The Interests of Investors and Founders Aren’t Always Aligned
Founders of technology startups often believe that their interests are aligned with those of their investors, and that belief is generally true. However, there are many situations where the interests of the founders and other shareholders differ from those of the outside investors. What’s more, if your investors serve on your board of directors, they will owe certain fiduciary duties to the company and its shareholders. If they don’t serve on the board of directors, they don’t owe the company or the other shareholders any fiduciary duties. To further complicate things, an investor serving on the board of directors will be charged with fiduciary duties when making decisions in their role as a director, but when voting as a shareholder will have no such duties.
When Do Investors Have Fiduciary Duties?
Investors in technology startups typically negotiate for one or more seats on the company’s board of directors as a condition to their investment. When investors (or their representatives) sit on the board of directors, they are bound by director fiduciary duties. This means they must abide by the fiduciary duties of loyalty and care and make decisions based on what is best for the company and its shareholders, not necessarily based on what is best for the investor’s personal interests.
When Do Investors NOT Have Fiduciary Duties?
In contrast to members of the board of directors, shareholders of privately held corporations generally do not owe fiduciary duties to one another. This means shareholders are free to vote on decisions of the corporation selfishly and based on their personal best interests. When investors serve on the board of directors they must abide by their fiduciary duties when making decisions at board meetings, but when it comes to voting in their capacities as shareholders they are not bound by such fiduciary duties. How does this work in the real world? Below is an example:
XYZ Inc. raised its Series A financing a year ago, which was led by VC Fund. Among the terms included in the deal with VC Fund were that VC Fund was granted a seat on the board of directors and a protective provision giving the holders of a majority of the Series A Preferred Stock a veto right on XYZ Inc.’s sale or issuance of securities with rights and preferences senior to, or on par with, the rights and preferences of the Series A Preferred Stock.
XYZ Inc. is running out of money from its Series A financing and is in desperate need of a cash infusion. Unfortunately, XYZ Inc. has struggled to meet its milestones and has found it difficult to raise its Series B round. However, it has found one investor, ABC Fund, who is willing to lead the round, but at a lower valuation than the Series A round, which will be highly dilutive to VC Fund.
XYZ Inc.’s board of directors unanimously approved the financing (including a “yes” vote from VC Fund’s designee on the board), but when the matter was passed down to the Series A shareholders for consent pursuant to the protective provision, VC Fund voted to block the deal.
Why would VC Fund vote in favor of the Series B financing at the board of directors meeting, but then exercise its veto right at the shareholder level? The reason is that when evaluating the Series B financing at the board meeting, VC Fund was bound by its fiduciary duties to the corporation and its shareholders. XYZ Inc. was in desperate need of a cash infusion, and the offer from ABC Fund was the only one on the table. However, when VC Fund exercised its veto right, it was acting not as a director that is bound by fiduciary duties, but as a shareholder who is entitled to vote its shares in a way that benefits its own best interests. For its own reasons, VC Fund felt the Series B deal was not in its best interests and was entitled to vote against it.
The Interests of Founders and Investors Aren’t Always Aligned
There is a common perception among many startup company founders that their investors’ interests are aligned with the interests of the founders and the company as a whole. After all, their investors are investing significant amounts of both money and time into the startup, so why wouldn’t they always want what’s best for the company? In a startup’s early days, this is often true. The founders and the investors both want to grow the business, achieve traction and market share, and increase the value of the company as much as they can. However, there usually comes a point where the interests of the investors and the interests of the founders are not 100% aligned.
Investors in technology startups generally follow an investment timeline; meaning, when an investor makes an investment in a technology startup, it usually expects to be able to liquidate its investment within a certain period of time. Investors who focus on early stage investments usually expect their investment to be tied up longer, and investors who focus on later stage investments are usually expecting to be able to liquidate their investment within a shorter timeframe. As an investment matures, the investor feels increasing pressure to finally liquidate its investment and realize its return (or loss). If the startup has been a positive investment, VC firms want to realize their returns so they can distribute them to their own investors or reinvest them into other promising startups. On the other hand, if the company is looking like a failure, investors usually want to cut their losses as quickly as possible so they can move on to other investments, some of which hopefully will be home runs. This divergence in interests often manifests itself by the investors pushing the company toward a liquidation event (typically a sale or merger with a larger company), even if the result would mean that, because of liquidation preferences, the investors make out much better on the deal than the founders and the other holders of common stock.
As a founder, it is important to understand that your investors can provide significant benefits to your startup, not only in the form of capital, but also in the form of mentorship and advice and making introductions to potential channel partners, strategic partners, future backers and the like. However, at the end of the day, your investors are also beholden to their own investors and/or to their own personal best interests. In the early days of an investment, these interests are generally always aligned with yours, but as an investor’s investment begins to mature, these interests will often times diverge. Just remember: it’s nothing personal, it’s just business.