Veto Rights – Meaning and its Importance

The process of negotiations between startup companies and investors is often hotly debated and contested. There are several points of contention between the two parties. However, the two parties are often able to reconcile most of their differences. However, when it comes to controlling of the startup firm, both the startup founders as well as prospective investors tend to take an aggressive stance. Both parties want to retain as much control of the startup firm as possible.

The concept of veto rights is often used by investors to gain some control over the startup firm. In this article, we will try to understand what veto rights are and how these rights affect the interests of all the parties involved.

What are Veto Rights?

In any company, the decisions related to the company are taken based on a majority vote. Hence, in the case of startups, this would mean that the party which has 51% of the vote will be in control of the decision-making. The other parties cannot unilaterally stop a decision if 51% of the shareholders back it. This is considered to be problematic from an investor’s point of view.

It is common for investors to have 10% or 25% voting power in a company. Hence, in most cases, their opinions will have no bearing on the decisions being taken by the government.

This is where the concept of veto rights comes into play. Veto rights are a legal arrangement that does not allow the investors to unilaterally take decisions on behalf of the majority shareholders. However, at the same time, they allow the minority shareholders to unilaterally prevent the implementation of any decision made by the majority stakeholder. Hence, even if an investor controls 10% of the shareholding, they can prevent the decision being taken by the other 90% from being implemented.

This is the reason that investors are keen on obtaining these rights as a part of their investment agreement. However, at the same time, founders are skeptical about signing away these rights.

Importance of Veto Rights

From an investor’s point of view, veto rights can be considered to be very important. In the absence of these veto rights, they would have very little information and control over their investments. Normally, investors have no interest in interfering with the day-to-day operations of the firm. Instead, the investors are more concerned about managing events that are outside the normal course of business.

For instance, if the founders decide to take the second round of funding at a lower valuation then the decision also impacts the existing investors. Similarly, if the startup founder wants to drastically increase the size of the option pool by diluting the shares of the current investors, then also the current investors are impacted.

These investors want to have a defense mechanism ready to protect them in such special cases. Interference in day-to-day operations would create chaos in the startup company and would end up being a lose-lose proposition for both parties.

Types of Veto Rights

Almost no startup founder would be willing to give away complete veto rights. This means that they cannot allow investors to use veto rights against every decision. Hence, a legal setup is created in which the investor can use their veto rights only in the case of certain decisions.

1. Reserved Veto Rights: A list of certain types of issues is agreed upon between the founders and the investors. These issues are called reserved issues. Hence, startup founders need to take the approval of the investors only on these issues. In case of regular issues, the co-founders can continue taking decisions independently.

   The list of these issues is generally restricted to topics that directly impact the valuation and dilution of existing shares. Founders also try to ensure that the veto rights are provided to all groups of investors. If only a certain group of investors has veto rights, they can hold the startup company hostage to special interests.

2. Exit Veto Rights: It is possible to provide exit veto rights to only a certain group of investors. Hence, they cannot use their veto rights for any other purposes. However, if they feel that the founder is selling their shares at a lower valuation or to a hostile party, then they can use their exit veto rights.

   It is also common for investors with the highest purchase price to receive such veto rights. This is because the other shareholders may be willing to sell the company since they receive a higher return even at a lower price.

3. Waiver Veto Rights: Waiver veto rights are the opposite of normal veto rights. In the normal scenario, the decision is made by the majority shareholders and the minority can reject this decision. However, when waiver veto rights are given, the majority shareholders waive off their rights to make decisions about certain matters.

   These rights lie only with the minority shareholders who may be the beneficiary of such clauses. Founders are often not comfortable providing waiver veto rights. These rights are only provided if the investors have a commanding bargaining position and the founder has very few options.

However, the bottom line is that veto powers provide very important legal rights to minority investors. Hence, these powers are highly valued by investors. Companies can expect their valuation to be raised significantly if they are willing to provide veto powers to the investors.