Controlling a Business: There’s No Magic in 51%

I frequently have conversations with entrepreneurs seeking investment, and one thing many of them want to see in a deal is that “I retain over 50% shareholding so I’m in control”.

This seems like a reasonable and logical request.  In a company with simple ordinary shares and standard articles any individual with more than 50% of the shares can win any vote at a general meeting.  This means that if they want they can call a meeting, sack the board, replace it with their own people and rule the roost!

The flaw in the logic is that most first round investments will leave the founders with more than 50% ownership, but without control.  To explain why, I’m going to briefly describe the legal documents that define how a company is run, and the terms that can give absolute power to minority shareholders!

Articles and Agreements

The Companies Act requires that every company has a legal document called the Articles of Association which contains the set of rules on how the company is run.  This is registered at Companies House and is available (for a fee) to anyone who wants to read it.  Articles define how the company handles board membership, decision making, shareholder voting and how the board delegates authority to executives.  The Companies Act offers a standard set of articles, but these are generic and unlikely to suit any particular company well.  Most lawyers and incorporation agents will make some changes, and investors will very often want to replace the articles with their own version.

Often investors will also want a separate (and private) contract between all the shareholders (founders and investors) with extra terms.  This is the Shareholder Agreement  or Investment Agreement.  This private contract can add extra rules over those in the articles, but can’t contradict them.  The shareholder agreement is private and is not registered with companies house.

Before accepting or signing articles or shareholder agreements, founders and investors alike need good legal advice from a lawyer who regularly works in this area (probably not they guy who did your conveyancing or wrote your will).  These documents are complex, use terminology that is often unfamiliar, and interact with each other and with the Companies Act and other law. 

The Veto

The main mechanisms by which investors gain control disproportionate to their shareholding is the veto.  Investors will ask for terms in the shareholders agreement allowing them to appoint a director, and give that director a veto over (i.e. the ability to block) major decisions such as:

• Changes to the business plan
• Capital expenditure
• Any large transactions
• Entering into any loans (giving or receiving), guarantees or indemnities
• Staff contracts and pay
• Issuing shares (to raise additional investment)
• Any IP related transaction outwith standard business operations

This means that the Investor appointed director(s) control all major financial transactions and events in the life of the company and thus effectively have control!  Percentage ownership is relevant for votes at shareholders meetings, but investor director vetoes can essentially override these by blocking necessary resolutions at the board.

Losing your Shares

Most investors will want to use articles and/or shareholder agreements that include “leaver provisions”

These mean that anyone who leaves the company (including founders and managers) will forfeit their shares and options.  A bad leaver (e.g. fired for misconduct, leaves to join another company) will get nothing in exchange for their shares.  A good leaver (illness, death or mutually agreed departure) will get “fair value” for their shares – but this may be a small fraction of what they might have received at an exit!

Founders may feel that losing their shares is pretty unreasonable, but investors will argue that if the founder leaves a replacement must be found, and that replacement will need to be rewarded with shares.  The investors won’t want to dilute their holding, so the shares have to come out of the holdings of the departing founder/manager!

There is some scope for negotiation in this area, especially where a founder has brought substantial intellectual property to a company, or has worked for an extended period with no salary to develop the company.  In this situation a founder may be able to negotiate to retain a portion of their shares if they are a “good leaver”.

Warranties

Although not directly related to control, warranties are usually required from the management.  This means that founders, directors and managers may be held personally liable if it turns out that any information supplied to investors was inaccurate or incomplete.  Warranties usually use the phrase “joint and several” which means that regardless of where blame lies, investors can seek redress from anyone in the pool (they will naturally go after the richest and easiest targets). 

Exercise of warranties is extremely unusual (I am not familiar with any case where it has happened) but nontheless they are big scary commitments and it can feel like they change the balance of power.

How to Avoid Losing Control

I am about to offer you a simple, 100% guaranteed and totally failsafe way in which founders can remain 100% in control of their business.  As far as I know, this simple approach is the ONLY way it can be done, and I’m offering it to you here, and completely for free.

DON’T TAKE ANYONE’S MONEY

That’s it I’m afraid.  You always have the choice of not taking money, but if you want investment the investor is very likely to want some sort of control which is independent of ownership share.