A seat on the board, strong conditions in the shareholders’ agreement, or preferred shares: venture investors have many ways to protect their interests, says Prof. Cyril Demaria. He has been an investor as well as a scholar for over two decades and teaches the program Entrepreneurial Finance: Venture Capital Financing at the Amsterdam Institute of Finance. Demaria shares insights about venture capital finance.
A new investor who enters a young, expanding business will, at first, always be an outsider who has to deal with others who are way more informed. Demaria: “This means they have a very big advantage over you. So, usually, I try to sit on the board, or I have an observer seat, as well as to secure other rights.”
Securing rights can be done through the shareholders’ agreement, but also with the use of preferred shares that confer specific rights to the holder. Preferred shares help mitigate the risk of losses, Demaria explains. “There is a significant misunderstanding among the general public about this. If you look at the stock exchange, typically all shares of listed companies are exactly the same. But in venture capital, the price per share varies a lot depending on the nature of the shares.”
Demaria gives an example of a so-called anti-dilution clause. That states that if within a timeframe of twenty-four months there is a new round of financing at a lower valuation than the one the investor got, the new valuation will apply to his investment. In case there is a down round, the investor will receive extra shares, thereby diluting the cut of all previous investors.
“You can be an entrepreneur, build something, successfully sell it and still end up with absolutely nothing.”Professor Cyril Demaria, EDHEC Business School
Typically, founders will be among these earlier investors. For them the consequences can be quite large, Demaria says, sharing a recent example. “In this particular case the founders had built their company holding common shares. At first, the valuation went up, but at a certain stage the winds turned and they had to get money under very strict terms. The company was ultimately acquired, and at that point all the money was captured by the preferred shares leaving the founders with zero. So you can be an entrepreneur, build something, successfully sell it and still end up with absolutely nothing.”
Up to about a year ago falling valuations and down rounds were mostly hypotheticals, but the tide has turned. Across the tech industry valuations have been falling with, most notably, the Nasdaq Composite being down about 25% since its 2021 peak.
Aside from protecting downward risk in the valuation, preferred shares also support investors’ interests by granting them extra rights when it comes to governance. Preferred shares might grant the holder a much bigger share of voting rights than common shares do, or they might give the holder a veto over certain corporate decisions.
“For example, if the management wants to spend more than 50,000 euros they could need the approval of the board. If one member of the board says no, that means it doesn’t happen. You can also set up special majorities for approving specific events in the life of the company, notably when it’s about to be sold. So it’s very, very powerful in terms of rights”, says Demaria.
Having these rights also gives investors the ability to intervene when they see things going awry. Demaria once used his authority to push for the appointment of a COO. “The management needed some structuring capacity. I insisted that we had to recruit someone. I didn’t decide whom it had to be, but I did demand that we recruit someone. It turned out that it was a very good idea to do that.”
Finding common ground
Are investors still able to keep an eye out for the interests of the entrepreneurs they are funding? “They have to”, Demaria replies. “This is not a zero-sum game with a loser and a winner. The sellers are going to stay with you, so you have to keep them motivated and you have to find common ground to be able to work from for the next five to seven years, which is a long time.”
This does also require a willingness on the entrepreneurs’ side to respect their investors’ perspective. The time spent doing due diligence is when you get the sense, as an investor, of who you’re dealing with. “This is to see how they react to your demands. Do they give in grudgingly or accept that it makes sense? You can have the best shareholders’ agreement in the world, but if they don’t respect it, then you will all lose. You would have to go to court. And then when the court decides it will be too late, everything will be lost. Ultimately, finance is a business of trust”, Demaria concludes.
Learn how to invest in new ventures and raise funds for startups. Join the challenging 2-day Entrepreneurial Finance: Venture Capital Financing program by Prof. Cyril Demaria at Amsterdam Institute of Finance. Learn more & reserve your place here.