HOW TO KEEP CONTROL OF YOUR STARTUP
Losing control of the company scares the shit out of entrepreneurs. You'll always fear what you don't understand. But if you pay attention and know what to look out for, you'll be fine.
If you want to keep control, there are four areas of control you need to address:
- ownership control
- voting control
- board control
- financial control
All of these elements work together and could be grouped together, but separating them like this allows founders to balance the different categories and understand the whole picture.
First, two important notes:
- Know what you're doing
Learn the basics. That's always the goal I'm going to emphasize here at Startup Legal Stuff. You're always going to be at a severe disadvantage with anything if you don't understand what's going on on a fundamental level.
Get the proper help. The small, technical details matter. The proper help doesn't have to be me. It can be. But it doesn't have to. The important thing I want you to do is to get the advice from someone who knows this area of law.
- Do not get power hungry!
There are realities an entrepreneur has to face as a founder. It is delusional thinking to believe that a founder can just get investors to pump money into the company and not let allow investors to have any control. An entrepreneur will lose some control with venture capital financing. When a founder does equity financing they give up a share of the company, including some change in voting power and board of directors. The founder's ownership percentage will go down (dilution.)
But as an entrepreneur you don't have to give up too much control if you know what you are doing and if you draft your documents and negotiate properly.
The KEY is to make sure that you will be in a position to receive a fair amount of the proceeds from an exit event such as a sale of the company while being able to build your company in the way you envision. And if you want to build the company in your way, then you need control.
Table of Contents
A. Ownership control
1. Track the ownership of intellectual property
a. Make sure IP belongs to the company, not the individuals
b. The company should own the property even if there's just one founder
c. Watch out for IP creators from the past
2. Vest Founders' Stock
3. Restrict share transfers
4. Watch out for excessive preemptive rights
5. Don't get excessively diluted
Bonus point: "Is it bad to license some property (IP or otherwise?)"
B. Voting Control
1. Don't let the company be held hostage
2. Don't allow for unreasonable protective provisions
3. Issue special kinds of stock
C. Board Control
1. Don't give up too many seats on the board
2. Don't have an observer or advisor board
3. Make sure independent board members and other advisors really are independent
D. Financial Control
1. Pay attention to valuation and option pool allocation
2. Don't allow for onerous liquidation preferences
3. Don't allow for participating preferred stock
4. Sell the company when it makes sense to you
Summary
A. OWNERSHIP CONTROL
Ownership control is about holding on to shares, holding on to ownership of the company, and even the company holding on to its property. So how do you do this? Make sure you do these things.
1. Track the ownership of intellectual property
a. Make sure IP belongs to the company, not the individuals
DON'T let one co-founder or employee run off with some intellectual property (IP) of the company. Make sure that prior to incorporation, IP owned by individuals are properly transferred over to the corporation and that IP developed after incorporation belongs to the corporation and not the individual who worked on creating it. If you don’t properly deal with a very important piece of IP that is the basis of your company—even if you own all of the shares of the company, then think about what you really own and what you really control. You deal with this by creating properly drafted technology and invention assignment agreements.
b. The company should own the property even if there's just one founder
I don't care if you're the only founder of the company. The company you create needs to hold on to the IP. If the company doesn't hold the IP, then investors will not invest in the company.
c. Watch out for IP creators from the past
Account for those that have worked on the ideas behind the company and helped create the IP even though they weren't part of the formal company creation process. Properly address all of the IP developers and founders when incorporating and distributing shares. You don’t want to have someone come out of nowhere and claim that they are owed a portion of the company. Think about the movie The Social Network. The twins were somewhat instrumental in creating what would later become Facebook but they were left in the dark. This became problematic later. Sort these issues out at the beginning of your startup.
2. Vest Founders' Stock
Vesting has huge implications regarding control of the company. If stock will vest, for example, over four years, that means that you have to be around for four years for you to own all of the stock outright. Before that the company has a right to repurchase the shares from you in certain circumstances.
What happens if there are no vesting provisions in place? You and two colleagues start a company and split the shares evenly into thirds. The plan is to develop some software and release to the market in 3 years. After one year, one of the founders leaves and no longer participates in the startup. That founder owns and controls a substantial part of the company even though he’s no longer involved. Don't get screwed like that. Vest founders' stock.
3. Restrict share transfers
Set up proper restrictions on share transferring and buy-sell agreements. Don't be in the position where one of your founders wants out and sells their shares to just any one. You will want to have some control over how those shares are distributed and sold. Otherwise you may be forced to work with his friend Joe Schmoe. And no one wants to work with Joe Schmoe. That guy sucks.
4. Watch out for excessive preemptive rights
Preemptive rights allow an investor to purchase more equity in a future financing on a pro-rata basis.
Limit these rights. You should make efforts to sell ownership to those investors that you feel can best help you going further. I always stress that investors should be able to offer you something more going forward than just money--look at what can an investor do (e.g., strategic connections) for the company besides give you money.
5. Don't get excessively diluted
Yes, dilution happens, but make sure that it's not excessive. Know how much money you should raise. Get proper valuations. Know how much equity to give out for compensation.
Bonus point: "Is it bad to license some property (IP or otherwise?)"
No. it's not bad. It's only bad if that property is CENTRAL to the core of your business and startup. If for some reason your company is unable to own some IP but is able to license it, then quickly and as soon as possible, find something comparable that you can substitute into your system if and when necessary. Don't get the rug pulled out from under you.
This is not theory. I've seen the rug pulled out from under a young startup doing massive business. Let me tell you--it fucking sucks.
B. VOTING CONTROL
Just because you own 50% of the shares of the company, that does not mean you "control" 50% of the company. It's not so simple. Not all shares are created equally. Keep an eye on voting rights and privileges of the different classes of stock.
1. Don't let the company be held hostage
Picture this: A classroom of kids get to vote on something. 10 boys vote together and 10 girls vote together. Both groups need to vote yes for some matter to take place. For whatever reason, 9 boys leave the room. Now 10 girls vote together and 1 boy votes by himself. What happens? The 1 boy can block the vote of the whole classroom easily. Talk about power.
How do you deal with a situation like this? Watch voting thresholds and draft your documents accordingly. Be careful of situations where an owner with a minority ownership percentage is able to command the company.
2. Don't allow for unreasonable protective provisions
Protective provisions are special veto rights that investors get in a VC deal. Unless the VC's agree, you can't do X, Y, or Z even if the other shareholders want to. Some of these protective provisions are reasonable. Others aren't.
3. Issue special kinds of stock
Whether or not investors will allow certain types of stock depends on the level of your business. Class F common is a special kind of common stock that founders can be issued. It can be called something else; doesn't have to be called Class F. Some features are that it is super-voting (10x vote), has protective provisions, and can elect a director that has special voting privileges.
As a startup lawyer in Houston, Texas and Dallas, Texas I usually do NOT recommend issuing special kinds of stock except in special circumstances.
C. BOARD CONTROL
The board of directors govern and make major decisions of the company.
1. Don't give up too many seats on the board
Some board members may be elected by the founders (common stockholders.) Some may be by investors. In a 3 person board, if 2 are elected by the investors and 1 by the common shareholders, then you are not in control.
2. Don't have an observer or advisor board
An observer or advisor has massive influence. Yes, they do not get to vote, but a lot of board meetings are very discussion and conversation driven. If someone from outside of the board of directors needs to be there, make them a silent observer.
3. Make sure independent board members and other advisors really are independent
The independent board member who is not an investor, is not a founder, but is the VC's best buddy is not really "independent." It's naive to think otherwise.
The same is true for "independent" consultants, lawyers, and advisors. Make sure "your" guy/advisor/lawyer is not really the VC's guy. Have your own advisor. Have your own lawyers. Have people you trust around you.
D. FINANCIAL CONTROL
If your company is going to be acquired in a massive deal, great. Congratulations. But if it means that you'll only get 5% of the exit proceeds and you did most of the heavy lifting, then that sucks for you. A captain of a ship that's only going to get a small percentage of the treasure is not a captain that feels in control.
1. Pay attention to valuation and option pool allocation
These and other variables determine price per share of stock that investors will invest in. Understand how the numbers game is being played.
Read this article on Startup Math.
2. Don't allow for onerous liquidation preferences
This is how much investors receive from a liquidity event before common stockholders (founders) receive anything. If the investors receive 3 or 4 times the amount they invested before you receive anything, by the time you look in that honey pot, there's not much left.
3. Don't allow for participating preferred stock
Participation allows for investors to receive their liquidation preference AND THEN also receive distributions ratably on an as-converted to common basis. This is called double dipping and should be discouraged. Watch out for this. Investors should either receive their liquidation preference OR convert to common.
4. Sell the company when it makes sense to you
Draft any drag-along agreement or voting agreements properly.
SUMMARY
Keep an eye out on four areas of control that you need in order to keep things from getting out of hand: ownership: make sure stuff belongs to who it should belong to; voting: don't let the company be held hostage; board: don't give these seats up easily; financial: get what you should. Keep those in balance, don't get power hungry, have a startup lawyer to keep things on track, and you'll be fine.