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Okay so remember we just the broke up the typical terms of preferred stock financing into five different, categories. We just spent a lot of time talking about pricing and pre-money valuation, and now we’re about to spend a little time talking about the other categories. Now the next one up to talk about is control. So investors often times will negotiate for certain provisions in the financing documents that allows a minority investor, again, remember we talked about range in the early-stage financing in terms of ownership level for a preferred stock investor being somewhere between 5-30% of the company. So they’re a minority investor, only own a minority of the business.
Often times from a control perspective, though, these investors were negotiating provisions in the financing documents that allow them to exhibit the behavior, if you will, of the majority investor. So they effectively can punch above their weight a little bit and have more control over the business enterprise notwithstanding the minority investor status.
What do I mean by control? Well depending on how big of a financing round that you have, it’s not atypical for a venture capital investor to insist upon having representation on your board of directors. So a typical construct of the board of directors after an early stage or Series A financing would be to have maybe a three-person board of directors where the common stockholders, namely the founders, get to designate one member of the board, the preferred stock investors get to designate one member of the board, and maybe there’s a third neutral party that is designated by the two other investors that’s mutually agreeable to the two other directors.
Certainly if you’re give representation the board of directors, that’s a lot of control over the company potentially. If there’s any committees of the board of directors, similarly the investor would be looking to have representation on those committees.
Not only with the investor oftentimes negotiate to have representation on the board of directors. In the scenario that I just described, it’s a three-person board of directors, and so typically a majority vote would carry out the decisions of the board of directors. So theoretically that investor’s designee on the board can be frozen out making a meaningful board decision if the two other directors vote in a way different from the way that he or she would want to vote.
Investors are certainly aware of that and, so they may negotiate for certain veto rights of the board of directors, and so for example, they might say that, notwithstanding the fact that the board has to approve future financing of the company, and two of the three directors, meaning the directors of the investors designated the board to prove that financing, that investor designee on the Board of Directors he or she may have to affirmatively vote for that decision in order for to go forward. Now you have board representation, but you have a specific director veto righter approval right on the board of directors that again is that investor a bit more control over the stewardship of the of the business.
You also for a stockholder level see the investor having certain veto or protective provisions so for example. even though an investor will maybe own 20-25% of the company, there could be a negotiated right saying that certain designated matters again a future financing. a sale of the company, an amendment of the company’s charter, things of taking on debt things of that nature require the approval of a specific investor. perhaps the preferred investors an entire class. would have to approve some of those things. So again control mechanisms whereby preferred investor can effectively have more control over the over the business in the otherwise might as just a minority investor in the business. that talked about pricing and economics of a venture capital financing we just talk about control, let’s talk a little bit now about an investor’s ability to monitor their investment.
So a typical term you’ll see in a preferred stock and financing is the ability of investor to monitor their investment in the form of periodic financial reports about the company. They may, for example, require the company’s financial statements be audited. Or even if they’re not audited, that financial statements or balance sheets were interim capitalization tables be provided to the investor on a monthly, quarterly, or annual basis so that they have significant visibility in the operations of the business.
This is particularly important for investors if they haven’t negotiated for representation of the board of directors. If you’re on the board, you have a lot of visibility into the operations of the business, but if you’re not a board member having any sort of information rights or even inspection rights to inspect the books and records of the company at any given time are going to be very valuable. Something to be aware of as a founder in dealing with preferred stock investors, something that they’ll typically negotiate for.
Another typical preferred stock term that you see in venture capital financing is an investor’s ability to maintain and increase their ownership percentage in the company. You think about a company that really is taking off, and we hear about unicorns all the time, these companies that have dramatic upticks in valuation. In those types of situations, some investors may choose to just sit back and watch their investment grow. Other investors, particularly investors that want to maintain a specific ownership percentage of the company, don’t want to have a contractual right to continue to invest in the company moving forward, so it’s not atypical to see an investor negotiate a provision that provides them with preemptive rights to participate in future financing. That way they can at least maintain their ownership percentage of the company.
It may be that the investor ultimately decides that they don’t want to participate in the future financing round, perhaps the valuation just got a little too high. It’s out of their comfort zone in terms of what they’re willing to invest in the company, or perhaps a investor just doesn’t have any more investment capital that they want to invest in that company, but notwithstanding that fact, the investor would like to be their decision as opposed to the company’s decision.
Finally, the last very important preferred stock term that typically see in venture capital financing has to deal with liquidity. By liquidity, I mean the timing in the form in which a preferred stock investor’s investment becomes liquid. Preferred stock in a private company is very illiquid. You typically have to, as an investor, have the expectation that you’re going to be holding onto that stock for an undefined period of time, but preferred stock investors don’t like holding their liquid securities forever. They want to know that at some point in time. Hopefully the companies that have grown that pot of gold at the end of the rainbow, whereby investors sale of the company or maybe even an initial public offering of the company will have the benefit of an exit event, and will be able to sell their shares, hopefully for a significant gain over the money they ultimately invested in the company initially.
So we typically see contractual rights surrounding when a company can be forced to liquidate its investments. Whether it’s forcing the sale of the company, forcing the registration of the company securities on a public stock market. Investors don’t want to leave that completely up to the whims of the management and the board of directors, they like to have some control over the timing of liquidity, and so again we typically see we typically see contractual right surrounding the timing and form of liquidity.