Voting rights is a governance term, which means it relates to who has decision-making power in the startup.
On general matters, Series Seed investors vote on an “as-converted basis.” For the purposes of voting on general matters, the preferred shares are treated as if they are converted into common shares for vote tallying purposes, but no actual conversion occurs. Assuming a 1:1 conversion rate, that means that on most matters, investors have no more power than founders. Each of their shares carry the same weight, so their votes are all equal.
For example, if an investor has 30K preferred shares and the founders collectively have 70K common shares, for the purpose of voting on general matters, the 1:1 conversion ratio would give the investor 30% voting power and the founders 70%. The number of preferred shares is deemed converted simply for the purpose of calculating the quantity of votes. This would not affect other specially negotiated rights of the preferred shares.
Matters Requiring Investor Approval
While most seed stage investors respect the founding team and would not want to interfere with the daily operations of the startup, there are certain decisions that are so essential to the value of their investment that investors insist on approving them. The term sheet highlights a list of issues ((i)–(vii)), which require the approval of a majority of investors.
Since most seed stage investors own around 20-25% of the startup, it is unlikely that they would be able to influence the majority when voting on an as-converted basis. Instead of gaining more equity and potentially demotivating the entrepreneurs from running the company, the term sheet includes a set of issues that require approval from a majority of preferred shareholders. These issues mainly relate to corporate actions that could affect the value of the preferred shares (e.g., anti-dilution and protection of special rights negotiated). The major reason why investors are asking for the right to approve these issues is to protect their investment (i.e., the value of the preferred shares). The seven issues that are considered essential to protect their share value and justify the preferred status are discussed individually.
Approval of a majority of the Preferred Stock required to adversely change rights of the Preferred Stock
The company can’t change the terms of the preferred stock. Seed stage investors have spent a lot of time and effort to negotiate the rights attached to the preferred shares, and the shares are valued accordingly. Similarly, the entrepreneur has also gone through a lengthy process of evaluation to decide how much of the startup he or she is willing to give up for a specific amount of investment. The negotiations and the details of the rights represent agreement after formal negotiations. Changing these rights would affect the value of the preferred shares, thus, it is understandable that the investors want to protect these rights. Requiring a majority of preferred shares to approve adverse changes to the preferred shares prevent the entrepreneurs from changing these rights without approval.
Approval of a majority of the Preferred Stock required to change the authorized number of shares
The company can’t change the number of total shares authorized. Increasing the authorized number of shares will dilute the shareholder ownership and reduce the value of each share. Take the example where an investor owns 20% of your company with a total of 10 million authorized shares. The entrepreneurs may issue 5 million new shares for themselves after the investment and the investor would only own 13% (2 million/15 million) of the company after the issue. This would significantly reduce the value of the preferred shares. Originally, the preferred share value was negotiated based on the value of the startup, so the investor paid a price based on the 20% value of the startup. Allowing a simple majority to approve the issue of new shares is equivalent to giving entrepreneurs the power to dilute the investor’s ownership. Thus, issuing new shares requires approval from a majority of preferred shareholders.
Approval of a majority of the Preferred Stock required to authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock
The company can’t give the same or better rights to other shareholders. Similar to changing the authorized number of shares, authorizing a new series of preferred shares senior to or on par with the existing preferred shares will decrease the economics and control for the investor. So, they don’t want that to happen without their approval.
Approval of a majority of the Preferred Stock required to redeem or repurchase any shares (other than pursuant to employee or consultant agreements)
Don’t buy back shares. Redeeming or repurchasing shares is another way to dilute an investor. Through redeeming or repurchasing shares from other shareholders (e.g., investors), the entrepreneurs are able to dilute the investor ownership and own more of the company than the investor would like. Redemption or repurchase of shares from employee or consultant agreements refer to shares from an option pool that are accounted for when the investment was made, which is excluded from the required approval.
Approval of a majority of the Preferred Stock required to declare or pay any dividend
Don’t pay out money to shareholders. Declaring or paying dividends is extremely rare for seed stage startups. This is because at seed stage, any capital the startup earns is expected to be reinvested into the company so the company can continue to grow and scale. Seed stage investors are not looking to make a return from dividend payments. Dividends are also not a tool for entrepreneurs to pay themselves a salary. Seed stage investors expect their investments to be used to grow and scale the company. They also expect any profits made to be reinvested into the development of the company. Thus, declaring or paying any dividend requires approval from a majority of preferred shareholders.
Approval of a majority of the Preferred Stock required to change the number of directors
Don’t change the board size. The board of directors is the highest level of legal authority in the company. It is responsible for making important corporate decisions, and there is a separate section in the term sheet that addresses the composition of the board. A change in the number of directors would alter the composition of the board and the required majority to pass a board decision. Most board decisions are passed by simple majority. This means that the influence an investor has through having one board seat on a three-person board can be very different to having one board seat on a five-person board. Therefore, the preferred shareholders would want to protect their negotiated rights through preventing a change in the number of directors.
Approval of a majority of the Preferred Stock required to liquidate or dissolve, including any change of control
Don’t shut down or sell the business. Having invested considerable time and money into a startup, it is understandable that the investors would want the ability to block an immature liquidation or dissolution of the startup. Liquidating and dissolving signifies a total loss of investment. The investor would want the ability to prevent such actions if there are other ways or directions that the entrepreneurs could take before giving up on the startup (e.g., selling to potential buyers at a loss). Furthermore, liquidation or dissolution would trigger the liquidation preferences that are a big part of the special rights negotiated. A change of control in the company typically refers to an acquisition of the company by another company. This is the moment that investors are waiting for: When the company sells, they make their money back. It’s not surprising that they would want to make sure that the company is getting the best acquisition deal.
In the Series Seed term sheet, the voting preference is as follows:
Voting Rights: Votes together with the Common Stock on all matters on an as‑converted basis. Approval of a majority of the Preferred Stock required to (i) adversely change rights of the Preferred Stock; (ii) change the authorized number of shares; (iii) authorize a new series of Preferred Stock having rights senior to or on parity with the Preferred Stock; (iv) redeem or repurchase any shares (other than pursuant to employee or consultant agreements); (v) declare or pay any dividend; (vi) change the number of directors; or (vii) liquidate or dissolve, including any change of control.
Thus, on general matters the investors vote along with the founders. However, on the matters (i)–(vii), a majority of the investors must approve in order for the company to take those actions.
You can find and read the whole guide on SEED funding here.