The Latest Changes in VC Deal Terms — Good Governance
I am not a control freak. However, I expect transparency, over-communicating when there are potential issues, and coming to the table with a solutions mindset. It's one of the reasons I've had success on both sides of the entrepreneurial coin-wins and losses as a founder and VC alike. So when I'm advising energy entrepreneurs who are seeking VC funding, I like to dig deep into the control and governance sections of the term sheet. The money is the easy part — you get what you need to keep going or you don't. And if you don't, you're done.
The first thing I'm going to cover here is governance — why it matters, how to set it up, and how it evolves over time. Protective provisions also deserve a close look — these are covenants that anticipate conflicts between founders and investors and lay out the road map for resolution. I'm also focusing on corporate governance in the US.
Corporate governance is not complicated — it's essentially the iterated playbook for how you will run your business. It's also not set in stone — a company's governance structures will evolve as the organization grows. At the angel investor or seed stage, it's okay to have perfunctory governance that's mostly on paper. You and your investors communicate hourly...but this changes as you gain traction.
As your company grows and more investors come on board, your corporate governance structure will expand and get more complex. In fact, when I invest into your company, I will require you to sign a side letter that details a set of "must haves" to ensure your governance structure is up to par with my expectations. As an entrepreneur, I did the same thing (signed multiple side letters) and it truly changed my thought process on why good governance is so important.
The goal of corporate governance is manyfold. The first, as I said already, is to create a playbook for managing your company. The second is to ensure that the playbook clearly defines how to balance the interests of your many stakeholders ( board members, shareholders, employees, customers, suppliers, community). Some of this will be spelled out in the Term Sheet (as per the title of my note). The rest may be spelled out by side-letters being requested by investors. For those items not covered by the above, it will be incumbent upon you, the entrepreneur, to setup the rest of your governance (i.e. employee handbook).
These are some of the factors that come into play when your governance is being hashed out.
- Ownership structure
- Geographical location
- Board of Directors structure and powers
- Protective provisions for key investors
- Stakeholder engagement approach (key business principles, values)
- Risk management and control policies
Speaking of geography, your company most likely will be incorporated in Delaware. As it turns out, more than half of Forbes Fortune 500 companies are incorporated there, with nary an office or PO Box in sight.
Why is this?
Delaware offers advantages that other states don't (currently) — namely, extremely flexible corporate structuring. Companies can have a single individual wear all the governance hats — director, officer, and shareholder — and you don't have to disclose the names of the officers or director on the formation documents. This layer of privacy is what makes a Delaware incorporation attractive to VCs and others.
Delaware's court system is the only one in the country to have a Court Of Chancery that specializes in corporate litigation (yes, Mississippi, New Jersey, South Carolina, and Tennessee have them too but not dedicated to corporate litigation). Cases are heard before a judge with expertise in complex matters of corporate law. There are no juries to muddy the waters. Most startup and VC attorneys are well versed in Delaware law since that's the jurisdiction of most US companies.
The Natural Progression of Governance
One day you're an entrepreneur with an idea and a concept, and the next day you're the CEO of a game-changing energy startup. How'd that happen, you wonder (well, you better not wonder?^&*%), and how am I going to manage the company (you should really be bothered by this since you are now representing investors that have real reputations to protect)? I'm the energy tech wizard. That's where your board comes into play.
The natural progression of a startup is a small board with the founder and a couple of early angel investors. Your vision is pretty straightforward — can your product or concept be developed to the point it is viable, and is there a scalable market for it? You're feeling pretty good about things and the concept models are promising, so you build a pitch deck, get a haircut (well not now during Covid-19), and start calling VCs that invest in the energy sector. Fast forward anywhere from a few weeks to a couple of years, and you have a VC who is serious about seed/series A-stage money for your company.
In exchange for their money, the VC is going to want a say in how the company is managed by having a seat on the board. This is not a bad thing for you — the VC is bringing management expertise to the table. Here's where energy VCs differ from other investors — they are specialized in the highly technical and innovative field of energy, and they're either partially or wholly funded by the existing energy giants. What does this mean for founders in real terms? It means you have access to the sales channels for the biggest companies in the world, as well as their expertise and experience. It also gives new meaning to the saying, "go big or go home."
Yes, I digress.
Let's say your company is growing: your product development is meeting the marks, sales look good, and there's a market buzz that you've got the Next Big Thing. STOP...I have been here myriad times. While this is really hard to do, your company is still vulnerable and far from returning capital to your investors...so listen up.
Your board has to grow to meet the new demands of investors and shareholders, and the decisions you're making are more nuanced and complicated than they were when it was three of you and a six pack of beer. Good thing you've got that playbook to direct you when there are disagreements on how to move forward.
Remember that while everybody on your board is supposed to be on your team, this is not always so true. Investors are focused on making their shareholders and partners happy and in getting your company to a successful exit. Keep that in mind when things aren't going well — their money and reputations are on the line, too.
Brad Feld refers to protective provisions as the rules of engagement, and he is (as usual) right. Term sheets are effectively laying out the ground rules. While founders have unlimited ideas, VCs have limited money and they need a successful track record to keep the cash taps open (this applies to us corporate VC's as well).
If you're in seed or early-stage funding, any protective provisions on the term sheet will be pretty much boilerplate. Your attorney may refer to these as standard provisions, or what's typical for any term sheet.
Standard provisions cover the basics. Investors have the right to block or veto certain actions as iterated in the term sheet, and a predetermined percentage of preferred (investor minority) stockholders must approve any such action. They also cover the number of board seats, liquidation process (simply a precaution by the investors to get their money back before everyone else), and amendments to the bylaws. These provisions are addressed in a few paragraphs.
The remaining pages of numbing legalese discuss the company stock — the total number of preferred and common shares, how those shares can convert, declarations of dividends and redemptions, and so on. Basically, preferred shareholders want to get paid first if things go badly. And this is really really important to understand so please do not dismiss and sign a term sheet before understanding.
For example, if you are facing a down round (this means that you have to raise money because you are not cash flow positive AND your company is worth less NOW than the last round of funding), there may be provisions in your governance that protect the existing investors from losing their percentage ownership of the company. The term sheet may have provisions that prevent you from issuing more stock without making sure existing investors are made whole. I will write more about this soon; however, I have learned that whoever is willing to lead the current round of funding can basically dictate the terms even for existing investors. Why? If existing investors are not willing to lead the next round, it means that they either do not have the funds or need a new investor to lead to show "progress." As a result, the existing investor is motivated to agree with the new investor on the new terms, or else the company could fail.
There are others protective provisions that are designed to protect existing investors including:
- Changes to compensation, hiring, and firing of executives. Investors at WeWork probably regret giving in on that provision.
- Any incurrence of debt.
- Any change in the primary line of business, or entering a new line of business.
- Any purchase of material assets from another entity.
These provisions take away your powers as the founder & CEO and distribute them to the investors. I believe this is good governance; however, you need to understand what you can and cannot do. Your leverage as a founder may be enough to get the investors to throw a few of the protective provisions out or reduce the impact. This may not be a good thing. Investors have a fiduciary (legal) responsibility to their shareholders, and what is in the best interest of the shareholders and the company will diverge at some point. A protective provision functionally separates the responsibilities of a board member from that of a given class of shareholders, and that is good corporate governance.
Trust — But Verify
Some opponents of protective provisions argue that they imply a lack of trust between VCs and founders. It's not a matter of trust. It's about ensuring that all parties understand the decision making authority at the outset. Working through these scenarios before you're faced with the reality of an unpleasant situation takes a lot of acrimony out of the equation. Ambiguity is the enemy of good governance, so go ahead and negotiate as many of the protective provisions as make sense for your company.
In short, strong corporate governance works to your advantage as you grow your company. You've got a road map, a playbook, a crystal ball, whatever works for you, and you can refer to when you need it. It will give you the confidence that you have the structure in place to see you through the rough spots. And remember, when you raise money from others, you are naturally giving up control of your baby. "Surely you need guidance to wage war, and victory is won through many advisers." Prov 24:6. Get the rest of the tools you need by reading about other recent changes in VC deal terms:
- The Latest Changes in VC Deal Terms — Avoiding the Valuation Death Spiral
- The Latest Changes in VC Deal Terms — How to Raise Money
- The Latest Changes in VC Deal Terms — Major Players in the VC Game
- The Latest Changes in VC Deal Terms — Understanding the Term Sheet
- The Latest Changes in VC Deal Terms — Liquidation Preferences
- The Latest Changes in VC Deal Terms — Pay-to-Play