How VC's Take Control of the Company

Control provisions in the VC term sheet
The VC-Preferred model enables the preferred shareholders to take significant control over the Company through the more obvious channels, such as board seats, but also through a number of less obvious provisions.

Board of directors
Elected by the shareholders, the board of directors has the ultimate management control over the Company. The board of directors acts as agent for the shareholders, and has fiduciary duties to manage the Company with good faith, care and loyalty. The powers of the board are mandated by Delaware statute and state business law, but some flexibility is provided through the Company’s bylaws and the articles of association.

No single director has power to act on behalf of the Company. The board operates as a single unit. For this reason, the board usually has an odd number of members, to avoid deadlock and majority votes are usually controlling. So, a startup founder on the board of directors has no power to make decisions unless he/she can win the support of a majority of the board members.

Preferred stockholders, according to Klein and Coffee[1], do not (usually) participate in the election of directors. However, under Delaware law[2], preferred holders are not restricted from contracting these voting rights. The contractual provisions of the financings, almost always provide for the holders of a class of preferred stock to elect one or more directors to the board. So, the VC buying series A preferred stock is guaranteed to elect its own candidate for the board. This is usually a partner from the venture fund. So, regardless of whether the founder has a majority of common stock the VC has its place on the board through its preferred stock and contractual rights.

Board of Directors:
At the initial Closing, the Board shall consist of [______] members comprised of (i) [Name] as [the representative designated by [____], as the lead Investor, (ii) [Name] as the representative designated by the remaining Investors, (iii) [Name] as the representative designated by the Founders, (iv) the person then serving as the Chief Executive Officer of the Company, and (v) [___] person(s) who are not employed by the Company and who are mutually acceptable [to the Founders and Investors][to the other directors].


The contractual provisions of the preferred stock financing usually also set limits on the structure of the board of directors. These limits are often written into the bylaws. So the structure of the board is set by the incoming investors.

According to Fenwick & West[3], where there are 2 investors, the board of directors tends to be made up of 5 members. Two are appointed by, and represent the preferred stockholders (investors), two represent the common stockholders (founders and employees) and the critical control issue resolves around how the fifth board member is elected. The fifth director is sometimes elected by the other directors, elected by a vote of outstanding shares and the seat is sometimes reserved for company outsiders. The same control issues arise where there is only one investor and the board is limited to three members. The preferred and common each elect one director in this situation, and the third board seat is allocated to a CEO recruited by the VC, or an outsider.

The outside director can often hold the swing vote and is often an associate or affiliate of the VC. As a result, the percentage of companies with VC-controlled boards was recently discovered to be close to 80-90%. [4] This is higher than previously measured because prior studies have failed to recognize that ‘independent’ directors align their interests with the VC—even if an independent director has the swing vote, the independent director is a repeat player in the VC-Preferred model and often acts as an agent for the VC.

Special authority to investor-appointed directors
Through contractual provisions, with amendments to the articles of association, the VC directors can establish special authority and essentially control any transactions above a certain threshold of size.

Matters Requiring Investor Director Approval:
[So long as [__]% of the originally issued Series A Preferred remains outstanding] the Company will not, without Board approval, which approval must include the affirmative vote of [____] of the Series A Director(s):
(i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of [two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors];[5] (vii) hire, fire, or change the compensation of the executive officers, including approving any option plans; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or encumber technology or intellectual property, other than licenses granted in the ordinary course of business.

Voting rights
Outside of the VC community, it is unusual for preferred stock to have voting rights. These rights are usually restricted to common shareholders. However, under the VC-Preferred model, preferred stock has voting rights, and when combined with the veto rights below, voting rights form a significant is a source of power for the VC.

Voting Rights:
The Series A Preferred Stock shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) the Series A Preferred as a class shall be entitled to elect [_______] [(_)] members of the Board (the “Series A Directors”), (ii) as provided under “Protective Provisions” below or (iii) as required by law. The Company’s Certificate of Incorporation will provide that the number of authorized shares of Common Stock may be increased or decreased with the approval of a majority of the Preferred and Common Stock, voting together as a single class, and without a separate class vote by the Common Stock.[6]

This provision not only gives the VC the power to vote on shareholder decisions, but also provides a veto right allowing the VC to block the Company from authorizing new shares to be issued.

Veto rights
One of the most significant decisions to be made by a corporation is the nature of the exit—whether, when and how the Company is to be sold to an acquirer or liquidated. The following provision provides the VC with a high degree of control over these decisions:

Protective Provisions:
So long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding, the Company will not, without the written consent of the holders of at least [__]% of the Company’s Series A Preferred, either directly or by amendment, merger, consolidation, or otherwise:
(i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any Deemed Liquidation Event; (ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred];[7] (iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred; (iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of [_____] Series A Director(s)]; or (v) create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit][other than debt with no equity feature][unless such debt security has received the prior approval of the Board of Directors, including the approval of [________] Series A Director(s)]; (vi) increase or decrease the size of the Board of Directors.


With these contractual provisions, the VC controls decisions involving the sale the Company, raising of financing, issuing of new securities and the sale of corporate assets. An acquisition offer that is acceptable to the majority—including management, the board of directors, and all the common stockholders can be blocked by the minority—the preferred stockholding VC. This can be a tremendous source of frustration when the interests of the VC and the entrepreneur are misaligned.

Drag along rights
The powers of the entrepreneur can be restricted by drag-along rights that effectively force the founders and other shareholders to vote with the VC when it comes to choice and timing of exits—selling or liquidating the Company.

Drag Along:
Holders of Preferred Stock and the Founders [and all current and future holders of greater than [1]% of Common Stock (assuming conversion of Preferred Stock and whether then held or subject to the exercise of options)] shall be required to enter into an agreement with the Investors that provides that such stockholders will vote their shares in favor of a Deemed Liquidation Event or transaction in which 50% or more of the voting power of the Company is transferred, approved by [the Board of Directors] [and the holders of a [majority][super majority] of the outstanding shares of Preferred Stock, on an as-converted basis.

Forced redemption
Many VC term shares provide redemption options that allow the preferred to force the Company to pay back the funds invested, with a premium.

The Series A Preferred shall be redeemable from funds legally available for distribution at the option of holders of at least [__]% of the Series A Preferred commencing any time after the fifth anniversary of the Closing at a price equal to the Original Purchase Price [plus all accrued but unpaid dividends]. Redemption shall occur in three equal annual portions. Upon a redemption request from the holders of the required percentage of the Series A Preferred, all Series A Preferred shares shall be redeemed [(except for any Series A holders who affirmatively opt-out)].


In practice, redemption rights are not often used; however, they do provide a form of exit and some possible leverage over the Company. If a series A investor demanded redemption rights, then it could be very difficult for the Company to attract investors for series B and subsequent rounds. The series B investor could say ‘I want to invest to build this company, I don’t want my money being used to buy out the series A investors.’ Not only can redemption rights block the Company from attracting future investors, but it often prevents banks and other lenders from providing credit facilities. Although redemption rights may appear attractive to investors on the surface, there’s a good argument that they’re not healthy for the Company or the VC in the long run.

Appointment of officers & management
The board of directors has the power and responsibility to elect, appoint and remove the CEO and other officers. Founders are sometimes perceived as great inventors and technologists but not great managers. Professional managers are usually appointed to run the business. After taking control of the board through preferred stock, the VC usually hires in management to replace the founders[8] filling the CEO position and other key officer roles with individuals selected by the VC.

There has developed a pool of professional CEO’s, CFO’s, General Counsels, and other executives that are regularly placed in venture-backed startups by VC’s and derive their living from these assignments.

These executives are often repeat-players moving from one venture backed startup to another. Many VC’s have Entrepreneur in Residence[9] programs where they retain CEO’s and executives within the VC firm awaiting new portfolio companies to which they will be assigned.

Control asserted indirectly by VC’s--Appointment of legal counsel
Although they have little formal authority, in-house and outside counsel are often powerful forces within a startup company. There are several large law firms that specialize in representing VC’s and VC-backed startups. If the Company is not represented by one of these firms, then one of the first decisions made by the board of directors and management after the VC takes control is usually to replace the outside counsel with the VC’s law firm of choice. This long-standing relationship between the VC and the outside counsel selected to advise the Company can be used as a significant source of power for the VC. Many of these law firms are bonded to the preference share model and derive the bulk of their billing revenue serving their VC clients.

[1] Klein and Coffee, Business Organization and Finance. 9th ed 2004. P 302-306.
[2] Del. Gen. Corp. Law §242(b)(1) &(2).
[3] Source: Current Venture Financing Environment, 4Q 2006 Bay Area Venture Capital Terms Survey. Fenwick & West Publications. http://www.fenwick.com/publications/
[4] Cf. Steven N. Kaplan, Berk A. Sensoy, and Per Stromberg, “What are Firms” Evolution from Birth to Public Companies 28 (reporting that, by the time of the IPO, median VC directorships is 3, median management directorships is 2, and media outside directorships is 2.
[5] Note that Section 402 of the Sarbanes-Oxley Act of 2003 would require repayment of any loans in full prior to the Company filing a registration statement for an IPO.
[6] For California corporations, one cannot “opt out” of the statutory requirement of a separate class vote by Common Stockholders to authorize shares of Common Stock.
[7] Note that as a matter of background law, Section 242(b)(2) of the Delaware General Corporation Law provides that if any proposed charter amendment would adversely alter the rights, preferences and powers of one series of Preferred Stock, but not similarly adversely alter the entire class of all Preferred Stock, then the holders of that series are entitled to a separate series vote on the amendment.
[8] Even in venture-backed firms that do well enough to go through an IPO, founders’ involvement declines from the time the firms receive VC financing to the time of the IPO and thereafter. See Steven N. Kaplan, Berk A. Sensoy, and Per Stromberg, “What are Firms” Evolution from Birth to Public Companies” 23 (working paper, January 2005)(reporting that at time of IPO 43% CEOs are non-founders); Noam Wasserman, “Founder-CEO Succession and the Paradox of Entrepreneurial Success,” 14 Organization Science 149 (2003). See, also, Utset (2002) later note __, at 92-6 (describing the ‘founder’s disease’ – the VCs’ “assumption that entrepreneurs will be unable to make the transition to effective managers.”)
[9] Almost all definitions of ‘entrepreneur’ refer to an individual that bears the risk of forming a new enterprise. Meriam Webster, et al. These executives are not strictly ‘entrepreneurs’ as they do not form their own startups or bear the risks therein. Rather they are management agents of the VC waiting to be assigned to new manage startup companies after the VC’s invest and take control.