Veto Rights - Meaning and its Importance
The process of negotiations between startup companies and investors is often hotly debated and contested. There are several points of contention between the two parties. However, the two parties are often able to reconcile most of their differences. However, when it comes to controlling of the startup firm, both the startup founders as well as prospective investors tend to take an aggressive stance. Both parties want to retain as much control of the startup firm as possible. The concept of veto rights is often used by investors to gain some control over the startup firm. In this article, we will try to understand what veto rights are and how these rights affect the interests of all the parties involved.
What are Veto Rights?
In any company, the decisions related to the company are taken based on a majority vote. Hence, in the case of startups, this would mean that the party which has 51% of the vote will be in control of the decision-making. The other parties cannot unilaterally stop a decision if 51% of the shareholders back it. This is considered to be problematic from an investors point of view. It is common for investors to have 10% or 25% voting power in a company. Hence, in most cases, their opinions will have no bearing on the decisions being taken by the government.
This is where the concept of veto rights comes into play. Veto rights are a legal arrangement that does not allow the investors to unilaterally take decisions on behalf of the majority shareholders. However, at the same time, they allow the minority shareholders to unilaterally prevent the implementation of any decision made by the majority stakeholder. Hence, even if an investor controls 10% of the shareholding, they can prevent the decision being taken by the other 90% from being implemented.
This is the reason that investors are keen on obtaining these rights as a part of their investment agreement. However, at the same time, founders are skeptical about signing away these rights.
Importance of Veto Rights
From an investors point of view, veto rights can be considered to be very important. In the absence of these veto rights, they would have very little information and control over their investments. Normally, investors have no interest in interfering with the day-to-day operations of the firm. Instead, the investors are more concerned about managing events that are outside the normal course of business.
For instance, if the founders decide to take the second round of funding at a lower valuation then the decision also impacts the existing investors. Similarly, if the startup founder wants to drastically increase the size of the option pool by diluting the shares of the current investors, then also the current investors are impacted. These investors want to have a defense mechanism ready to protect them in such special cases. Interference in day-to-day operations would create chaos in the startup company and would end up being a lose-lose proposition for both parties.
Types of Veto Rights
Almost no startup founder would be willing to give away complete veto rights. This means that they cannot allow investors to use veto rights against every decision. Hence, a legal setup is created in which the investor can use their veto rights only in the case of certain decisions.
However, the bottom line is that veto powers provide very important legal rights to minority investors. Hence, these powers are highly valued by investors. Companies can expect their valuation to be raised significantly if they are willing to provide veto powers to the investors.
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