Companies often issue equity to investors in exchange for capital to facilitate growth. As a result, the proportion of equity held by existing shareholders (including the company's founders) will be diluted unless those shareholders purchase additional equity to maintain their equity ownership proportion. Lead investors may also receive certain rights with their shares, such as the right to appoint a director to the company's board. These rights and the dilutive effect of equity capital raising may result in the founders grappling to retain control of the critical decision-making processes of the business. This article explores some strategies founders can implement to retain control over their company while raising capital.
Board Composition and Decision-Making
The composition of your company's board, the nature of the decisions made at the board level and the thresholds required to approve those decisions all play an essential role in determining the day-to-day control of the company. Let us explore each of these in further detail.
We usually recommend that founders retain an entrenched right to appoint directors under the company's constitution or shareholders agreement as long as they hold shares in the company. This ensures that the founders may be represented at the board level. At the same time, they continue to have shares in the company, regardless of whether their ownership percentage dilutes when the company brings on new investors.
We ordinarily recommend that your board contain an odd number of directors to avoid deadlocks in decision-making. Although uncommon, a founder director may have a 'casting vote' under the company's governance documents. This allows them to break a deadlock should it arise. This ensures the founder has the final say regarding whether a decision is approved.
Ideally, the board should contain more founders than 'external' directors to ensure the founding team determines the business' overall strategy and direction. However, this may not be possible when the company has only one founder and brings on new board members.
You should consider whether a prospective board appointee has the same vision for the business as the founding team. Otherwise, their appointment may cause disharmony and hinder efficient decision-making and management.
Nature of Board Decisions
It is common for the company's governance documents to contain a list of critical business matters that must be decided at the board level rather than by the company's shareholders. This ensures that the founders will continue to play a prominent role in the critical decision-making of the business, even if their ownership is diluted.
Some of the board's critical business matters are set out below.
|Critical business matter||Summary|
|Capital expenditure||To enter into any transaction or series of transactions involving a capital expenditure above a specific value.|
|Asset acquisitions or disposals||To enter into any transaction or series of transactions in which the company proposes to acquire or dispose of assets above a specific value.|
|Change in the nature of business||To cease or materially change the scale of operations and nature of the business activities conducted by the company.|
|Issuing securities||To issue any equity securities, including shares, options or other convertible securities.|
|Loans||To enter into an agreement or arrangement to grant or take on a loan, line of credit or other financial accommodation other than in the ordinary course of business.|
|Dividends||To set, declare or change the company's dividend policy.|
|Share buy-backs||To buy back or redeem shares in the company.|
|IPO||To take steps to apply to list the company's shares on a publicly listed stock exchange.|
|Winding up or reorganising the Company||To take steps to reorganise or wind up the company to limit its right to carry on business.|
You should consult a lawyer before determining the matters that the board can determine. This is because the law limits directors from wresting certain rights from shareholders.
A decision-making threshold is the approval percentage required to pass a resolution or decide on a particular matter. Founders should consider whether the board composition (discussed above) will restrict the founders' ability to meet the thresholds. This may, in turn, influence the decision-making threshold founders set.
For example, suppose Smith Limited's board has 5 directors (4 founder directors and 1 independent director). At least 75% of the board must approve critical business matters. In this scenario, the founding team comprises 80% of the board. This ensures they always outnumber 'external' directors and retain the necessary support to approve critical decisions provided that:
- each founder director retains its board seat;
- the board is comprised of five directors; and
- the approval threshold for critical business matters remains at 75%.
Another strategy you can use to retain founder control is to ensure that any given matter obtains the approval of the founders. You may hear this right referred to as a veto power because the founders can vote against a particular issue. Consequently, it will not be approved.
Pre-emptive Rights and Right of First Refusal (ROFR)
A company's governance documents likely grant founders and shareholders pre-emptive rights. These give the founders the first right to purchase the pro-rata proportion of new shares the company intends to issue before offering them to outside investors. This right provides founders with a mechanism by which they can 'top-up' their shareholding to avoid dilution when the company issues new shares to raise capital.
Another tool founders can use to increase their percentage shareholding is by including a 'right of first refusal' regarding share disposals in the company. Where the company's constitution or shareholders agreement incorporates this right, any time an existing shareholder intends to sell their shares, the founders have the right to purchase them before outsiders.
Founder and shareholder dilution is unavoidable as the company grows and undertakes capital raises. However, there are strategies that founders can implement to ensure that they maintain practical control of the company. For example, founders can retain control by ensuring that:
- founders have entrenched rights to appoint directors;
- the company's governance documents provide for critical decisions to be made at the board level;
- the decision-making thresholds can be achieved by the founding team without relying on approval from 'independent directors', taking into account the board composition;
- founders have customary pre-emptive rights on new share issues and, where possible, a right of first refusal on share disposals.