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Term Sheet from Hell: (Constrictive) Veto Rights

This is the third post in my “Term Sheet from Hell” series. The second post discussed redemption and put option, while the first discussed liquidation preference and participation.

I promised to talk about veto rights last time round, but have been neck deep in getting Silicon Straits set up so it’s taken me a while to get to this. I’ve also been procrastinating on this post because I dread having to type out all 26 veto rights – yes, you heard me right, items A through Z.

Also known as protective provisions, veto rights give minority investors control over specific actions by the founders and company. It’s important enough to come up in investment discussions with start-ups, but usually not high on investors’ and entrepreneurs’ checklist until after other key terms like valuation, redemption, liquidation preferences and participation have been discussed. At its core, veto rights are meant to protect minority investors from unfair behavior by majority shareholders, which at early-stage financing means founders. You can think of it as an added safety net for minority investors, who are most likely not going to be in control of the company’s board post-seed, post-bridge or post-A raises.

Venture Hacks has a great post on why investors care about veto rights – I recommend that you spend time reading that post if you haven’t already. It provides a solid framework for you to have an informed opinion about the 26 veto rights that you’re going to see. The terms are in red while my comments are in blue. Here we go!

For so long as the Investor shall hold A RCPS in the Company, the Company shall not, without the prior written consent of the Investor:

  1. cease to conduct or change the nature of business substantially as now conducted; fair
  2. acquire or dispose of any material interest in any subsidiary or affiliate; fair
  3. sell or dispose of the whole or a substantial part of the undertaking and goodwill or the assets of the Company; fair
  4. increase, reduce or cancel the authorized or issued share capital of the Company or issue or grant any option over the non-issued portion of the authorized share capital of the Company; it’s a little strange that the ESOP pool isn’t exempted here.
  5. authorize, issue or purchase shares of stock, convertible securities, options or other securities; fair
  6. amend or change the Memorandum and Articles of Association and/or By-laws affecting the rights of the A RCPS; fair
  7. approve the appointment, remuneration and any proposed revision to the employment terms of the CEO, COO, CTO, CFO and Executive Directors and key management of the Company; typically seen only in later-round financing where key management are hired guns with less equity motivation, unusual in early-stage investments. Reeks of micromanagement
  8. undertake new business ventures in industry segments other than those in which the Company is currently participating; pretty standard
  9. undertake any merger, corporate reorganization, sale of control, or any transaction in which all or a substantial part of the assets of the Company are sold; fair
  10. increase the aggregate amount of debt or capital expenditures above mutually agreed upon predetermined levels; vague, possibly relevant depending on business nature
  11. make any material changes in their business activities; catch-all clause repeating point 8
  12. change the auditor, banks or solicitors of the Company; micromanagement
  13. approve their annual budget, including all changes to the agreed upon management fees; micromanagement
  14. adopt any policy changes on financial matters such as significant accounting practices, depreciation practices, dividends, bonuses, senior management compensation, directors’ fees and remuneration; shouldn’t be as critical in early stages of company, certainly not before a proper Series A or B raise.
  15. approve signatories of company cheques; micromanagement at seed stage
  16. permit any of the Company’s assets to be secured or pledged; fair
  17. set up or acquire a new subsidiary for the Company;
  18. settle the terms of any employee share option scheme; fair, if ESOP isn’t decided upon closing
  19. enter into any related party transactions; fair
  20. transfer of intellectual property and technology; fair
  21. purchase or acquisition of assets in excess of []; fair
  22. declaration or distribution of any dividends or returns of any kind to its shareholders; fair
  23. voluntary winding up, merger or amalgamation; fair
  24. any matter not in the normal course of business or make any payment, give any guarantee or enter into any transaction which is not at arms’ length terms; fair
  25. entering into or undertake any transaction or arrangements involving payments to be made by the Company of an amount equivalent to or exceeding [.]. Subject to the approval of the Investor, the issuance of cheque for such payment of such amount being equivalent to or exceeding [.] shall be in the manner signed by at least an Investor’s Nominee shall be required for any such transaction or arrangement, as the case may be; micromanagement at seed stage or
  26. any matter referred to in this para which relates to the subsidiary of the Company. fair

The veto rights reminds me of an investor who craves for control and subscribes to the School of Micromanagement. It isn’t such a bad thing to do if all the companies you invest in are run by crooks or entrepreneurs with little integrity. It also feels as if the investor gave in to the entrepreneur on board majority but decided to reinstate virtual control over most of board matters in the form of a near-exhaustive list of veto rights.

I didn’t get to see the investment agreement so I don’t know if this is true in this case, but I’ve heard of investors that include veto rights giving them the ability to force founders to transfer their stakes to investors for nominal consideration if the founders got into lawsuits of any sort. This opens up the technical possibility of a party conveniently unrelated to the investor suing the founders, thereby allowing the investor to take over control of the company.

Boa Constrictor

Veto rights aren’t the most important in any financing negotiation, but can be misused or abused by minority investors seeking to gain further control over the company’s actions. Such constrictive clauses introduce transaction costs in communication between founders and investor, and erodes trust quickly. Short-sighted investors will load up their list of veto rights and may get away with it, but certainly won’t be high on the list of investors the same entrepreneurs approach for investment the next time round; penny wise, pound foolish!

[dark_box]I decided to extend this series from 3 to 5 posts, with my next and 4th post on valuation and the last post on how entrepreneurs can negotiate with investors.[/dark_box]
James ChanTerm Sheet from Hell: (Constrictive) Veto Rights