Convertible Notes and Startup Funding
February 12, 2025
The modern banking system is considerably different from what the average person believes it to be. Banks are not institutional moneylenders. They do not simply collect money from people and lend them to others. Instead, banks in the modern world have the power to create money when they lend it out. The process by which […]
Artificial intelligence (AI) and machine learning (ML) are disrupting the entire business landscape across the globe. The retail industry is no exception. Leading retailers from across the world have started experimenting with Artificial intelligence (AI) and machine learning (ML). There has been an influx of various technologies into the sector in order to shape the […]
If you have regularly observed the stock market, you may have noticed that a lot of time when the market falls, experts attribute this fall to profit booking. The concept of profit booking is known to a lot of people. However, the knowledge is merely superficial. In this article, we will have a closer look […]
Creative Accounting and the Need for a Theory of Accounting The rise of “creative accounting” practices, an euphemism for hiding some unfavorable financial details and highlighting favorable ones to create an impression of sound financial health has resulted in the accounting profession taking more hits to its credibility. It is a well known fact that […]
The field of strategy is not an exact science. This is because strategies are made based on the assumptions that an individual or a group of people have about the future. It is for this reason that if different people undertake the activity of strategic financial management, they are likely to come up with different […]
The process of negotiations between startup companies and investors is often hotly debated and contested. There are several points of contention between the two parties. However, the two parties are often able to reconcile most of their differences. However, when it comes to controlling of the startup firm, both the startup founders as well as prospective investors tend to take an aggressive stance. Both parties want to retain as much control of the startup firm as possible.
The concept of veto rights is often used by investors to gain some control over the startup firm. In this article, we will try to understand what veto rights are and how these rights affect the interests of all the parties involved.
In any company, the decisions related to the company are taken based on a majority vote. Hence, in the case of startups, this would mean that the party which has 51% of the vote will be in control of the decision-making. The other parties cannot unilaterally stop a decision if 51% of the shareholders back it. This is considered to be problematic from an investor’s point of view.
It is common for investors to have 10% or 25% voting power in a company. Hence, in most cases, their opinions will have no bearing on the decisions being taken by the government.
This is where the concept of veto rights comes into play. Veto rights are a legal arrangement that does not allow the investors to unilaterally take decisions on behalf of the majority shareholders. However, at the same time, they allow the minority shareholders to unilaterally prevent the implementation of any decision made by the majority stakeholder. Hence, even if an investor controls 10% of the shareholding, they can prevent the decision being taken by the other 90% from being implemented.
This is the reason that investors are keen on obtaining these rights as a part of their investment agreement. However, at the same time, founders are skeptical about signing away these rights.
From an investor’s point of view, veto rights can be considered to be very important. In the absence of these veto rights, they would have very little information and control over their investments. Normally, investors have no interest in interfering with the day-to-day operations of the firm. Instead, the investors are more concerned about managing events that are outside the normal course of business.
For instance, if the founders decide to take the second round of funding at a lower valuation then the decision also impacts the existing investors. Similarly, if the startup founder wants to drastically increase the size of the option pool by diluting the shares of the current investors, then also the current investors are impacted.
These investors want to have a defense mechanism ready to protect them in such special cases. Interference in day-to-day operations would create chaos in the startup company and would end up being a lose-lose proposition for both parties.
Almost no startup founder would be willing to give away complete veto rights. This means that they cannot allow investors to use veto rights against every decision. Hence, a legal setup is created in which the investor can use their veto rights only in the case of certain decisions.
The list of these issues is generally restricted to topics that directly impact the valuation and dilution of existing shares. Founders also try to ensure that the veto rights are provided to all groups of investors. If only a certain group of investors has veto rights, they can hold the startup company hostage to special interests.
It is also common for investors with the highest purchase price to receive such veto rights. This is because the other shareholders may be willing to sell the company since they receive a higher return even at a lower price.
These rights lie only with the minority shareholders who may be the beneficiary of such clauses. Founders are often not comfortable providing waiver veto rights. These rights are only provided if the investors have a commanding bargaining position and the founder has very few options.
However, the bottom line is that veto powers provide very important legal rights to minority investors. Hence, these powers are highly valued by investors. Companies can expect their valuation to be raised significantly if they are willing to provide veto powers to the investors.
Your email address will not be published. Required fields are marked *