5 founder-friendly financing terms that give power to entrepreneurs

In the first half of this year, the level of venture-capital investment hit its highest quarterly mark since Q2 2001. Big M&A deals like WhatsApp, Oculus and Zillow have become prolific. And more and more companies are getting financing at eye-popping valuations.

For many startups, the hot venture-capital and exit markets mean an increase in deal leverage when negotiating with venture investors. [Editor’s note: Venture capitalists have noticed, and are trying to differentiate themselves.] As a result, founder-favorable terms are increasingly a part of formation and financing documents where they wouldn’t have been just a year or two ago.

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The are several founder-favorable terms we’re seeing more frequently today. Not many companies or deals have all, or even most, of them. And choosing among them is usually linked to founders’ specific hot buttons. Regardless, all are worth considering, and often worth considering early.

1. Retain control: Supervoting Stock

What it is: “Supervoting stock” allows founders to maintain control as stockholders throughout the life of the company, even as their ownership is diluted. To implement supervoting stock, the company will typically establish two classes of common stock, Class A and Class B. Class A common stock will carry multiple votes (usually 10-20, sometimes more) per share on all matters in which shareholders are required to vote, as compared to Class B which will carry one vote per share. Founders will be the sole owners of the Class A supervoting stock, and Class B common stock will be reserved for issuance under the company’s option plan to the rank and file. Setting up supervoting will ensure that founders will be able to retain a greater level of control over their company over a longer period of time.

Additional considerations: Supervoting stock only works if founders have enough leverage to negotiate for its survival at each round of financing. If the founders are confident they can maintain that kind of leverage, then supervoting stock may make sense for a startup. It may, however, come at a price down the road on an IPO, since public-market investors can impose a discount on the “inferior” Class B stock that gets issued when a company goes public.

When to implement: Supervoting stock should be implemented at formation. If the founders choose to adopt supervoting stock after formation, all then-current common stockholders will be entitled to receive supervoting stock, or must voluntarily elect to convert their supervoting stock into non-supervoting stock in exchange for something in return. This voluntary conversion may be difficult to accomplish and is, in any event, suboptimal from the founders’ standpoint.

2. Alternative: Supervoting at the Board Level

What it is: Supervoting at the board level means that the board seats held by the common stockholders get a multiple (e.g., 2-5 times) on their votes. As a result, the common director designated by the common stockholders will have control over major board actions, such as effecting M&A transactions or creating new classes of stock in future financings.

Additional considerations: Supervoting at the board level achieves a similar result as supervoting stock—the founders retain greater control—but it is less direct: The common holders control the board, but they don’t have greater control at the stockholder level. Importantly, board members owe fiduciary duties to the company stockholders that stockholders don’t. This means that the common directors voting at the board level could theoretically be forced to vote against their own interests as individual stockholders, if so doing would be in the best interests of the company. Notwithstanding that fact, supervoting at the board level ensures that founders will have substantial say in all major corporate decisions.

When to implement: A major advantage of supervoting at the board level is that founders don’t have to implement it at formation. Founders can choose to amend their charter after formation to implement board-level supervoting, for example, at the time of a financing when they add directors and lose numerical majority status on the board.

3. Early Liquidity: FF Preferred Stock

What it is: FF Preferred Stock is stock issued to founders that acts like common stock, except that it has a special conversion feature allowing it to be “cashed out” prior to acquisition or IPO, when founders would otherwise normally get liquidity. Here’s how it works: the company issues a portion (usually 10 to 33 percent) of a founder’s total equity as FF Preferred Stock. The FF Preferred’s conversion feature allows it to be exchanged into Preferred Stock in a future round of financing at the time, and at the price, at which that Preferred Stock is issued. Practically speaking, when a venture capitalist makes an investment in the company, the VC can buy FF Preferred from the founders as part of its total venture investment, and the FF Preferred will automatically convert into that series of Preferred Stock. The VC gets its preferred equity, and the Founder gets early partial liquidity. The FF Preferred model is also less dilutive to the founders than if the VC purchased all of its shares from the company.

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Other considerations: Any time a founder sells shares to gain liquidity, there are tax consequences both to him as an individual and to the company. Other ways of getting liquidity, such as selling common stock directly to investors, can have negative tax implications, and also may affect the price at which company options are issued. In addition, if a founder sells common stock directly to an investor, the delta between the sale price and the then current fair market value of the common stock is usually treated as ordinary income. By contrast, with FF Preferred Stock, a founder who has held his shares for more than one year may be able to take advantage of more favorable capital gains treatment on that delta, without implicating Company option pricing.

When to implement: Practically speaking, FF Preferred Stock must be implemented at formation.

4. Limit the VC’s Control: Voting Control

What it is: Over time, we’ve noticed that more and more companies are unwilling to provide investors some of the protective voting provisions that have historically been standard to give, such as voting blocks on acquisitions and on future equity financings. By eliminating these voting-control provisions, companies give founders the freedom to dictate when and whether the company sells or raises capital. VCs will always receive some protections in their investment documents, but these provisions are increasingly limited to preserving negotiated-for rights of the investors, such as the Preferred Stock liquidation preference or the right to elect a director.

Alternative construction: Rather than eliminating protective provisions during financings, which in many cases is not feasible, founders can achieve “negative” control by writing in mirror-image protective provisions for common stock. The holders of preferred stock receive voting blocks for M&A events or future equity financings, but the common holders also enjoy these same voting blocks. This means the investors and founders must be in lock-step on all major corporate actions.

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When to implement: Protective voting provisions will be negotiated during each round of financing with each new investor.

5. Greater Ownership: Aggressive Founder Vesting

What it is: Increasingly, founders are able to maintain aggressive provisions on founder vesting. Instead of the “4-year vesting with a one-year-cliff” paradigm that has long been the norm for Silicon Valley startups, some founders have vesting provisions that give them full vesting in three years (or less), often without a vesting “cliff.” These aggressive vesting schedules are usually coupled with partial acceleration on certain events such as changes in control or involuntary terminations without cause. We’re seeing implementations of founder-favorable vesting / acceleration regimes during seed and angel rounds where investors are less concerned with founder vesting and are inclined to punt on these issues until the next (larger) round of financing.

Other considerations: In most cases, founders should take care not to be overly aggressive with vesting and acceleration, since doing so is likely to increase the chances an investor will want to renegotiate a founder’s compensation arrangement entirely at the time of financing. When we set up companies, we advise them as to the range of possibilities on vesting and acceleration but try to end up somewhere within market, even if on the pro-founder end of the spectrum.

When to implement: Founder vesting should be implemented at formation if there are multiple founders and, in any event, prior to a financing round.

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Caine Moss, a partner in Goodwin Procter‘s Technology Companies Group, has significant experience working with software, telecommunications, Internet, and financial services companies through all stages of their growth. In addition, he has broad transactional expertise, particularly in the areas of venture capital, public and private mergers and acquisitions, and representation of issuers and underwriters in public equity offerings. He is a key contributor to Goodwin Procter’s Founders Workbench, an online resource for startups, emerging companies and the entrepreneurial community.

Emma Mann-Meginniss is an associate in the Goodwin Procter’s Business Law Department and a member of its Technology & Life Sciences Group. She advises founder, company, and investor clients on a variety of corporate and transactional matters, including formations, financings, investments, and mergers and acquisitions.