Posts Tagged ‘Governance’

By Hari Venkatacharya

Having now been involved as either a Vice President or CEO in six early stage companies, and having advised countless others over the last 12 years, I’ve come across all kinds of situations regarding Shareholders’ Agreements: from not having one, to multiple types of share structures that were so complicated that at the time of exit, the buyer decided to throw out the original Agreement, and treat everyone as if they had Common Shares!

When a start-up CEO asks me whether they should invest time and money in developing a Shareholders’ Agreement, my answer is an absolute ‘Yes’, but only after they have reviewed their entire documentation and governance strategy, including intellectual property protection.

The Shareholders’ Agreement itself must form an integral part of a comprehensive approach to creating a professional organization, even if there are only a handful of people in the company. This will not only allow the initial Angel Investors the comfort that you are an experienced leader, but will also attract additional investors that will be impressed with the level of critical thought that has taken place in such an early stage venture.

Regarding types of shares- keep it simple. The most straight forward structures I’ve seen have all Common Shares, thereby giving all shareholders equal rights, with no extra provisions for either founders or the first seed stage investors, or negative covenants if milestones are not met. While the seed investors may ask for Preferred Shares with a discounted next round of financing guaranteed, I would strongly advise against this, especially if the next round of financing may come from a strategic corporate investor. A way around this is to give the seed investors, and founders, the first right of refusal at a discounted rate, with a hard timeline by which they must invest, based on milestones. This will confer some benefit, but will not tie the company up in a situation where other investors cannot be solicited.

In my experience, the most important element in the Shareholders’ Agreement is the drag along clause. This will determine what percentage of shareholders will have to agree to a Change in Control of the company, which usually occurs if a significant investor comes on board to take a majority share, or the company is sold outright.

I’ve been in a scenario where the drag along clause stipulated that 67% of shareholders had to agree to the sale of the company, and an investor who had only invested $30,000 at the founding of the company, and stood to gain over $1 million in less than two years, wanted to have a share of SRED tax credits paid back to him, essentially making his initial investment worth $20,000! While the entire management team and Board was against this, since without his shares we would fall below the 67% required to allow the transaction to proceed, we had to pay him the additional amount. While in principle we were against this, we could not allow one dissident, but significant shareholder, the power to stop the transaction from proceeding. It certainly did cause a lot of acrimony though! Subsequently, all my ventures have included a drag along clause that requires a simple majority for a Change in Control to be executed, and that has worked because I’ve always held a minimum of 25% ownership in these companies, essentially ensuring that the founding team would have control of the destiny of the company.

Eventually though, the initial Shareholders’ Agreement will most likely be replaced by a more complicated one by a larger, possibly strategic investor; but these guidelines may be of value in the very early stages of company formation, and will help send the right signals to all stakeholders.

Hari is a seasoned entrepreneur with over a dozen years of experience in building and exiting businesses in Canada, US and India.

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Reposted from Maple Leaf Angels

By Craig Hayashi


Continuing my discussion on start-up legal issues, I met with Rubsun Ho, partner and co-founder of Cognition LLP to discuss term sheets. Again, standard disclaimers apply in that topics covered  are meant as general information only and not meant to imply specific legal advice.

Craig: Rubsun, thanks for taking the time to talk . I thought we would talk about term sheets today and walk through some of the common term sheet clauses (see here and here). I’ll provide the (angel) investor’s perspective and you can comment on how this would impact things from the start-up and entrepreneur’s perspective. To start off, let’s begin with the type of deal structure: Equity vs. Convertible debt. What are your thoughts on these two approaches?

Rubsun: From a company’s perspective, I would recommend they try for an equity deal. Although as you and I would both agree, the attractive part of a convertible debt deal is that it postpones the valuation discussion, entrepreneurs need to make sure they have a clear understanding of what they would be giving up with a convertible debt based deal. They should work through the calculations on the accrued interest and the percentage discount and see what the share capital structure would look like if the convertible debenture ran its full course. We have seen cases where this can add a significant amount of shares to the company and thus dilution to the founders. Entrepreneurs should also ensure they understand any covenants placed on the company through the debenture. We have seen term sheets that put in place conditions where the debt can be called (i.e. if the company is not cash flow positive by a certain date).

Craig: So if an equity deal is done, what about common vs. preferred shares?

Rubsun: Again, we’d recommend trying to stick to one share class as it makes it easier to govern. To give a judgement on a preferred share deal, a lot would depend on the additional requirements investors are putting on the preferred share class.

Craig: In today’s climate, investors are putting more emphasis on liquidation preference to give them the greatest chance of getting their money back. This can take the form of terms such as upon sale of the company the preferred shares are paid out first (1x or 2x) and then all remaining proceeds are split pro-rata across all shares. What are your thoughts on this?

Rubsun: Obviously this is what an investor would want. The entrepreneur would need to ensure they work out the implications of this. i.e. run though some scenarios of various acquisition prices and show how the proceeds would be distributed to each shareholder. Depending on the amount of preferred shares issued, having a 2x liquidation preference can dramatically raise the price target that a company would need to be acquired at in order to provide other share classes an adequate payout as well. Investors should also do these calculations as they will want to ensure management still has enough equity incentive to want to stick with the venture. A good way to align management and investors is to have a separate carve out where a percentage of proceeds of an acquisition is reserved for management or to have a clause that eliminates the liquidation preference if the acquisition price is above a certain amount.

Governance and Control

Craig: After ensuring they can get a good ROI, maintaining governance and control over the company is next on an investor’s priority list. At the seed stage, often companies do not have a board constituted. Do you have any recommendations as to how to structure the board at the seed level to provide governance but still allow for expansion with future investment rounds?

Rubsun: I would advise companies to start with a board of 3 with at least one of the seats being an independent director and another to represent the investors. As the company secures new investors with new financing rounds, this structure makes it easier to expand the board to include representation from the new investors or to bring on other board members that can help the company at their stage of growth. If you start with a large board at the seed stage, it can be hard to ask people to leave the board down the road when new investors come in.

Craig: In addition to the board and the term sheet outlining actions that require board level approval (i.e. setting the compensation of the management team, approving the annual operating budget), investors sometimes put actions in that require shareholder approval (i.e. entering into debt arrangements or contractual commitments over a certain dollar amount). What are your thoughts on this?

Rubsun: Corporate law requires that some fundamental changes such as creating a new class of shares, changing the company name or selling substantially all of the company’s assets need to be approved by holders of two thirds of the shares and potentially by each class or series of shareholders independently. Apart from these items, it’s usually better to try to push other actions to the board as it may increase the administrative burden on the company to call shareholders’ meetings or track shareholders down to approve resolutions.

Craig: A common reasoning I see when talking with entrepreneurs on valuation & how much money they are looking to raise is for them to start off and say they want to retain 51% of the shares so they retain control and then work back from this to figure out a valuation and how many shares they are prepared to give up in relation to how much money they are looking for. Can you comment on why this is a bad approach?

Rubsun: For the reasons we discussed above, using separate share classes, certain rights and vetos in shareholders’ agreements and through having a controlling number of board seats, an investor can easily structure a term sheet to have ‘control’ of the company while owning less than 51% of the total shares. Entrepreneurs are better to first decide what important areas of the company they want to retain control over and then ensure the term sheet is aligned to this.

Tomorrow legal costs and negotiating

Craig Hayashi is a founding board director of Maple Leaf Angels, Ontario’s largest and most active angel investment group with more than 40 members and approximately $6m in financings closed since the group’s inception in 2007. Follow Craig at www.mapleleafangels.com and www.startupnorth.ca

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By David Pasieka

Governance is the system by which organizations are controlled and managed. Paramount to this system is the relationship of the Board of Directors to its CEO – specifically “How active is the Board in the operation of the company?”

At one end of the scale (The “A” End), we have the Passive Board often referred to as the rubber “Stampers.” In this model, we usually have a very dominant and knowledgeable CEO who is setting and driving the strategic agenda of the corporation. Board members are friendly to the process and few tough questions or contrary opinions ever get tabled. With Management setting and controlling, Board etiquette is often in a constant state of “scramble”. These Boards are typical of early stage organizations where the CEO is a knowledgeable, strong-willed and passionate. Board members are usually hand-picked from a group of friends or acquaintances.

At the other end of the scale (The “Z” End), we have a very active, all controlling Board who often spend a lot of their time managing the “minutia.” Here the Board is usually large,  consists of a number of sub-committees and has a detailed process of checks and controls. The Board in this case, digs deeper into day-to-day management issues influencing Marketing, Sales, IT and HR procedures. Boards appointments are less likely to be influenced by the CEO and their friends. Sometimes we often see an executive committee of the board, which essentially amounts to a “Board within a Board”. Boards at the “Z” end tend to be Public, Not for Profit or Co-Op. Sometimes in crises mode, the Board transforms itself into the minutia. This often happens when the CEO is not performing or has asked for help in managing the complexity.

Boards operate between the “A” and “Z” ends of the spectrum. The factors affecting the operating model include: Historical roots, Stage of Development, Competence of CEO, Experience of individual Board members and Stakeholder influence to name a few. Board operating models are also known to evolve over time as factors in the internal and external environment change.

A more sustainable approach is one of Moderate (“M“) Board participation and consistent with the notion of “Nose In and Fingers out” (NIFO).  A NIFO board is more in tune with the fact that the Board exists to “enhance the decision making capability of Management”. Best Practices in Governance suggest that Boards at both ends of the spectrum need to migrate towards the NIFO middle. Boards in NIFO mode operate with fewer committees, less meetings and prioritize their efforts on results, strategy, risk and policy. “Day to Day” details are left for Management to execute.

A good exercise would be to profile your existing board on the “A” to “Z” scale. A good place to start would be to pull the Board Charter documentation and read the language. An open dialogue on the topic at your next strategic retreat would also be helpful in analysing your Board’s effectiveness in its current Governance model.

Is your Board’s model consistent with the stage of growth, source of capital and skill sets of your members and its CEO? Is your Governance model consistent with “acting in the best interests of the Stakeholders”?

Can you see the Power in operating in a manner more consistent with Nose In Fingers Out?

David Pasieka is the Entrepreneur-in-Residence at the RIC Centre. Learn more here.  Visit Our Contributors page for more information about David. Read his blog at www.cedarvue.blogspot.com

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