The Case of the Shareholder Shenanigans

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HEIDI: Welcome to the Startup Solution and "The Case of the Shareholder Shenanigans." I’m Heidi Roizen from Threshold Ventures.

A few months back, an entrepreneur I work with, who I’ll call Joy, got a shocking phone call from one of her investors. Let’s call him Robin. Robin’s firm and my firm were the two largest investors in Joy’s company, so we both had board seats. And the three of us had all recently voted as board members to move forward with a financing. It wasn’t a great deal, but it was the only offer we got, and it was better than going out of business, so we voted to proceed.  

A few days later, Joy got the call that shocked her.

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JOY:  Heidi, it’s Joy. I just got a call from Robin and I’m floored. He told me that their firm was going to vote its shares against the fundraise. I don’t understand how he can even do this. I mean, he already voted for the fundraise, so how can he change his mind now? He says he has enough votes to tank the deal and that I should tell the new investors he wants to talk about renegotiating some of the terms. I’m not getting any of this. Can you call me to explain what’s going on and what I can do about it?

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HEIDI: It’s time for Joy to get a master class in shareholder voting rights.  

Voting rights are usually determined at the time shares are issued and sold. And for many entrepreneurs, this doesn’t seem like something worth paying that much attention to. But it turns out that shareholder voting rights can become critically important down the line, especially during fundraises and M&A. So, it’s important to understand the ins and outs of voting rights when they’re first set up, as opposed to only thinking about them when you have an issue that whacks you in the head – like Joy is experiencing right now.

But before we dive deeper, let’s clear up the question Joy had about how Robin can vote both for and against something and why it might even make complete sense for him to do so.  

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VCs often wear two hats when it comes to voting power. One as a shareholder and another as a board member. And those two hats come with very different responsibilities.

As a board member, Robin has the fiduciary obligations of care and loyalty. This means that when Robin is acting in his capacity as a board member, he’s required to pay full attention to what’s going on and put the interests of the company and its common shareholders first – ahead of his own interests.  

With Robin’s board member hat on, he understood that this was the only offer and that the alternative was to wind down the company. So, he voted for the financing when it came to the board for approval.

But Robin also has rights to vote in another capacity, that as a shareholder. And unlike his board role, where he’s required to put the interests of the common shareholders first, he has no such obligation to do so when he’s voting as a shareholder. When that’s the case, Robin gets to vote with only his firm’s interests in mind.  

And, as it turns out, Robin’s firm didn’t like the terms of the new deal and its impact on them as shareholders. The deal was a recap, which is something I’ve covered in detail in a prior episode – but for today’s purposes, all you need to know is that in a recap, Robin’s firm will lose their valuable preferences unless they put more money into this round. And Robin’s firm is out of cash, so they can’t do that.

Because of this, Robin and his partners made the very rational decision to vote against the deal, or at least to threaten to vote against the deal, to see if they could force the new investor to lighten up and offer something a little less punitive to them.

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Now, in situations like this, the best practice would have been different than what Robin did. Instead of waiting for the board to approve something and then throwing a wrench in the process after the vote, Robin should have brought the problem up before the whole thing went to the board in the first place.  

But Robin hadn’t faced a situation like this before and was kind of surprised when his partners told him to hold up the shareholder vote for a better deal. But that’s what they wanted, and they had every right to do it. Hence, the call to Joy and the new crisis for her to resolve.

Shareholder voting rights can be extremely complicated. You might have thought that it would be one share, one vote, and simple majority rules type stuff.  

But, in reality, shareholder voting rights can be set in vastly different ways in each round. It’s normal in each round for the common shares and the preferred shares to be treated somewhat differently, but there could also be multiple classes of preferred shares, even in a single round. And those could carry different voting rights from each other.  

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Even the number of votes each kind of share can cast could be different.

For example, some founders, especially repeat founders with a winning track record, might ask for a dual-class share structure. In that structure, the shares given to employees will usually be one vote per share, and the shares sold to investors will also likely be one vote per share. But the founder’s shares may be given many votes per share, giving them extra weight in decisions that have to be voted on.

These structures tend to come and go as markets run hot and cold. And if you listen to me often, you’ll know that I’m not a fan of dual-class shares. I think companies do better with strong governance, and to me, that includes balanced voting among the shareholders. But hey, venture capital is a market, and you can certainly ask for a dual-class structure if you really want to. That said, many investors consider the dual-class structure a deal breaker, and if you insist on it, they might just pass on investing.

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Another method for changing voting rights is to create a separate shareholder voting agreement alongside the issuance and sale of certain shares. For example, when a shareholder signs what’s called a “drag-along agreement,” they agree to vote for their shares in alignment with whatever some majority of the other shareholders vote for. And the percentage majority required to trigger a drag-along isn’t always a simple majority – that’s another thing that’s negotiated when the agreement is put into place.  

Speaking of vote hurdles, they can also be popular with acquirers. Your bylaws might say that a simple majority of your shareholders voting yes would allow you to sell the company. But in sort of crummy deals where no one is making a decent return, an acquirer might demand an additional hurdle, requiring that, say, 80-90% of your shareholders need to approve the deal. They see this hurdle as a way to lessen the chance that they’ll be sued by some unhappy shareholder after the deal closes.

If you find yourself in this situation, you’ll likely have to call many of those shareholders to explain the circumstances and ask them for their votes. And trust me, it’s a whole lot easier to do if you’ve been honest with them about your company’s performance all along the way. If you haven’t, well, you might be in for some painful surprises of your own.

Founders may want to have specialized voting agreements for their founder shares. They often have large stock positions, but those positions are still vesting, and so the founders may want to specify that as long as they’re employed by the company, they get to vote all their shares – not just the ones that have vested.  

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I’ve also seen situations where some co-founders end up leaving, while others stay, and the ones who stay feel that they should have more voting power than the leavers because of their continued involvement. To accommodate this, co-founders can agree up front to have reduced or even expiring voting rights if they exit the company. Or they could agree to a drag-along with the remaining employee shareholders. Then, if a majority of the employee shareholders vote a certain way, that founder will have to vote the same way, too. 

I was involved in a situation that would have really benefited from having an agreement like this. The company was going to have to wind down if it wasn’t sold. Only one of the two original founders was still there, and she’d worked hard to find a buyer. It wasn’t a great deal, but her investors were going to get about half their money back, and she and her employees would be able to keep their jobs. But then there was the other founder, who had left a few years earlier and was really sour on how everything had turned out. His shares were going to be worthless in the deal, and because he had a lot of them and, therefore, a lot of voting power, he threatened to tank the deal just for spite. We talked him out of it and the deal got done. But we could have avoided the whole unpleasant situation if we had set up founder drag-along agreements during the company’s initial financing.   

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This voting stuff becomes even more complicated in situations where there is a preference stack and different classes or series of shares are going to be treated very differently in an outcome because of those stacked preferences.  

I’ve talked about stacked preferences a lot, and if you don’t know what they are I’ve put a link to a great explanation in the show notes.  

But for the purposes of this discussion, let me give you a simple way to think about it.  

In what’s called pari passu preferences, each shareholder has an equal claim to their preferences. So, if a company raised $20 million and then sold for $10 million, each investor would get roughly half their money back.   

Stacked preferences, on the other hand, are treated very differently. In a stacked structure, some investors are in line ahead of others when it comes to claiming proceeds, and usually the last money in has priority to be the first money out. So now let’s imagine that same company with $20 million of funding, but this time, $10 million of it was invested in the A round, and then another $10 million was invested in the B round, which had a senior preference. The company again sells for $10 million. But now, because of the senior preference, the B shareholders would be entitled to that whole $10 million, and the A shareholders would get nothing. 

As you can imagine, in pari passu structures, everyone is weighing similar outcomes for their investment, and so they’ll likely vote similarly about any given deal. But in a stacked preference, some classes of shareholders will be treated very differently from others. And so, they’re likely to vote in alignment with their own interests, as they have a right to do. And that typically makes for a much messier voting situation.

Now, there’s nothing inherently wrong with stacked preferences – they’re often negotiated for when companies raise big rounds at high valuations, and as I often say, it’s a market.  

But I’m bringing it up today because we’re talking about shareholder voting, and stacked preferences, from my experience, have a big impact on voting, which you should at least take into consideration when you’re signing up for them.

I’ve had more than one entrepreneur say to me, “Why should I care how the stack above me is ordered – it’s all just money off the top before my team and I get paid.” Well, yeah, but with pari passu preferences, as I said, everyone’s kind of in the same boat. However, with stacked preferences, that can be a very different situation. The ensuing conflicts between shareholders can, at a minimum, be a headache for a founder, and worse, it could lead to your carefully crafted deal not getting the votes it needs to pass.

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And here’s another thing about these shareholder votes that may not be obvious at first. When you model out how your shareholders might vote – don’t make the mistake of analyzing this by share class alone. Don’t assume that if B shares will be in the money, they’ll all vote yes, whereas if A shares are out of the money, they’ll all vote no.  

Why? Because, while most payout analyses present the payouts by share class, most of us VCs have likely participated in multiple classes, which have different share prices and different places in the preference stack. But even if some of our shares are winners and some are losers, we’ll likely vote all our shares for whichever thing nets out to be the best payout across all our holdings. 

Are you starting to get a knot in your stomach about how complicated and messy these things can be? Well, good, because it’s much better to consider them and negotiate them up front rather than when you’re running out of cash and in the heat of an urgent M&A negotiation. And here’s where I put my usual recommendation – you need a really good lawyer on your side to make sure this is all done properly.

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There’s one final voting right I want to cover – which is the election of directors. How this is voted on is usually negotiated when the investments are made – and they often change with each round, as new investors come in while others may have reduced positions that no longer merit board seats.  

These can be set up many different ways: common might be able to elect their own one or two directors, preferred might be able to elect one for each class or even two from a particularly big class. Independent directors might be nominated by any other director but voted in only by unanimous board approval. What I’ve just described are pretty common constructs though there are lots of different flavors you can consider. The main point is, that who is on your board will be very important to you. So, understanding how these voting rights will result in real people on your board is a pretty critical thing to nail down at the time of your financing.

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Now that you're up to speed on how all this stuff works and how crazy it gets, let me return to Joy. She's the entrepreneur who was shocked when her board member, Robin, called to say that even though he voted for the deal in the board meeting, he was now going to vote against it.

As you now understand, and as I explained to Joy, in the board meeting Robin was voting in his capacity as a board member. But once the board approved the financing, Robin then updated his partners about the deal, and as shareholders they didn’t like it. While I wish he would have figured this out in advance, luckily, we hadn’t taken the deal to a shareholder vote yet, so we still had a little time to work behind the scenes to sort this out.

After I spoke with Joy, she went back to Robin and asked him what his partners wanted, reminding him that this was the only deal on the table, and if it fell through, the company would have to wind down. Robin knew there wasn’t a lot of wiggle room, but it was his hope that 20% of the preferences they held could still be honored. Since this would benefit not only Robin’s firm but all the other firms who held preferences – and who would now be voting on the deal – Joy thought that made sense. She convinced the new investors that this relatively minor give would get the deal through, and they acquiesced.  

The deal was revised, the board again voted for it, and when it was taken to a shareholder vote, it also passed. So that’s the good news. But Joy and Robin were both frazzled by the experience, and it damaged their relationship. And that could have been avoided if both of them had understood up front the ins and outs of shareholder voting. At least now they know for the next time – and so do you.

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HEIDI: And that concludes "The Case of the Shareholder Shenanigans." For the record, this situation is real, but Joy and Robin are composites. And much thanks to Ken King at Skadden Arps, who made sure I got all the legal stuff right in this episode.

Thanks for listening to “The Startup Solution.” We hope you’ve enjoyed this episode, and if you have, please pass it along to someone who could use it. I’m Heidi Roizen from Threshold Ventures.

Further Reading

For those of you who think shareholder shenanigans only happen in small companies, Joy’s case is similar to the HP case of many years ago, fascinating reading for those who like Succession and boardroom drama.

Every entrepreneur should understand the impact stacked preferences may have on governance, board votes, and shareholder votes. This article does a great job of laying those out. 

The Council of Institutional Investors has an interesting piece on dual-class stock here.

And for more details on why I think good governance is good for entrepreneurs and their companies, see here.

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