I recently came across a very interesting academic article about the uniqueness of start-up corporate governance. For US corporations, the default is that the common shareholders ‘control’ the company. This means they collectively could outvote any other class of shareholders, and are represented by a majority of board directors.
Common shareholder control is seen as beneficial for the company as a whole, because as commons only have a claim to the residual value of the company, they are the most incentivized to maximize total shareholder value. Creditors or preferred shareholders in comparison have have an incentive to choose lower-value, lower-risk investment and exit strategies over higher-value, higher risk strategies.
Venture Capitalists invest in a start-up through preferred shares and usually negotiate for control of the company through board representation, information rights and veto power over key decisions. So-called ‘drag along’ rights also give them the right to compel the common shareholder to accept any exit that is chosen by them. In such a case, they are in full control of the company.
This set-up is seen as necessary to reduce the tremendous risks that VC undertake when investing in a start-up. The other side of the coin is that it leaves common shareholders (founders and employees) vulnerable to so-called ‘preferred opportunism’. This is the kind of risk averse behavior that benefits the preferred shareholders but destroys total shareholder value. A good example is a VC pushing for a low ball exit whose limited value will only create a pay-out for them. This could happen to a start-up that is facing some difficulty. In such a situation the common shareholder have an incentive to adopt high-risk strategies that could turn the company around and result higher value over the long term, while the preferred shareholders will tend towards a low-risk ‘cut your losses’ strategy.
Preferred shareholders, when they control the board, can indulge in opportunistic behavior without having to fear any legal complications arising from that behavior. Delaware courts have adopted a doctrine of ‘control primacy’, which entails that whatever class of shareholders control the board have no fiduciary duty to the other classes of shareholders. A preferred controled board can freely indulge in opportunistic behavior without having to take the interest of the commons into account.
Is this in the interest of the start-up ecosystem? Who can tell… On the one hand VCs will argue that their control of start-up is necessary to mitigate the already tremendous risk they are willing to take on. On the other hand, we have all heard stories of visionary ‘trouble makers’ founders being replaced for a dull CEO by the preferred controlled board, almost never resulting in long term value creation.
Perhaps all this is changing now that there is a subtle trend towards founder control. Founders are common shareholders in start-ups, just like any employee who owns shares.