“You might have noticed by now that I’m allergic to veto rights” – That was how I started a recent email to an investor with who we are finalizing the paperwork for an up and coming investment. Maybe we should start from the beginning. This is our 4th investment round for SOOMLA and my first company EyeView had too many rounds to count by now. All this experience has led me to focus all my negotiations on the veto rights. Here are 5 reasons why you should consider a similar approach.
Veto rights can decrease your valuation
Most likely the protective provisions that the investor will ask for are designed mostly to limit your ability to raise future rounds. Some investors will be upfront about this but in other situations you might find different terms that require investors’ consent for board changes, changes to existing rights or other changes that might look innocent. In reality even the latter ones effectively mean that the investor’s consent is needed in order to raise a new round. In theory, an investor should have a motivation to keep the company alive but in reality more institutional investors are eager to increase their position, and controlling future funding means they can force an internal round at a lower price.
While most founders will be ok with an outcome of a few million dollars investors usually have a target return that is x times bigger than their investment or sometimes x times what they planned to invest in the company life (even if they haven’t invested it yet). Investors can usually afford to take bigger risks since they are diversified. Most likely a $20M exit after 3 years could be a really good thing for a young founding team of 2-3 founders but investors might not be that happy with the outcome even if they invested a year earlier at a price of $5M. To prevent founders from selling too early, investors add control provisions that allow them to prevent a liquidation event if it’s too low.
Certain control provisions create leverage
While some rights might look innocent, the ability to veto budget decisions, salaries, expenses or any other operational decisions can create leverage for the investor and give him or her tools to force the company into a situation where it needs quick cash. Given in the hands of the wrong investor these types of rights can limit the company’s funding options and result in a down round.
Sets precendence for future rounds
The reality of funding rounds is that while the share price of the last round is the starting point for the next round, the protective provisions you gave in previous rounds are the minimal rights the next investors will ask for. The number of times an investor gave up a right given to previous investors is zero.
Distinguishes good investors from bad ones
Successful companies are run by their CEO. Investors that try to drive from the backseat are preventing companies from succeeding and one of the best ways to identify such investors is by the amount of operational control provisions they want. In addition, focusing negotiations on the veto rights leads to real discussions about future situations and what everyone expects from them. Its easy for investors to say, I want to veto salary changes but what they really want is to make sure you don’t liquidate through the salary and there are less controlling mechanisms to ensure that.
As a last result require coalition for veto right
There will be situations in which you will have to give up your fort. The investors will insist on them and you will not want to walk a way. If that happens the second best to having no veto rights is requiring investors to unite in order to activate that right. Ideally, you would want investors to agree unanimously as a condition to activate the veto but any threshold that forces investors to form a coalition makes it hard to use it as leverage.