Fast-growing private companies are exciting to observe as outsiders, but on the inside the company founder has the challenge of securing enough capital to fuel the rapid growth of the business. The company’s continuous need for capital places the founder in the position of having to manage the company’s operations while at the same time engaging in perpetual fundraising efforts. And as new investors come on board, the founder will face significant pressure to cede control and also to reduce the founder’s ownership interest in the company because the equity that the new investors are acquiring in the business have to come from somewhere – namely, out of the founder’s hard-earned ownership interest. 

This is the founder’s dilemma: how to grow the business in way that does not require the founder to say goodbye to control of the “baby” the founder has birthed and grown? This post reviews a game plan that is designed to help founders thread this needle successfully in growing their businesses. At a minimum, founders should take proactive steps that prevent them from being kicked to the curb by new investors who seek to leave them with little to show for their efforts.

How Fast to Go – Haste May Not Be the Founder’s Friend

The pace at which the company grows is one of the founder’s most vexing challenges. On one hand, growing the company quickly creates energy and excitement, which brings momentum that will help keep the company ahead of its competitors. On the other hand, a fast growth rate is what generates the need for the founder to secure more capital than the business can produce on its own. But when the founder secures new investors to provide this additional capital, not only will it dilute the founder’s ownership stake, but the new investors may also seek to remove or substantially limit the founder’s control over the business at some point, including by terminating the founder’s status as both an officer and employee.

To avoid conflicts with investors, the founder may want to consider growing the business at a slower rate. If the founder adopts a more moderate rate of growth for the business, this may enable the company to cover the cost of its expansion from its own earnings or from third-party debt financings rather than from equity investments. The loans that the founder obtains will have to be paid back, of course, but banks and other lenders may be better business partners than new investors because lenders do not tell the company founder how to run the company or seek to remove the founder from the business. The cost of capital is frequently a determining factor when a found decides between debt and equity financing, in addition to whether or not the company then satisfies a lender’s credit requirements.

In short, founders need to weigh the pros and cons of a rapid growth strategy. Both approaches carry some amount of risk, because growing the company at a slow pace may cause it to fall behind other competitors in the marketplace. But if a slow growth approach does not harm the company’s business prospects, this approach may avoid the need for the founder to obtain new investors and new capital, and this will, in turn, allow the founder to maintain control over the company throughout its growth cycle. 

Don’t Get Bitten by the Helping Hand – Maintaining Control Is Key

The founder’s ability to secure new investments can seem like a godsend at the time, but the new investors may turn out to be wolves in sheep’s clothing. Investors who provide growth capital do so with the clear expectation of securing a very substantial return on their investment. Therefore, if the company does not perform as expected, or fails to generate returns as quickly as desired, the investors may turn on the founder. In their minds, this is just the nature of business, and they will exercise their power to replace the founder with a president/CEO they consider more capable of delivering the financial results they are seeking. 

There is no free lunch for founders, and sophisticated investors will not provide capital to purchase an interest in a private company without securing the rights to exercise some measure of control over the business. But the founder, to the extent it is possible in the negotiations with new investors, should limit the terms demanded by these investors to avoid what amounts to immediately turning over the keys to the castle. The devil is in the details, but the following are some critical parameters:

• Veto Rights – The founder’s ownership percentage in the company will likely be reduced as new investors purchase interests in the company, but the founder should retain voting rights that prevent certain key actions without the founder’s approval. This may require the company to agree that unanimous consent is required for certain actions, which gives the founder a veto right to approve/reject these actions. Some examples of the types of veto rights the founder should seek to obtain may include the right to approve the sale of the business, material changes being made to the company’s governance document, the issuance of new shares/units, removing a director or manager, or expanding the size of the board.
• Board Seats – Regardless of the ownership percentage held by the founder in the company, the founder should be permitted to serve on the board or as a manager of the business. In addition, the founder may insist on being able to appoint at least one other board member or manager to serve on the board regardless of the amount of equity that is held by the founder in the company. This may not place the founder in control, but it will give the founder another, hopefully persuasive, voice at the table involved in the decision-making process by the board.
• Governance – When new investors join the company, the founder may want to require that the business operate with a greater degree of formality. For example, the founder may want to require that board meetings be held regularly/frequently to ensure that everyone is on the same page as to how the business is performing. In addition, the founder may want to preclude the board from taking actions by less than unanimous written consent. This will require all decisions by the board to take place at actual meetings or by unanimous written consent rather than behind the scenes without the opportunity for the founder to participate.

The provisions discussed above will provide the founder with protections when new investors join the business. These are subject to negotiation with the investors, and investors may not choose to go forward in making the investment if they determine that the rights that they are obtaining are too limited. That may be a good thing, however, because new investors who show no deference to or confidence in the founder at the outset may be signaling that the founder will be on a short leash and subject to quick replacement.

When Forced to Say Goodbye, Make Sure It Counts (in Dollars and Cents)

The final critical issue the founder needs to address when new investors come into the company is the status of the founder’s continued ownership in the business. Investors may insist on being granted the right to remove the founder as CEO/president as a condition of making the investment. The founder may agree to accept this condition to secure the investment, but if the investors do exercise this right at some point in the future, the founder needs to ensure that the termination takes place in a way that enables the founder to realize at least some portion of the value that the founder has created in the business.

Specifically, the worst case scenario for a founder is to be removed from the company without receiving any payment and then be left on the sidelines hoping for some future liquidity event that pays the founder something for his or her ownership interest in the business. This dire situation can be avoided, however, if the founder insists on securing an employment agreement or requiring the company to adopt binding provisions that protect the founder’s interest when the new investors make their investment. Here are some specific protections for founders to consider:

• Termination – The founder can insist that his or her removal can only take place on a showing of cause, i.e., improper conduct. Alternatively, if the founder does agree to be removed by new investors without cause, that type of removal should trigger the payment of a substantial severance payment to the founder. The founder may agree to serve in a consulting role after termination, but these terms will need to be spelled out, including the founder’s new duties and compensation rights.
• Put Right – In addition to the severance payment, if the founder is removed without cause by the new investors, the founder needs to be permitted to sell some or all of the founder’s otherwise illiquid equity in the company at a price that is determined by a formal process the parties agree to in advance.
• Noncompetition Restrictions – The company and the new investors may insist that the founder be subject to a noncompete restriction after termination. This may be acceptable to the founder if the company makes a substantial severance payment to the founder at the time of termination, along with purchasing all the equity held by the founder. But if the severance payment is modest and the founder does not receive a full buyout of all equity, the founder will want to narrow the scope of the noncompete restriction as much as possible to permit the founder to pursue other, possibly competing, opportunities after the termination takes effect. 

Conclusion

Company founders seem to be faced with a no-win choice: They need to bring in new investors to provide funds that fuel the rapid growth of their business, but securing this influx of capital puts them in a danger zone. The founder may have to cede control over the business to the new investors who later decide to remove the founder from the business when they become displeased by the company’s performance. There is a win-win structure available here, however, that strikes a balance between the new investors’ goals and the founder’s objective of staying active in the business or in providing for an exit on favorable terms.

This game plan for the funder has a number of components, but the goal is to permit the founder to retain some measure of continued control over major decisions by the company. To secure the new investment, the founder may need to grant investors with the ultimate right to terminate the founder’s employment in the future. But the founder should negotiate to include a provision providing that, if this right is exercised, the founder will receive a severance payment and obtain a buyout upon exit of the founder’s interest in the company (at least in part). The takeaway is that the founder who secures additional capital is doing right by the business, but the founder also needs to look out for No. 1. When new investors are brought into the company, the founder needs to insist on including terms that, in the event of the founder’s ouster, provide a reasonable return for the blood, sweat and tears the founder has devoted to the business.

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