What are Veto Rights?
In VC investments, the investor usually does not control the company. Even large investors will hold a minority stake – often as little as 10-25%. Most investors find this troubling because they are putting their money at risk. As a result, many investors insist on veto rights.
Veto rights do not entitle your investors to make decisions on behalf of the company. But rather allow them to prevent a decision being made that they disagree with. Some of the issues covered by veto rights are crucial for the adequate governance of the company. It is also in the entrepreneur’s best interest to involve his/her lead investors in these crucial matters (sale of the company, allocation of more ESOP, Fund raising, etc.).
However, veto rights provide its holders with significant power. When give to a single investor, this power can sometimes be abused.
When negotiating a term sheet, you should seek to form a well-functioning partnership among your investors. Building a company is a long process with unpredictable ups and downs. A good partnership is a source of great power and support, but it requires compromise - from everyone.
The challenge with veto rights is typically not the rights themselves but rather who holds them. Most investors, when leading a round, will request veto rights. Meaning that, they will have the power to veto any major decision. When conflicts arise, investors with veto rights are less likely to compromise. Giving veto rights to single investors will increase forceful interactions. And unfortunately, conflicts are a part of building a company with many parties.
Conflicts are highly likely to arise throughout the journey of building your company. However, you can solve conflicts through open discussions and compromises to reach decisions and solve issues. The way to do this is by giving veto rights to the investors as a group instead of to single investors. Each investor will not be able to cast a veto, but as a group they can stop the CEO from making unreasonable decisions.
Why keep veto rights at all?
As a founder you want a mechanism of control over the board, especially as you add more investors. If you don’t like veto rights you can replace them with affirmative voting rights. Affirmative voting rights give the investor the right to approve all major decisions . We don’t like, and never ask for affirmative voting rights. Reaching each investor in order to get decision approvals is highly inefficient when running a company. Casting a veto is a big deal and investors will think twice before doing it. On the other hand, delaying a decision approval is a lot easier and your investors will not consider it as big of a deal. If you ask for affirmative voting rights, you should expect lengthy decision making processes.
TLV Partners’ approach and recommendations
We take veto rights seriously, for us it can become a show stopper when doing a deal. We insist on sharing veto rights even if we are the largest investor. If previous investors are not willing to share their veto rights, we may pass on the deal. We also cut veto rights as much as possible and reserve it only for the most crucial of matters.
Have a great summer!
There is a common belief that participating preferred is always better for investors.
Here’s a brief overview of the various liquidation preferences investors may ask for. Liquidation preferences determine how to divide the proceeds from the exit.
VCs have one common goal - they all aim to increase shareholder's value. Many Israeli entrepreneurs share this dream as they want to build long-lasting companies. This alignment of interests makes sure everyone is working to achieve the same goal.
Yet, participating preferred creates an inherent misalignment of interest between VCs and entrepreneurs.
Take for example an entrepreneur who faces a decision whether to sell the company now for $150m. His investors agree that the company’s potential could be much higher in 2-3 years. But the company would have to raise another $20M to reach said potential. Luckily, there is a late stage investor who is eager to invest in the company at a reasonable valuation. The decision should be simple - a good opportunity to increase the value at a reasonable price. But here is where the participating preferred misalignment kicks in. The entrepreneur, upon an exit, will have to pay back an extra $20m plus interest before seeing any profits. Not to mention the fact that he/she will be further diluted. VCs are professional investors and part of their job description is to take risks. Entrepreneurs are dreamers that dedicate their life to build companies. Some entrepreneurs at this point will decide to sell the company and reduce their personal risk. The investors will lose much more than the potential profit from the participating preferred.
Cloud computing is an area we find especially exciting. It has brought enormous change to the world of applications and it would be no exaggeration to say that most of the innovation in IT over the past decade has been enabled, catalyzed, or caused by cloud computing. Currently, we are in the midst of a microservices revolution, one that has, until now, been championed by containers. Through our investment in Aqua Security over a year ago, we have witnessed first hand the rapid growth this market is experiencing, and believe it will continue to proliferate enterprises across the globe. We are now on the cusp of another revolution in cloud infrastructure: the move to serverless computing.