Friday, August 1, 2008

For both investors and founder, it’s a control thing

Control comes up a lot in my line of work. At the outset of an investment relationship, it rears its head in relation to ownership control. As part of any venture investment, the investor and the entrepreneur negotiate about who starts out with majority control. As most investors tend to buy a minority position, the issue of who owns most of the economic control is not a particularly contentious one. Investors like to see management well incentivized with a meaningful stake in the business. While some venture investors prefer a position of ownership control from the get-go, most accept that their money will buy less than 50 percent of the company. So far, so good.

Controlling the purse strings
Economic control is different, however, from decision-making control. While most entrepreneurs wrapping up a venture capital financing will retain ownership (and therefore economic) control, few realize — until they get to legal documentation of a financing — that minority venture capital investors need some level of operating control to feel comfortable about engaging in a partnership in which they can be outvoted by virtue of management’s ownership and economic control.

Venture investors achieve this trick by structuring their investment as a new class of “preferred” stock, which carries certain rights that are tantamount to blocking rights. The rights that a minority investor cares most about relate to decisions that might erode the company’s value. These include: raising new capital or taking on debt, hiring key executives, shifting company strategy/direction, selling off assets, etc.

The idea is that the investor does not want to risk that its minority investment position can be undermined by a decision made by the majority-owning management team. So, while a given round of financing may provide the founders with the lion’s share of the economic value of an investment, the trade-off is that management needs permission of the investors to take any of the actions listed above.

Both investors and owner-managers need to take care with their respective rights to control. Management needs to appreciate that decisions that might affect the value of their business are decisions that need to be made collaboratively, not just with the new board of directors that is formed concurrent with a venture round, but also with the lead investor in a given financing series, whose “special rights” exist outside of board decisions. A management team that thinks their economic control will give them the autonomy that they understandably want may be disappointed to learn that their new minority partner has powers that make them seem like a majority partner. This is normal and not a bad thing, even if it seems to be counterintuitive.

Investors, too, need to handle carefully rights they have relating to issues of control over decisions. While many investors recognize that they have substantial voice, few investors see value in exercising control in a way that engenders animosity from management. Investors who interfere too much with management’s relative autonomy may find that their team opts to hand the investors the keys and say “you run it.”

Two-way street
So the message here is that real control is illusory for both parties as it cuts both ways. Investor and entrepreneur are well advised to develop a partnership from the get-go, mutually avoiding the need for either party to invoke rights they possess by virtue of majority ownership or negotiated minority rights.

Both parties are best advised to recognize that theirs is mutually assured destruction if they can’t strike the right balance in their roles, whatever the ownership structure may say about who is “in control.” Entrepreneurs and investors are like married couples. Sometimes, it’s not a question of who has power, but about how you’re going make the marriage work. And good marriages, like good businesses, are not about control.

 

Michael Gurau is managing general partner of Clear Venture Partners Inc., a $50 million secondary-city fund in formation in Freeport, Maine. For the past five years, Michael has invested a $10 million, early-stage, secondary cities fund in Northern New England. Michael can be reached at mg@clearvcs.com.