In Parts 1, 2, 3, and 4 of our series on venture capital (“VC) term sheets, we focused on their basic components and their economic terms. Beyond the economics of an investment, the other thing VC investors pay close attention to is the issue of control.
The more the company grows, the more the VC investors’s share is worth, which both sides can get behind. In a less ideal scenario, a VC investor may prefer decisions that maximize the company’s value in the short term but do not align with a founder’s long-term strategy in areas like maintaining corporate culture or catering to a certain market segment. For this reason, an investor will generally want more control, and the founder will want the investor to have less control.
Let’s look at some of the terms impacting control.
Use of Proceeds
In the use of proceeds term, the VC investor may try to limit what the investment can be used for, such as product development, marketing or recruiting a CEO and management team. This is to make sure the money is being used for activities that will directly impact the value of the company. The start-up will generally prefer to keep this term as broad as possible, such as “for working capital purposes,” which means the money can be used for anything that has to do with running the business.1
The Composition of the Board of Directors
The law requires corporations to be run by a board of directors, who are usually elected by the shareholders.2 The board of directors hires the CEO and management team and votes on the company’s major business decisions. As a result, one of the major terms a VC investor will push for is controlling a certain number of seats on the board as a way of formally guiding business in a direction that is best for the company and ensuring the VC investor has some input in this process.
Generally, a board of directors can consist of as many or as few members as the corporation desires.3 Ideally, the size should be small enough to get things done, but big enough to consider all viewpoints. This can often be 5 members for an early stage start-up, or 7 to 9 members for a more mature start-up.
One thing to keep in mind is maintaining the right balance of different voices at the table, including the founder, the company (usually the CEO), the VC investor, as well as any outside directors. Outside (or “disinterested”) directors are often successful businesspeople who have no direct financial stake in the start-up, so these seats can be used to counterbalance VC investor votes, especially when many different VC investors are at the table.
Board Voting Rights
A VC investor may be given the right to choose a certain number of directors on the board, and will have that many votes in any board of directors vote approving a major strategic decision or transaction. The term sheet may also require that board ratification (approval by majority vote) must include at least one of the “preferred directors” (that is, a director chosen by a VC investor) to be valid.
Often, as the holder of whichever amount of stock was specified in the money terms (such as 20% or x number of shares), the VC investor will also be entitled to that many votes in a shareholder vote approving major business decisions. The general rule is that one share equals one vote. A shareholder vote may come into play when an acquirer is looking to purchase the company or when a start-up wants to go public.
A VC investor may also request board observer rights, which don’t include voting rights. Even without the right to vote, an observer may end up swaying discussion or stalling progress on a decision. Sometimes, a VC investor will insist on this term, and having an observer around may not be too overwhelming.
In the next part of our series on VC term sheets, we’ll look at another set of rights the VC investor may ask for in a term sheet: protective provisions.
- See Daniel I. DeWolf, Venture Capital: Forms and Analysis (Securities Series) § 2.02(5) (2014). ↩
- Regardless of which form a start-up takes when beginning business, such as a limited liability company (LLC), a VC investor will almost always require the business to take the legal form of a corporation before investing. ↩
- A corporation will designate a maximum number of seats for its board of directors in its certificate of incorporation, which is filed with the state when the entity is formed and officially recognized by the law. However, it is not required to fill the maximum number of seat at any given point. For example, if there is a maximum of 15 directors, the board can still function with 9 members. ↩