This article first appeared August 13, 2009.
Our shareholders’ agreement provides a minority investor with the power to prevent us raising equity capital, despite the fact that they are no longer interested in investing. We have other investors that want to invest but not under the existing shareholder’s agreement as they don’t want their money controlled by a disinterested third party.
If we can’t close this round it could kill the company…It seems morally and ethically wrong…what can we do?
It is often the case that VC or angel investors take a minority equity position. For this reason they require certain protections enshrined in the shareholder’s agreement that prevent the majority interests making decisions to their detriment.
The problem with protective provisions is that they can be a two edged sword.
Consider a typical situation where a company requires further funding and may be presented with an investment proposal at a lower valuation than the original round (down round). Existing investors would therefore be diluted if they either chose not to participate or could not participate.
In this case a protective provision exists to ensure that the company does not force a down round without the protected minority interest’s consent. This seems reasonable from the perspective of the existing investor who wants to preserve the entry value of his investment.
This protection is usually combined with a pre-emptive right which ensures that the existing investor has the right to invest at the lower valuation to a pro rata level. But what if they cannot – or choose not to invest?
This situation presents the investor with the choice – to allow the round to proceed and suffer the consequential dilution (assuming he does not have anti-dilution protection) or block the round and take the risk that the company may fail as a result of not being able to raise further capital.
If failure to secure the new investment would likely result in company failure, it is typically the case that the existing shareholder would still allow the round to proceed…a smaller piece of something is worth more than a bigger piece of nothing!
On rare occasions it may be that the existing shareholder continues to block the transaction. The motivations for such behaviour boil down to the vagaries of human nature.
If the company is thereby rendered insolvent, the remaining active shareholders may put the company into voluntary administration in order to acquire the relevant intellectual property and re-start a new company without the burden of an uncooperative minority interest.
The frustration of my correspondent is a salutary reminder of the importance of taking shareholder’s agreements very seriously – despite the likely euphoria associated with closing the early investment. Just like a pre-nuptial agreement they have their greatest impact when things go wrong. Unfortunately, particularly in early stage investing, they often do!
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Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology-based businesses.
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