Not Running Your Own Show: Why Majority Ownership Does Not Mean Control
Founders often believe that maintaining majority ownership in their startup equates to ultimate control over company decisions. However, in practice, corporate structure and investment agreements along with management side letters, can significantly dilute this control, even when founders retain majority equity.
Understanding the Distinction Between Ownership and Control
Ownership refers to the percentage of equity you hold in your startup. Control, however, pertains to your ability to influence or dictate key business decisions, strategic direction, and day-to-day operations. Surprisingly, majority equity ownership doesn’t necessarily guarantee control.
How Founders Lose Control Despite Majority Ownership
1. Voting Rights and Classes of Stock
Startups frequently issue different classes of stock, each with distinct voting rights. For instance:
• Common Stock: Typically held by founders and employees, often has standard voting rights.
• Preferred Stock: Issued to investors, frequently carries enhanced voting rights, senior economic rights whereby investors are paid first (1-2x liquidation preference) or veto rights over specific company decisions, thereby diluting founders’ control.
2. Protective Provisions and Investor Consent Rights
Investor agreements commonly include protective provisions that require investor approval for major corporate actions even if you have the most common stock as a founder, such as:
• Raising new capital or issuing new shares. Do you want to fund a quickfire bridge round? You may need investors to OK new raises.
• Changing board composition. Hope to rebalance the boardroom? You often can’t stack the board in your favor later.
• Engaging in mergers or acquisitions. Plan to sell on a short horizon? Generally no M&A is allowed without investor blessing.
• Altering the company’s charter documents. You generally cannot retrofit corporate org documents to eliminate or soften investor rights.
These provisions grant investors significant influence regardless of equity ownership percentages. Founders must carefully review investor consent requirements during fundraising negotiations to protect their control interests.
3. Board of Directors Composition
Control over the board of directors often directly equates to control over the company. Even with majority ownership, founders can lose control and get outvoted if investors secure multiple board seats or require independent directors. Decisions made by the board typically override decisions based solely on shareholder votes. Be wary of key actions that are subject to majority board approval in instances where investors have a majority board representation.
Ensure board composition aligns with your strategic vision by proactively negotiating board rights during early funding rounds.
4. Founder Agreements and Shareholder Agreements
These documents may contain specific provisions that limit founder control, including:
• Rights of first refusal
• Drag-along rights (investors forcing the sale of the company)
• Tag-along rights (founders obligated to allow investor participation in equity sales)
Clearly understanding these terms before agreeing is crucial for founders aiming to retain operational control.
Steps Founders Can Take to Protect Control
• Negotiate Carefully: Engage experienced legal counsel to carefully navigate and negotiate investment terms and shareholder agreements.
• Define Governance Terms Clearly: Be explicit about voting rights, board representation, and consent provisions in early funding documents.
• Stay Vigilant: Regularly review your corporate documents to ensure compliance and alignment with your control objectives.
Conclusion
Owning the majority of your startup’s equity doesn’t inherently guarantee control and can be illusory in nature. Understanding how corporate structures, stock classes, and investor rights affect decision-making power is essential for founders seeking to maintain control over their company’s direction and growth. Seek to front load analysis and leverage counsel negotiation at the term sheet stage, to reduce risks of boxing yourself in on key terms of the deal documentation.
Reach out to the team at Runway Legal if you are looking for advice on your particular situation or need help structuring or navigating your fundraising materials and investor rights.
Disclaimer: This article is for informational purposes only and does not constitute legal advice nor create an attorney-client relationship with Runway Legal. Always consult with an attorney for advice tailored specifically to your situation.