In the venture investing world, all of the attention is focused on the multi-million dollar investments made by established, well-connected venture firms. But this ignores of smaller investors – the individual angels and smaller funds – who provide startups with initial seed investment or help fill larger rounds.
You would think seed investors’ critical role would be recognized as the company takes on more money in future rounds. But this is quite often not the case. Seed and other smaller investors frequently see their rights taken away or diminished, in favor of larger VCs.
While the stereotype of the venture capitalist is the hard-bargaining, shrewd negotiator, you may be surprised the extent to which seed and other smaller investors are not only treated like second-class investor citizens – they are expected not to take the hard-bargaining positions as the larger VC firms. Investors who negotiate hard run the risk of being excluded from investment opportunities, as oftentimes the larger VC firms can exert control over who is permitted to invest.
At the same time, while taking a tough line on investment terms for smaller investors is frowned upon, smaller investors are always at risk of receiving inferior rights or having the rights they receive effectively becoming illusory.
A prominent example are pro-rata or participation rights that are much-coveted by investors. Such rights provide investors the option of purchasing a percentage of securities issued in future rounds, allowing prior investors to maintain their percentage ownership in the company.
In the typical company, these types of rights are granted to investors as part of the transaction documents in an equity financing round. At the outset, each individual investor is typically required to sign on to such documents to get these rights.
But these transaction documents get amended over time or rights granted (including pro-rata rights) may need to be waived, most often in the context of future investment rounds. For example, if a Series B lead investor is unwilling to allow other investors to participate or participate to their full pro-rata share, pro-rata rights may need to be waived in whole or in part. This creates the danger that any individual investor, by refusing to agree to an amendment or waiver, may hold up an entire round. An unscrupulous investor could even use this to extract concessions.
For that reason, the typical transaction documents for an equity financing allow a majority of investors to amend or waive the terms of the agreements on behalf of all investors. It’s for the good of everyone – or so people say.
But that’s often not what happens in practice. The upshot of being the largest existing investor is that you may, by yourself, control the “majority of investors” required to amend or waive the terms of the transaction documents, including the pro-rata rights. Let’s say you are that large investor and hold 20% of a company after the Series A. It comes to a Series B and shares are being sold at a $75 million pre-money. You think that’s a great deal for this company. So, you want to exercise your pro-rata right. Now, if you let all the other investors invest their pro-rata right, then you will buy shares and may only preserve your 20%. But if you waive the pro-rata right on behalf of everyone but yourself, then you spend the same amount of money, but suddenly have more than 20% of the company.
Of course, this sounds like it couldn’t happen. If you waive all the other investors’ pro-rata right, but exercise it yourself, you haven’t waived the pro-rata right at all. Who would sign something that would allow that?
Well, many more investors than you would think. In fact, the model financing documents put out by the National Venture Capital Association (NVCA), the common templates used for venture financings, permits larger investors to do this as a standard term.
Specifically , the amendment section of the Investor Rights Agreement, which is the document that provides the pro-rata right, provides for amendment by a majority (or some other specified threshold) of preferred shareholders. But following this language, the agreement makes it seem like the scenario provided above wouldn’t be allowed:
“Notwithstanding the foregoing [i.e. the provision allowing amendment by the majority of preferred or other specified threshold], this Agreement may not be amended or terminated and the observance of any term hereof may not be waived with respect to any Investor without the written consent of such Investor, unless such amendment, termination, or waiver applies to all Investors in the same fashion . . . .”
Larger investors waiving pro-rata rights on behalf of smaller investors, but exercising that right for themselves, would not seem to “appl[y] to all Investors in the same fashion.”
But the sentence above continues: “(it being agreed that a waiver of the provisions of Section 4 [which provides the pro-rata right] with respect to a particular transaction shall be deemed to apply to all Investors in the same fashion if such waiver does so by its terms, notwithstanding the fact that certain Investors may nonetheless, by agreement with the Company, purchase securities in such transaction).”
In other words, a waiver of pro-rata rights by Investor A (the majority holder) can be deemed to apply equally to all Investors, including Investor A, even if Investor A is allowed to exercise its pro-rata right or buy even more shares than that.
Again, this isn’t a rogue provision put forth in the occasional aggressive VC round. This is the standard language upon which the typical VC round is based.
So, that begs the question – what can you, as a smaller investor, do to protect your rights without jeopardizing your reputation in the investment community (and your chance to make further lucrative investment)?
First, try to lock up your rights in a side letter. When you make your initial investment in a company (whether by convertible note, safe, or otherwise), if there are rights you want to ensure you get, document them at that moment. It is when you have the most leverage. And, equally importantly, try to get those rights documented in a side letter to which only you and the company are parties. Why? Because a side letter will generally not be amendable or waivable without your consent, the way the transaction documents in an equity round (of which you are just one small fish) may be.
Second, try to syndicate with other small investors. Pooling investment with other smaller investors brings more money to the table (i.e. more leverage) and gives you a larger “vote” when it comes to whether rights can be amended or waived on your behalf in future financing rounds. In other words, it is easy for a big investor to waive away your rights if you hold only 10% of the preferred shares in the company. If you are pooled together with other investors to make up, say, 40%, it may be hard for a larger investor to cobble together a majority of the preferred to waive away your rights.
Third, don’t disappear after you put money into the company. Try to provide some value to the founders, whether that be business advice, introductions to other investors, or connections to potential strategic partners. If the company founders see you as providing value, they may be more likely to want to go to bat for you and negotiate on your behalf when larger investors come in. Even if you have no leverage in future funding rounds in terms of protecting your rights, the company very likely will. In addition, if larger investors see you as a value add to their portfolio companies, they may be amenable to providing you protections and investment opportunities they may withhold from other smaller investors.
Without smaller investors providing the seed funding for startups to ramp up to the point where a large VC would be interested, the whole venture capital funding system would need to drastically change. But no matter how critical a role these smaller investors play, in any given startup, that role will have played out by the time a larger VC comes in.
So, frustratingly, the importance of the smaller investor rarely translates into leverage as a portfolio company matures. But by using some of the strategies we’ve discussed, and walking into your next investment with the knowledge of the dangers that may be posed by later larger investors, you can at least place yourself in a more advantageous position than your investing peers.
About The Author
David Siegel is a partner at Silicon Valley law firm Grellas Shah, where he specializes in helping startups.
David is an unusual startup lawyer in having done sophisticated legal work in both transactional and litigation matters: he is an accomplished startup lawyer and litigator who has extensive experience with our firm in handling a broad range of corporate, transactional, and intellectual property matters, including work on multi-million dollar financings and acquisitions, all in addition to having a deep expertise in handling complex intellectual property, corporate, and commercial litigation matters. Prior to joining Grellas Shah, David worked for five years at the nationally-recognized firm of Gibson, Dunn & Crutcher, initially out of its New York office and subsequently out of Palo Alto. He has a keen interest in working with startups and has worked closely with early-stage companies since joining the firm while expanding his expertise in the startup field.
David is licensed to practice in California and New York. He has extensive experience in both state and federal courts and has done in-depth work connected with SEC investigations, including managing a team of 30 lawyers in defending a client in a particularly intensive investigation.