To understand that cohort of issues which has to do with the control of a startup, some background is in order. Thus, in a mature business corporation, it has been understood, at least since Berle and Means's seminal work, that non-management purchasers of stock in public companies are passive investors. If they don't like the way the company is being run, their remedy (absent some actionable legal wrong) is to sell their shares. Venture capital operates on an entirely different set of principles. When raising money from his own investors—the limited partners in his venture pool—the professional manager of a venture-capital partnership holds himself out as someone with the expertise to "add value" to the investments under his control. The notion is that the typical founder is an incomplete businessman, with gaps in experience in matters such as financial management and marketing. An active board of directors, staffed by representatives of the investors, is expected to help fill these gaps. Significantly, even in successful venture-backed companies, a large percentage of the founders are fired, moved sideways or otherwise relieved of their duties as chief executive officer prior to the company's achieving its maturity. It is rare to find the likes of a Ken Olson at Digital Equipment or a Bill Gates at Microsoft, executives with the necessary breadth and scope to take the company through every phase of its path toward maturity. Consequently, a term sheet will deal with a series of related control issues immediately after the question of valuation is tentatively settled.
A business corporation is, as a legal matter, run by its board of directors. In point of fact, many boards elect to yield the operational management of the company's affairs to a single individual, the chief executive officer, but the residual legal responsibility is not delegable. The board remains responsible. The president is a member of the board (under the laws of most states he has to be), and certain powers are delegated to him formally, usually in the bylaws. But the president's authority is derivative; to restate this important point, a seat on the board carries with it legal power and responsibility, whether the occupant likes it or not. In negotiating the term sheet, the struggle for power concerns who sits on the board.
That question breaks down into sub-issues. If the investors hold a majority of the stock but elect to retain fewer than 51 percent of the seats, when is it appropriate for the investors, assuming that they agree together as a group, to take over control? Regardless of who holds a majority of the outstanding shares, should the founder and his management colleagues retain control of the board until something objectively goes wrong, such as a failure to meet revenue benchmarks for X quarters, for example? The term sheet often un-bundles the macro question of control and allocates the parts separately, across a spectrum of issues and across a period of time. Thus, it may provide that the investors may retain control over certain core questions—management compensation, for example—and not others. Further, the term sheet may provide for a control "flip," meaning that the investors are content with a minority of the board as long as everything is going well; they succeed to outright control of the board when and as the company gets in trouble, allowing them to tie a can to the founder. Control flip can occur when benchmarks are not met or for more serious reasons, such as the violation of negative covenants in a Stock Purchase Agreement.
From the investors' standpoint, control is a two-edged sword, since control entails some quantum of legal responsibility. Venture-capital investment is risky enough if all that has been put at risk are the dollars invested in the enterprise. If, in addition, an investor can be held liable to the creditors and other investors in an insolvent enterprise, his risk parameters are undoubtedly exceeded. Further, whether or not the liability is imposed by reason of the exercise of controlling influence, any board member has an assortment of "fiduciary duties," a phrase that, once appearing in a judicial opinion, usually takes on a precise legal meaning, that is, recovery by the plaintiff. And each board member has a duty of loyalty and care to all the stockholders, not just his fund.
Apart from a few isolated decisions or special-fact situations generally involving lenders, it has as yet not been popular to impose liability, beyond the investment made, on investors who are deemed to be in control of a failed corporation unless they do something to impact directly on the minority, such as squeezing them out of the enterprise or feathering their own nests. Indeed, if such were to eventuate through the agency of activist judges making new law in line with their underdog sympathies, it would be a formidable problem for the venture capital industry generally. The bulk of the cases to date have involved variations on the theme of the doctrine of equitable subordination whereby senior investors, those holding a debt security of some sort, have seen their priority vanish in an insolvency proceeding. The notion is that if the creditors take control of an insolvent company and manage its affairs so as to favor themselves, it is somehow inequitable to allow them to retain their status as creditors. Because of the heavy debt structure of leveraged buyouts, the doctrine of equitable subordination is much discussed in that arena. In start-ups, where the investors are not as prone to invest in debt securities, the doctrine is less intimidating. However, "fiduciary" liability in the event of a finding of control is an issue that cannot be ignored. Various provisions can be reflected in the term sheet to deal with the problem. Thus, some careful investors prefer to bargain for visitation or attendance rights for their representative on the board of directors, meaning the right to attend board meetings but not to vote. Occasionally, calling the investor representative an "honorary or advisory" director memorializes these rights. If favorite gives veto rights to the stockholders, requiring a supermajority for certain things to happen, a change in the business plan. The venture capitalists are empowered, like any stockholder, to exercise these rights as they please. These measures should be viewed in context. The real power the investor group has over a cash-poor corporation is economic, not legal; the investors are the only source of fresh funds to keep the doors open. No law requires an investor group to advance fresh money (absent an agreement or except at the conclusion of a lawsuit holding it liable in damages for some form of misconduct), so the power of the purse rests with the investors. As it is sometimes phrased, the Golden Rule obtains: "He who has the gold makes the rules."
Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com
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