2021 February AAIA Event Recap
The Dynamics of Corporate Control -- A Case Study and Guidance
On Saturday, February 27th, Asia America Innovation Alliance (AAIA) held its second event of 2021. In this workshop, Shui Luo, a founding member of AAIA and a lawyer at Luo Legal Professional Corporation, took the audience on a deep dive into the dynamics of corporate control and provided practical legal guidance for startup founders.
To start today’s discussion, let’s look at the case of RoadStar.ai. RoadStar.ai is an artificial intelligence-powered autonomous vehicle startup founded in Shenzhen in 2017. The company was founded by top talents in the field of deep learning and artificial intelligence. Founders Tong Xianqiao, Heng Liang, and Zhou Guang came from technology giants such as Baidu, Apple and Google. In May 2018, the company set a record for the largest single financing for an autonomous driving company at the time: a US &128 million Series A financing. RoadStar.ai was one of the most promising rising stars in the field of autonomous driving. But it did not take long for things to get ugly, RoadStar ai was caught in a team fight and quickly collapsed after. So what contributed to the fall of RoadStar.ai?
The company had a 1:1:1 shareholding structure. Since everyone had equal say in the company, conflict is inevitable when the founders have different approach to business operations and strategic direction of the company.
One of the founders supported early investors to make operational and financial decisions for RoadStar.ai, depriving the power of the CEO.
Tong and Heng accused Zhou of receiving kickbacks during fundraising and forced his exit through social media platforms. This action exposed internal conflicts to the public without consulting the company’s investors. As a result, one of the RoadStar.ai investors released a statement stating that the decision to dismiss Zhou was not done with consent from the board, and so investors rejected the decision.
The conflict between the company’s founding members had dishearten the investors. As a result, A-round investors filed an arbitration on the grounds of “violation of relevant investment agreement,” and requested the return of funds. Angel investors on the other hand, were left with nothing. After the collapse of RoadStar.ai, Zhou joined another autonomous driving startup.
Purposes of control
To dive further into the dynamics of investors and founders we need to understand that the purposes of a founder and an investor are different.
For the founder, control rights over the company mean the ability to direct the future of the company, the leadership of the team and the retention of the wealth accumulated in the company. It also helps the founder to achieve his/her objective of improving the nature or society which is a public welfare. Investors, however, evaluate a company on the basis of financial return and returns, and thus they seek controlling rights to maintain their returns. As their returns are tied to their ownership ratio in the company, from an investor’s perspective, any situation that may dilute the investor’s ownership ratio will be taken seriously.
Investors, in hoping of increasing value of their investment, will in most scenarios align with the founders to help grow their company. However, if their interests are misaligned, the investor may abandon the founder at any time. The above case of RoadStar.ai is a great example of this.
Examples of control by founders and investors
Let’s take a look an example where founders maintain their control in different ways:
Jack Ma - at the time of Alibaba’s IPO only held 8.9% of the company’s shares. In fact, SoftBank (34%) and Yahoo (22%) have signed an agreement to transfer part of their shares to Jack Ma. A partnership system was also established where board members are nominated by partners and voted by shareholders. Therefore, the control of the company was actually in the hands of a team of partners led by Jack Ma.
Examples include Element AI and other extreme cases where investors have acquired the control of the companies and taken away the interests of the founders.
What control means
In most cases, founder’s shares will be diluted when more investments come in. In other cases, founders are forced to step down from the CEO’s post.
The ownership control embodies three levels:
- Voting rights of the shareholders
- Veto rights of shareholders
- Seats on the board
Demonstration of dynamics of corporate control by a fictitious case
Let’s go through a fictitious example to decompose how the company’s control develops and evolves through various stages.
Founding Stage: David is developing a new internet delivery app and wanted to commercialize it. Mike, a marketing expert agrees to help David in his venture. They agreed to split the shares 50% for David and 40% for Mile, with 10% remaining for employee share option pool. Both David and mike are directors of the company.
At this stage, founders have absolute control.
Angel investment: David contacted some angel investors, and one of them agreed to invest $500,000 at a post-money value of $2.5MM to obtain 20% of the common stock. No board seats are required, but the angel investor required a right of first refusal and veto right for certain things of the company, including the increase of authorized number of ESOP option shares and new round of financing.
At this stage, David and Mike (together owning 72% of the shares) still have control over the company. However, should the angel investor be given the above rights? When negotiating this term, try to avoid it as much as possible. If the investor insists, give the rights to the angel investors as a group instead of giving it to the investor alone.
Shortly after the angel investment, Mike decided to quit and sell all his shares. According to founders agreement, the company can purchase back half of Mike’s shares at nominal price. For the rest 50%, by exercising its right of first refusal, the angel investor purchased the full remaining 50%. After that, the investor appointed one director to the board. The board now comprises of 2 directors, including Mike and a representative of the angel investor,
At this stage, David and angel investor have equal ownership. David is gradually losing control over the company. In hindsight, what could David have done to avoid losing control?
- Give Mike less ownership at the founding stage
- Establish a longer vesting schedule for Mike
- Avoid giving investor ROFR or give ROFR to all shareholders
After Mike’s departure, David found another co-founder, Jack, and gave all authorized option shares to Jack.
At this stage, ownership does not change from before. When new founders join, David can consider the following arrangements:
- A longer vesting schedule
- Voting trust
A VC has given David a term sheet for $5MM investment at post-money value of $25MM with the following terms: 1. 20% ESOP; 2. Liquidation preference; 3. Participating right; 4. Drag-along triggered by 51% approval; 5. David and Jack’s shares subject to a new vesting schedule of 3 years; 6. 1 board seat and 7. Veto rights on a number of company affairs, including issuance of new preferred shares.
At this stage, the company is controlled by investors. If David agrees to the above terms, David will have no control over the company because his ownership will be diluted to 29% and will hold only 1/3 of the board seats. To avoid this situation, David can consider counter-offering 10% ESOP instead of 20% and bringing in an independent director to balance the board seats.
The business went well and attracted the attention of an internet giant. The internet giant proposed to acquire the company at a value of $20MM. David rejected the offer, however, the board of shareholders representing a majority of the votes decide to take the offer, and fired David and Jack. According to the vesting schedule, the company purchased back 2/3 of the shares owned by David and Jack at nominal price prior to closing.
At this final stage, David loses all his control and walks away with only $2MM. What could David have done to maintain his control?
- keep more shares to himself initially
- Better vesting schedule for co-founders
- Better ROFR clause
- Proactive consideration of ESOP
- Voting trust for employee shareholders
- Control board seats up to A-round
- Be careful in giving veto rights to investors
- Higher threshold for drag-along rights
- Careful in granting participating rights to investors
- May consider super-voting shares
Q: In the case of founder departure where the founder has earned vested shares, what’s a reasonable price for the company to repurchase?
A: Typically, the market price is to be used, but generally the agreement will stipulate that the board of directors will determine the market value, or how the market value should be determined. Sometimes, an appraisal will be performed by an appraiser.
Q: Under what circumstances is it appropriate for David to consider setting up super voting rights for himself?
A: This depends on the founders; if the investor does not agree to super voting rights, the founder has to change it back. So consider super voting rights if you the founder is confident that the company cannot thrive without you.
Q: Regarding the employee option pool, my understanding is that when key employees join the company, the company will component the employees with some options. Can the options ne taken back?
A: The options can only be exercised upon vesting, if you leave before vesting, the corresponding options will be cancelled. If you have vested, you can exercise the right to obtain the company’s shares, and the company can only repurchase them back at the market price unless otherwise agreed.
Q: If the term sheet states that a M&A needs approval from at least 51% of the shareholders and the law requires 2/3, can the term sheet overrule the law?
A: The term sheet is an agreement used to force the opposition shareholders to vote in accordance with the terms of the agreement, thereby satisfying the legal requirements.