The Myth of 51%

One of the greatest misperceptions in the early stage entrepreneurial world is that control revolves around maintaining greater than 51% ownership in a firm. In many term sheet negotiations, I have seen entrepreneur after entrepreneur focus intently on maintaining majority ownership. While this is key for buyouts when the company is cash flow positive, it is not the key factor with venture deals. How so???

In talking with friends who have flown commercial aircraft for the main carriers, they all comment that their job involves doing things right for about 5 minutes at take-off and 5 minutes at landing. Not much action occurs otherwise (usually) during the rest of the flight. This is similar in the venture business. The majority of change, power plays, management turnover and such occur right around financing events. The rest of the time is just build up to these main events. When a company is burning cash and runs out of cash, it doesn't matter if investors have 5% or 55%, this is when they have significant voice in the running of the business.

New investors will generally not come into deals if existing investors are not participating (insiders know more than they do and must have issues with the company if they are boycotting a financing). New investors will often come to many of the same conclusions that existing investors have about a business model, a management team or competitive situation.  So, if there are any disagreements between an entrepreneur and his/her investors (especially if the entrepreneur refuses to acknowledge or strongly disagrees), they must be resolved before the new capital comes in. Investors may be concerned that the burn is too high and the entrepreneur, hoping success is just around the corner, has his/her foot on the gas pedal. This is why you often see RIF's and other cost reduction efforts around financings. You also see new CEO hires occuring around financings (granted most of these are with the mutual consent of the entrepreneur and investor).

Later stage investors and buyout firms will often demand 51% ownership and board control because the firms they invest in are cash flow positive or have the ability, in short order, to become self-sufficient. Without legal control, they lose their voice at the table. However, early stage companies need to realize that ownership does not drive the leverage. Of course, they will want to hold onto as much ownership as possible for economic reasons and for when they are cash flow positive. But, they should not expect this ownership to have much impact on their relationships with investors. Mutual respect, alignment of interests and cash flow are the key drivers.

Later this week, I will do a post or two based on some emails sent to me by readers about how power plays develop within the investor syndicates themselves and how this impacts the company.

Comments

[Rob]

So I think you're saying that a majority in the board room and on the cap table only yields power on liquidation/funding events, which makes sense to me. Could you clarify what decisions actually require full board votes? From the sounds of it, the board can't formally get the CEO's foot of the pedal without firing him, and what you're saying is that sort of thing needs to be squared away before liquidation/funding events no matter what level of control the investors have, since there will likely be no funding if they don't re-up in later rounds...