“ In capitalism, those with the capital usually get the ism.”
ACTUAL CASE HISTORY: Paul and his partner, Elise, seemed to be “riding a rocket.” Their six-year-old software company had come up with a very neat solution to a common business problem, namely, real-time updating of the prices charged by a company’s critical suppliers. It almost ensured lowest prices.
Their success, though, was their problem: they needed to hire very talented coders, who were in increasing demand, and for this reason quite expensive to hire. This left them cash-starved, and unable to continually update and enhance their product to meet market demand. Fortunately through their accountant, they were introduced to an investment firm that was interested in providing a cash infusion in return for a piece of the company’s ownership.
The initial meetings went quite well. In return for a $5 million cash infusion, the investors wanted only 10% of the company’s stock, and 5% of its profits. After a brief time Paul and Elise suggested that their business attorney – an expert in software patents – prepare the necessary legal papers. Instead, the investment firm suggested their own internal attorney should prepare the legal papers, in order to save money for Paul’s business, which was “music” to Paul’s ears.
After presentation, review and minor modifications of the legal papers, the investment was completed, and Paul and Elise were more ready than ever to grow their business through new – and now affordable – hiring opportunities.
All went well . . . for about six months. Then the Board, now composed of Paul and Elise, and three younger members of the investment firm, had one of its monthly meetings. At that meeting, the Board voted 3 to 2 to cut salaries and benefits by about 10% in order to slow the company’s rate of “cash burn.”
Paul and Elise didn’t think it would be a good idea, but they gave in, and explained to their staff members that this was a sign of “long term thinking,” and necessary to show the investors their deep commitment. They also cautioned their staff that the cuts were necessary to keep relations with the investors on a positive note.
Two months later, the “fit hit the shan” when the Board voted to issue a “special dividend” to the investment firm, in effect, to themselves, and replace the company accountant and the company lawyer with their own. Paul and Elise started feeling like someone had “hijacked” their company. Unfortunately, they were right. What they had built up over years of effort and sacrifice was, slowly but surely, slipping through their fingers.
The changes kept coming, including a decision to pay the investment company a monthly “management services fee,” a company name change, the office was relocated, more debt was piled on, and the investors even brought in other investors, with what was called “super-voting” shares. Before they knew it, the best assets of the company were being sold to competitors, while Paul and Elise were reduced to mid-level managers of a company they once independently ran. This was not what they had envisioned. Not near it.
When they consulted their own attorney, they soon learned that his expertise in software patents was not expertise in company operating documents, and that embedded in the legal documents they had signed, nearly invisible to them, was their agreement to permit the investors to do essentially whatever they wanted.
Yes, the investors still owned just 10% of the “stock,” and received just 5% of the “profits.” While at first that seemed comforting to Paul and Elise, the larger “control” decisions being made daily made “ownership” and “profit” issues not to matter much at all.
LESSON TO LEARN: “C.O.P.” stands for “Control,” “Ownership,” and “Profits.” It is an analytical and explanatory rule of thumb I have made up and use often when working with the creation, growth and evolution of small and/or young companies.
“C” stands for “Control.” Control means who will make decisions, how they can be made, and what limits exist on those decisions. The “Control” provisions of a company’s operating agreement (no matter what its title may be) are rather boring, often confusing, and almost always ignored by the non-lawyers. That often leads to tragedy, because “control” provisions can change who owns a company, what profits they get, and even who will remain owners, officers or employees of a company. “C” comes before O and P in the alphabet, and comes first in “C.O.P.” because it is far and away the most important of “C.O.P.”
“O” stands for “Ownership.” Ownership means who owns how much of a company. While it seems to be so very important, if those who “Control” a company can change its future ownership, what “ownership” means, or who gets the usual “fruits” of being an owner, it makes the initial ownership not as important as it often seems.
“P” stands for “Profits.” Profits means who gets moneys that the company earns, after paying the bills and taxes, and how much they get of the profits. Profits is the least important, because it can be changed in so many ways by those who have Control to do so. “P” comes after “C” and “O” in the alphabet, and comes last in “C.O.P.” because it is far and away least important of the three.
The legal documents that govern how a small or young company operates are essentially devoted to (1) who will make what decisions, (2) how those decisions will be made, and (3) the limits, if any, on those decisions. (Sort of like the U.S. Constitution, come to think of it.) Unfortunately, these documents are often very confusing, obtuse and highly “legalistic,” enough so that they can put an insomniac to sleep. Attorneys not familiar with the issues that arise in the “governance” of smaller businesses, and the applicable law, often meekly comment “Looks pretty good to me,” which is a sure sign that he or she is well beyond his or her legal expertise and street smarts.
When presented with a business operating agreement by potential investors – a “partnership agreement” for a partnership, a “shareholder agreement” for a corporation, or an “operating agreement” for a limited liability company – principals and their attorneys often mistakenly focus, first, on “Ownership,” and numbers of “shares” or “units,” which describe who owns how much of a company. The thought is, “If we own a majority of the shares (or units), majority rules, right?” The truth is, “No. Not necessarily.”
Next, principals and their attorneys, when presented with a business operating agreement by potential investors, often next focus on the “Profits,” or the phrase “profit distribution.” If a certain amount or percentage seems reasonable, then they are often pleased, seeing a reasonable sharing of profits as a sure sign of good intentions and reasonable business investor-partners.
What they rarely focus on sufficiently, because it is a “fuzzy” concept often “buried” or “disguised” in a whole slew of provisions written in legal mumbo-jumbo (that is a Latin phrase meaning “hocus pocus”) is the most important issue: “Control,” meaning “Who makes what decisions, how, and what limits exist on those decisions?” At the risk of being sued, I will refer to this issue as “The Art of the Deal” although, in truth, it is often more accurately characterized as “The Art of the Steal.”
So, the focus of thinking, analyzing and negotiating investment in small businesses must be on “Control” because whoever has control can later change both “Ownership” and “Profits.” Got it? “C.O.P.” and “C” comes first.
Don’t get me wrong: ownership and profits are really important issues. But if someone has the “Control” to change them, against your judgment or will, the initial “Ownership” and the initial “Profits” don’t mean a hill of beans, as those with “control” can change them. And, if they have the “Control” to fire you, or your partners, or change the name, location and model of the business, what good is their investment in the first place?
There are innumerable ways that “Control” can be disguised, stolen and “fuzzied.” The idea is to make sure it is hard, if not impossible, to make later important decisions against your wishes, in violation of your vision, and against your interests, by asking for changes, or insertion of limits, that will protect your “business baby.”
Bear in mind, something that is also quite important: only you understand your business, how it works, what makes it tick, and even what your vision is. Don’t presume that your lawyer or any other lawyer knows those things – and the things you fear, too. We all know you want your business to succeed and grow. We don’t know that much about what you would find hurtful to your dream, because, frankly, it is your dream. The best collaboration with an attorney on these issues takes several cups of coffee, multiple mugs of beer, or at least a whole lot of candid conversation.
Bottom line: as you can see, a 10% ownership and 5% share of profits, can – by legal papers – be turned into a sale of a company. When it happens in a large company, we call it a “corporate takeover.” In a smaller version, it is simply a personal tragedy.
WHAT YOU CAN DO: Like it or not, investors in a smaller or younger company often have different interests than those who have started and/or built it. And their perspectives may be different, too. If your company finds itself about to speak with “money people” regarding their coming in as investors, don’t let them hijack the ship. Use “C.O.P.” as your analytical and navigational tool. Here are 18 pointers, hints, and insights to help you do so:
- A. Prior to Discussions
1. First and foremost, do all you can not to let your company get to the point where it is dependent on this particular investment partner and what he or she offers. Simply put, “dependence is dependence,” and dependence makes a free person into something of a slave. While easier said than done, do your best not to let you company get into a dependent position in which you have little or no choice but to agree to things that are not good for you.
There are many ways to put together necessary funds, including reducing costs, delaying vendor payments, factoring receivables, selling non-critical assets, borrowing from a lender, even tapping savings, friends and family. Even if your business is in desperate straits, you would be wise to avoid sharing that news, or making that impression. At a minimum, it probably would help, every now and then, to drop the phrase “the other investors” into your conversations.
2. It is strongly suggested that you use a Non-Disclosure Agreement (“NDA”) before sharing confidential information. A Non-Disclosure Agreement, or (“NDA”) is a written understanding to be signed by potential business partners and investors before they are provided confidential information. An NDA says that you are sharing your company’s information with them based on their promise that they (a) will not share it with anyone else, (b) will not use it for any purposes other than assessing whether to make this investment, and (c) will return or destroy it after it has been used for its intended purpose.
An NDA is standard fare in situations like this, and should not be a problem for anyone acting in good faith. It is a good practice to use one to avoid the world knowing – and possibly taking advantage of – your business’s confidential information. It shows others you know what you are doing. If an interested investor balks at signing one, that is not a good sign.
Want to share a great business idea, or interest an investor, partner, lender or other critical affiliate, to protect your idea or information use our Model Formal Non-Disclosure Agreement (“NDA”). To obtain a copy you can adapt, just [click here.] Delivered by Email – Instantly!
3. Before engaging in serious discussions or negotiations, retain an attorney who has experience, expertise and the wisdom of “scars and bruises” in these matters. An attorney experienced in these matters will be able to advise you properly about likely issues of control that may arise, and how to respond to investors’ suggestions, requests or demands. Your discussing those issues, even in preliminary conversations, might just come back to haunt you by your later being told “But you agreed . . . “
Your cousin Mel, your “family attorney” and your “patent lawyer” are not the professionals you need at this time. It is good to have an attorney who knows you, your business and your industry. But even better would be an attorney who can spot the issues, foresee the problems before they arise, and professionally “navigate” those issues for you. By the way, there is nothing wrong with having both an industry attorney and a business on your side, so long as you can afford it. At the same time, there is nothing wrong with working with an “industry” attorney, and a “business attorney,” at the same time, provided you can afford to.
If you do engage in early discussions without an attorney, once you get to the “negotiating table” I promise you will hear “but you already agree to X, Y and Z”, which will surely make your attorney a weaker negotiator on your behalf. In my experience attorneys of this type can be found by speaking with other attorneys and business people who have worked with clients who have taken investors in, and whose clients have successfully survived the process intact.
- B. During Discussions
4. Try to adopt and maintain a mindset of “If it is not right, it will not be done.” There is no loss in avoiding a problem, and that goes doubly so for a calamity. In negotiating issues at the heart of your business, and most especially “control” elements of your company’s operating agreement, be clear, candid and firm about what limits you feel may be necessary for you to maintain a reasonable degree of control of your company, its operations, its ownership and its profit allocation. (“Control loss limiters” are further explained below.)
It important to show a reasonable degree of flexibility on all issues, but with “control” issues that degree of flexibility must be offered quite sparingly.
5. “Just trust us” is a big, fat, red flag. In your discussions of “who will make what decisions,” which are what we call “control loss limiters,” (as well as other issues of importance to you), if you hear “Just trust us,” take a very deep breath. Then consider proposing that the “shoe be put on the other foot,” that is, the investment be made without any legal papers at all, but just with a hearty handshake. That is, you might just say, “OK, let’s both do that; instead of putting anything in writing, why don’t you just make your investment without legal papers, and trust me, too?” See how far that gets you.
No one should fully trust anyone else in business, and that is precisely why we have lawyers and legal papers. Ever hear “Good fences make good neighbors”? Well, “Good agreements prevent lawsuits.” Identifying, assessing, and limiting risk is the heart and soul of business. And risk of loss of control of a business is the number one risk there is.
6. At the same time, don’t expect any investor to be truly “passive” (other than your 82-year-old Aunt Ida, and maybe not even her.) It’s a push-and-shove world. Please don’t be so naïve as to expect any investors to simply “lay down and roll over” when you take steps to protect your own interests, including asking for limits on their control over their business. After all, they feel a need to protect their investment capital from what they may see as less knowledgeable business people such as yourself.
To a reasonable extent, always try to show some flexibility. Continually search for compromise solutions. Don’t be insulted, no matter what they say. So long as the discussion continues, and you are not losing anything by continuing the dialogue (see, though, the next section about “positional leverage), keep the conversation flowing. Bear in mind that this is – hopefully – the beginning of a long and mutually advantageous business relationship.
7. While discussions or negotiations are taking place, do not give up “positional leverage.” Positional leverage is leverage lost or gained as a result only of “where you sit or stand.” So, for example, if you have a loan installment due, or a tax payment deadline, every day that passes makes you more in need of the investor’s capital, and thus losing “positional leverage” in that way.
As another example, do not stop speaking with a bank about a bank loan, as that would make you that much more in need of the investor’s funds, and thus in a weaker position of leverage. So, you can gain or lose leverage in a negotiation not only by what happens in the discussions, but by many decisions you make outside the conference room.
One more example: Don’t start “working together” until the papers are all signed, as unraveling a joint business effort once it has begun might prove stickier than you think.
8. Before having any agreement drawn up, use a “term sheet” or “deal memo” format to raise and resolve basic points. Many times I have seen formal contracts drafted by attorneys and presented for review long before the basic terms of the deal have been hammered out. This is what I call a “sharp shove” in negotiation – that is, being encouraged or even required to “move two steps too fast.”
The often-seen result of drafting documents before the deal is struck is the parties foolishly debating the equivalent of words and punctuation, instead of the larger issues of “Control,” “Ownership” and “Profits.” That is, reviewing drafted documents tends to take your focus away from the really important issues relating to the “shape of the forest” and instead distracts your attention toward far less important ones relating to either the kind of “trees,” or even the number of “the leaves.”
What is a “term sheet” or “deal memo?” Nothing more than a list of important issues about how the company will be run, who will make what kind of decisions, and the resolved of unresolved differences of the parties on each point.
Here is an illustration, assuming we are discussing investment into a fashion design business whose owners are two brothers who act as CEO and COO:
|Timing:||$500k each six months|
|New Board:||Investors get 2 of 6 seats, Founders 4|
|Management Team:||CEO, COO, CFO, Lead Designer|
|Managers:||Founders continue as Designer, CEO and COO|
|Finances:||CFO, reporting to CEO; dotted line to Board|
|Sale, Merger, Acqisn:||Unanimous Board|
|New Stock Issuance:||Unanimous Board|
|Business Reorg:||Unanimous Board|
|Daily Operations:||Management Team|
|Daily Authorities:||(a) Capital Projects: Unanimous Board|
|(b) Hiring, Firing of CEO, COO, CFO: Unanimous Board|
|(c) Commitments over $100k: Board Majority|
|(d) Retention of Professionals: Board Majority|
|(e) All other All other Hiring and Firing: CEO|
|(f) Contracts $100k and below: CEO, COO|
|Profits, Dividends:||(g) Board Majority|
|CEO, COO Comp||(h) Board Majority|
|Other Compensation:||(i) CEO, COO|
|Artistic Design Issues:||(j) Lead Designer|
|Branding, Publicity:||(k) Management Team|
|Office/Retail Location:||(i) Board Majority|
|Transfer of Stock:||(k) Board Majority|
|Unresolved Disputes:||(m) Mediation Attempt; If Unresolved: Local Court|
This is a rather simplified Deal Memo or Term Sheet, meant for illustrative purposes only. And these terms are not meant for all companies considering taking in investors.
As you can see, there are limits set on each kind of important decision to be made which may, or may not, be acceptable to your investor. Only when all or most of the most important deal points are agreed should you consider having formal legal documents drafted.
- C. The Document Process
9. Seek to avoid their attorneys preparing the first draft of legal documents. This is a subtle, yet substantial point: if possible, do not agree to let the investor’s lawyer(s) prepare the first draft of legal documents. It is usually suggested by investors with the rationales (i) It will save the business money, (ii) We like to use our form agreements, and (iii) This is the way we always do it.”
Your responses on this point might be (a) :Our lawyer has already been working on this for a while now, and do not view using him/her would be a waste of money, (b) We have many form contracts, and we want this one to be of the same style and format, and (c) This is what we have always done, and it works quite well for us.”
Why care? Here are just a few of the reasons: (1) It is easier for an attorney to draft exactly what he/she wants than it is get another attorney to agree to make changes in what he or she has drafted. (2) Legal drafting can be something like three-dimensional chess; words, phrases, and sections are “woven” together in a way that is often hard to fully comprehend. It is better if your lawyer, not theirs, has in this way “set all the traps.” (3) There is a subtle giving up of control when their attorney, not yours, is “leading the way.” (4) Lastly, why should an outsider draft the critical “inside” document of a business? It is a first, and worrisome, step of that outsider – the investor – taking over control.
10. Simply do not accept any confusing or unintelligible “legalese” in the document, especially a business’s operating agreement. No one wants to seem unintelligent, but I am often quite proud to say, “I am sorry, but I don’t understand what this means; please redraft it so even a person of my average intelligence can understand it.” It amazes me how so many smart people are reluctant to openly admit they cannot understand obtuse, confusing and unintelligible legal writing.
Whether it is done intentionally or as a result of poor writing skills, lawyers get away with preparing documents that no one understands, so no one should even consider signing. And, too, just because a document is entitled, for example, “Standard Provisions” does not mean it is unimportant, or unnecessary to read, before signing. Don’t be hoodwinked by misleading titles of documents, or their sections. This is often how “control” of your company will be taken from you, in the fashion of a “three-card-monte” dealer.
11. Your constant “mantra” should be “What happens if this happens? What happens if that happens?” To yourself, and to your lawyer, it is wise to think about many different scenarios, and testing what would happen because “Stuff happens.” As examples: The CEO gets sick or passes. The company wants to merge with another. It becomes necessary to seek more outside funding. The music that the company specializes in goes out of fashion. The economy is so bad, no one is buying the expensive jewelry the company is known for.
Who will make the decisions that these new circumstances might require be made? How? It’s a very creative endeavor, and it can be very exhausting as well, but that is the best way to test your company, and its arrangements with its new investors as business partners who have different interests and perspectives.
- D. Specific Discussion Points, including “Control Loss Limiters”
12. Who sits on the Board, how they are selected, and their voting power, are the critical “Control Loss Limiters.” Simply put, the Board of Directors of a corporation (or their equivalent in a partnership or limited liability company) makes the major decisions, including those decisions that might transfer control of your company to the investors. Though these provisions may seem confusing or boring, they are so, so important.
Especially on these matters, your agreement must be so simple that a 12-year-old could understand it. Really good lawyers draft agreements using language that is easy to understand, because they know that members of juries – who may have to decide what they mean – are often not very highly educated.
13. Maintain control of the selection of the company’s accountant(s) and attorney(s). Simply put, control of information in business is like control of the oxygen supply to a person’s brain. Thus, the investors should not be able to replace the company’s present accountants and lawyers with theirs.
If, in the future, you cannot trust the “numbers” that the company’s accountant reports to you, you will not be able understand what is happening in your company, or make wise decisions about it. The same thing holds true for legal issues and legal documents. If, for example, your company creates computer code and algorithms, you want to be sure that the copyrights, patents or other ownership documents are properly recorded in the company’s name.
Your business’s present accountant and its present attorney should be your company’s future accountants and attorneys. This is a critical “control loss limiter.”
14. Resist energetically any possible imposition of “non-compete agreements” on the company’s present founders, owners, or principals. You may well hear, “Executives or managers who work for the company must have a signed non-compete agreement so they cannot take the company’s business away.” Makes sense, yes? Well, no, it does not, if it applies to the company’s founders or present owners or principals.
Suppose one day you are told that your salary is reduced to minimum wage, your office is moved to the storage room, or your duties include cleaning the rest rooms. If so, you are going to want to leave so badly that you may give up your shares of ownership and profits. That would be bad enough, but to remain outside your industry for one or two years could be catastrophic. And, at the same time, if you have the freedom to leave, and start over, your investor-partners may well make sure you are never so unhappy as to want to do so.
Incidentally, “non-solicitation” agreements or provisions should be treated the same way as “non-competition” ones.
While resisting non-compete’s and non-solicit’s is not an obvious way to maintain “control,” it is a subtle, ongoing and powerful way to do so.
15. Seek a clear prohibition on “any change in company control by any means without unanimous Board agreement.” If you own 60 shares of a company that has 100 shares outstanding, you own 60% of the company. Suppose, though, at a Board Meeting, it is decided to sell 9,900 more shares to the investors for a total of $100. Then, your 60% ownership becomes 0.6% of the company, that is, less than 1%. Ouch! That is what we call a loss of control by “dilution.”
Suppose, instead, that all of the shares of the company are called “common shares,” and one day members of the Board want to create a new kind of shares called “preferential shares,” and give “preferential share” owners the right to appoint 4 new members of the Board. That effectively results in a “change in control” on the Board. This is what we call a loss of control by “Board re-composition.” There are many, many other ways that you could lose control of your company to investors.
Your attorney should insist on a strict and clear prohibition of any measure by the Board that results in an effective change in control, including without limitation, issuance of more shares, or other classes of share, or otherwise, without a unanimous vote of the Board. This is an important “control loss limiter.”
16. In the “creative” industries, “Creative Control” can be just as important, as “Company Control,” or even more so. In theater companies, design shops, fashion houses, art galleries, film enterprises, music labels, and other creative industries, decisions about creative works, creative direction, branding, and creative hiring and firing, can be monumental to those involved.
While success in most business means “financial success,” in these industries that is not usually the only metric for measuring success. For example. emotions can run quite high if, for example, the company’s devotion to high-fashion is replaced by a focus on better-selling jeans and backpacks. “Numbers people” are not often so devoted to concept, culture, chemistry, class or couth, as they are devoted to return on investment. Once more, but from a different perspective, we see how important maintaining Control over decision-making can be.
17. Ask for a provision that “Unanimous” or “Majority” Board votes are based on “all Board Members” and not just “those Board Members in attendance at any Board or Committee meeting.” I was once consulted on a case where the shareholder agreement of a smaller company that had taken in investors defined “Unanimous” and “Majority” Board votes on “those Directors in attendance at the meeting.” When the non-investor-Directors were out of the country on business, the investor-directors called a Board Meeting, and made their own – and self-serving – “unanimous” Board votes. A small detail? Very big consequences.
18. Last but not least, do your best to refuse any provision requiring Arbitration to resolve disputes. Over the course of my 34 years in law practice, I have come to see arbitration as a means to almost certain injustice. Let’s be clear about what “arbitration” means.
Let’s start of with the usual lawsuit. Your claim is submitted to a Court, which is a public place, in which your case is heard. The judge does not get paid more if he sees more cases, and he or she does not like cases to last a long time. Neither judge nor jury has any reason to want to make either side happy. If the judge or jury makes an error that is unfair or against the law, the decision can be appealed. Although sometimes slow and frustrating, it is as impersonal as the post office.
Arbitration is very different. First, unlike Court, arbitrators work for private arbitration companies who want more business. So, who brings more cases to arbitration companies, large law firms or small law firms? Yes, large law firms, and so who do arbitration companies want to make happy? 100% naturally, they favor the clients of large law firms, which tend to be large companies. It is a built-in – and powerful, and undeniable – conflict of interest.
Second, the Judge in a Court does not want cases to go on and on forever. He or she already has too much work to do. On the other hand, Arbitrators make a living by arbitrating, and who pays them? – you do. So, if they have kids in college, mounting bills, perhaps are building a summer home, it is likely your case will last long, and be very expensive. Court costs next to nothing. Judges always try to get cases settled, and quickly; almost always they are successful. On the other hand, in scores of arbitrations, I have never once seen an Arbitrator settle a single case.
Third, while Court proceedings are public, and mistakes can be appealed, arbitrations are secret, there is no record of what takes place, and there is no appeal, other than in extremely limited cases.
Bottom line: there is no fairness in arbitration, but rather extreme unfairness, and the deck is heavily stacked against smaller companies who usually employer smaller law firms, and heavily in favor of larger companies and larger law firms. Resist it as best you can. There is a reason they want it, and the reason is precisely the reason you do not.
By these warnings, these examples and these stories, I do not want you to think that taking in investors is a bad thing to do. To the contrary, it is the easiest way to save a cash-strapped business and help it grow. However, I can only quote Andy Grove, the man who founded a once-small company named Intel: “Only the paranoid survive.”
P.S.: If you would like to speak with me directly about this subject, I am available for 60-minute or 120-minute telephone consultations. Just [click here.] Evenings and weekends can be accommodated.
SkloverWorkingWisdom™ emphasizes smart negotiating – and navigating – for yourself at work. Negotiation and navigation of work and career issues requires that you think “out of the box,” and build value and avoid risks at every point in your career. We strive to help you understand what is commonly before you – traps and pitfalls, included – and to avoid the likely bumps in the road. For those considering bringing in outside investors, it’s not an easy thing to do. You are thinking about their dollars; you and your lawyers must also thing about your business’s potential damage.
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