Control Dynamics refer to power distribution among different stakeholders of the company. In the context of Series A term sheet, it refers to the distribution of decision making power between the investors and startup founders. To understand the basics, you can refer to the first article of the series on basics of Term Sheet.
In an ideal situation, an investor would hope that the startup is moving according to the stated milestones, has a consistent burn rate, and is perfectly positioned to secure the next round of funding. Mostly, such scenarios will provide investors a profitable exit. In such situations, an investor would prefer not to meddle with the affairs of the startup, and expect the founders to do a good job. However, for many startups, this may not be the case.
The markets keep evolving. New trends, products, competitors, etc. keep cropping up. And, situations may not always remain the same. In such a dynamic environment, it’s possible that the growth plan proposed by the startup may not go exactly as planned. In such situations, an investor would be concerned about their investment. And, it’s possible that the investor would prefer to take an active role in the company.
To ensure startup founders can’t ignore the investors’ counsel in unforeseen situations, an investor includes different terms that gives more controlling power. Sometimes, the founders may not be in favour of the decisions. But, the founders need to follow them because of these ‘control’ terms stated in the sheet. It’s best if the startups understand these, so that they know what they are getting themselves into.
In this article, we’ll focus on the terms that address the ‘control’ dynamics of a term sheet.
‘Control’ Terms
Different kinds of control terms can be framed by the investors on the basis of the scenario in context, i.e. startup stage, industry, growth expectations, etc. In this section, we’ll focus on covering the most commonly used terms that influence the ‘control’ aspects of a term sheet. The list of terms are shared below:
- Board of Directors: It refers to the board that takes the most important decisions in the startup. Every decision that is critical to the company comes to the board of directors, who take a final call based on a predetermined process, i.e. voting, veto power over specific decisions, etc. All the essential details related to the board of directors are included in this clause.
In general, an early stage startup will comprise members from the founding team and representative(s) of investors in the board. However, it is essential to understand the distribution of power in the board. Otherwise, it is possible that the startup won’t be able to take any crucial decisions. Most of them will be outvoted by investors.
For example, let’s assume that 2 investors are going to invest in your company. If the investors set the condition that no more than 2 co-founders can be a part of the board, and each investor gets to send a representative. It means that the decision making power is already equally distributed. If an outside board member is chosen by both for the board, then there’s a good chance of a decision to be made in the favour of investors.
A good understanding of such dynamics is very important to the founding team. Observing how it can reduce their decision making power will force the founders to rethink and suggest a better board dynamic. - Protective Provisions: Protective Provisions, in simple terms, refers to a list of specific activities the startup can’t do without investor’s consent. Usually, it includes most of the terms that can affect the investors’ equity, or can dilute their control. For example, issuing new shares, adding new members on the board, taking a huge loan, declaring dividends, etc.
An important point to keep in mind is that these protective provisions don’t mean that the startup can’t do it. It means that the startup needs to confirm with the investor before going ahead. There can be dire situations where you need to take some unwanted steps for survival, which an investor might agree to. However, it’s essential to take their consent before going ahead with this. - Drag along Agreement: Drag along agreement, in simple terms, means that everyone has to follow the majority.
In a few situations, it’s possible that there is a conflict of opinion among investors, or few investors and founders, about the next course of action. In such scenarios, this clause ensures that the majority of preferred shareholders has the right to drag along the rest of preferred stockholders and the common stockholders to their preferred choice of activity.
Usually, this clause is used in the context of liquidation of the company, but it can also be used in other situations, based on context. - Conversion: It refers to the right of an investor to convert preferred stock to common stock based on the specified terms.
An investor generally sets such conditions to ensure that they can maximize their returns based on the company’s current position. For example, an investor would choose to convert to common stock if there is more merit to conversion than getting through liquidation and participation preference.
In general, most of the term sheets set a conversion ratio of 1:1, but it might vary based on the situation. Also, an investor can convert their preferred stock into common stock, but can’t go back anymore once converted.
In the Final Analysis
In this article, we have covered some of the prominent terms used by investors in the term sheet to influence their controlling power in the company. We have covered general standard offer terms by most investors, but it might vary heavily depending on the industry, startup’s leverage, etc.
The primary goal of this article is to give a glimpse into the controlling terms, and how they can influence the startup in the long run. Founders should try to understand these terms well and negotiate wherever necessary. This will provide more control to the founding team and ensure they can build the startup on their own terms.
