we’ve examined simple scenarios, those where there’s a founder group and a single investor. As time goes by, SaaSco scales and attracts new investors. How do the founders and investors negotiate a position that works for them all, without killing the business? Easier said than done – founders and venture investors alike can have tricky egos and strong opinions.
Let’s scan some ideas about power-sharing mechanisms and for reaching a consensus on who gets what.
Can’t everyone get a say?
No. At least, not always.
At some point, as the shareholder register gets longer, a decision has to be made. Not every investor can get all the same rights. Otherwise, the board would be swamped with board representatives and investor-appointed directors. Worst still, the more parties who get to have a veto over crucial decisions affecting SaaSco’s future, the more likely it becomes that no decision is possible. And at that point SaaSco starts to drift. So, we need to find some ways of deciding who gets a share in the decision-making, and whether or how those rights are shared.
So who does get a say?
A common theme of these posts is that big shareholdings, big cheques, and big brand names command influence, but competition for the deal may reduce that influence. The negotiation over control rights is a headline issue ideally to be hammered out before committing to a new investor group, and competition to be that investor will help founders and previous investors improve their position.
That aside, a new investor getting a meaningful stake will typically demand, and usually get, board representation and the full set of information, step-in, and consent rights. The amount of capital deployed isn’t really the issue. £10m committed to a unicorn may not be a meaningful contribution. In contrast, a £500k seed investment that gets a 20% shareholding might earn the right to a full set of investor protections.
The complexity comes when there are existing investor rights. How are these incorporated into the new investment agreements?
- There’s an element of passing on the baton from first stage investors to their successors. This might reflect those first round investors gradually getting diluted; the increasing cheque size of later-stage investors; and possibly the greater sophistication of the later-stage investors. This evolution may be welcome. A specialist S/EIS investor might, for example, be delighted to hand over responsibility for being the bad cop on founder pay.
- Individual early-stage investors with small shareholdings, who put in limited capital, and who do not act as a group, will typically lose their investor protection rights as later-stage investors come onboard. They have a much better chance if they act collectively – a point covered below.
- Existing investors with an ongoing significant percentage shareholding will almost certainly seek to retain some or all of their shareholder protections.
The problem comes when SaaSco has accumulated several investors all of whom have a burning wish to hold onto their rights. Too many cooks..,?
How can the decision-making be shared?
It’s important to keep the decision-making process efficient and effective, limiting the chance of deadlock, and delivering swift answers. There are a few ways that might be achieved without entirely disenfranchising key shareholders:
- Consolidating rights. This works particularly well when early-stage investors become diluted, but still hold in aggregate a material stake. The investment agreements will specify a mechanism for consulting these shareholders and delivering a majority view from this particular investor group.
- A variation on this mechanism where there is a particularly important investor is that they must be part of any majority decision – so there need to be two sets of green lights: consent from a majority within the investor group and from the key investor within that group.
- Another variation is to create a mechanism for the investor group to nominate a lead investor, who may also be a non-executive director, to deliver consents on their collective behalf. This is, in essence, our position at DSW Ventures, where we represent our investors on a collective basis and handle consents on their behalf.
- A fall-back for the investor might be the right of consultation – to be allowed to form a view on a decision, to give their own views – but ultimately not to have the veto over, or even a formal say on, a decision.
- To reduce the risk of failing to get any response at all, the investment agreement could specify a limited period for consultation following which, absent a specific response, consent is assumed. This mechanism is not popular with investors, as there’s a risk of the request for consent being overlooked. There’s also a risk of dispute about whether the procedure was correctly followed. It does, however, deal with the problem of gone-aways. Small fund managers, corporate VCs, and accelerators tend to come and go. You don’t want to be chasing consents from a lawyer in a foreign jurisdiction handling the investor’s winding-up.
Before wrapping up on this subject, a quick note on reputation: founders and investors don’t like sharing consent rights with investors who are known to be difficult or fractious or who take perverse positions. As we all learned at the age of four: play nicely with the other children and you get asked round to play again.
Everyone benefits if the investor protection rights are not spread too widely, and if efficient decision-making mechanisms are in place. Most importantly, think about that last paragraph: don’t let people you don’t like to get a say in the company’s running. Ideally, of course, don’t have them as investors.
Next post: we’ll wrap up this short series with some thoughts on how scale-up company boards operate in practice to reach consensus between investors and founders.
Partner, DSW Ventures