Carl Icahn. Daniel Loeb. Bill Ackerman. Your best friend’s super rich uncle?? Can that be a thing?!
Yes. And you too might unwittingly become the proud new owner of an activist angel investor who wants to micromanage your start-up company, or impose their will on management for no other reason than because they can. Beware, of the warning signs before it’s too late, or you may end up spending a ton of money on legal fees. Or worse yet, your company may fail through no fault of your own.
The most common way that a start-up can end up with an activist angel investor is by allowing one investor to gain a disproportionate amount of control within a class of shares. This is a real risk for you, and your other investors, if you primarily raised seed money through friends and family. More than likely you will have one key angel investor who invested 51% or more of the capital into the round. Controlling 51% of a share class means that investor controls the voting rights for that class, which can often include veto rights for operations.
When your best friend’s rich uncle believes in your start-up idea, you will find it difficult to turn down the investment, or ask for less money, so he doesn’t control the voting rights. But you have to if you want your company to survive. By having 2 to 3 investors who control the class together, you will have mitigated the risk of a single investor viewing himself as the sole proprietor because he put in the most money. If one person insists on having 51% control of a share class, you will need to stand your ground and at the very least, require them to take a seat on the Board of Directors, so they have to be a fiduciary.
Control Breeds Greed, Which Breeds Entitlement
The cascade of events from friendly investor to activist is not going to happen at once, but over the course of years. When you realize that you are dealing with an activist it will be too late to fix the problem, so it’s best to avoid it through prevention. The best vaccine for activist investor disease? Good cap table management and spreading control among as many investors as possible so that a consensus is required.
The following is a real world case study that nearly sank a growing company:
In 2011, a new company formed around the idea for a better product in the healthcare sector. The founders were seasoned experts in healthcare, and had proven success launching new products. During the seed funding capital raise, the founders met a “value added” investor. The term implies that the investor not only has money to invest, but can add greater value to the company by other means. In this case, the investor offered the company a license to a technology he invented that would enhance the company’s original product.
The founders knew the enhancement would give them a meaningful competitive advantage in the market. And the investor had enough capital available to make follow-on investments for working capital. The founders closed the investment. They also completed an exclusive license agreement with the investor, and the company secured the rights to the filed patent, and the right to develop and launch the new technology. The investor decided to make an investment of $1,000,000 in the company. Fourteen other investors, consisting of friends and family, invested $500,000. The company issued preferred shares for the seed round, and following the closing, one investor controlled 2/3 of the preferred shares. That meant that he controlled 100% of the voting rights for the class.
At first everything went well, and the company executed their strategy. The honeymoon period with new investors typically lasts a year, in my experience, before problems may arise. This company was no exception. Their strategy was to commercially launch the original product concept, while they perfected the new technology. Needing FDA approval on the new technology meant the company would need at least two years and more working capital to get the product to market. By launching the original product concept, the company could use revenues to offset R&D costs.
The management team’s strategy was successful and the FDA approved the new technology with only minor delays. The original key angel invested more money for working capital to insure success. The company had demonstrated growth with the original product, and generated more than $2,000,000 in sales. All the hard work was completed, and the investor’s technology was ready for the market. That is when the wheels started to fall off. The angel became the devil overnight, and the management never saw it coming.
The investor hired a lawyer and found clauses in the original Seed Round voting agreement that gave him operational control over key decisions — including the ability to raise additional outside investment. He decided to exert his control, despite never doing so up to that point. He understood that owning 2/3 of the Seed Round shares meant that he could act as the sole decision maker for the company, and essentially become a “super board.” The actual Board of Directors became meaningless. The investor had never accepted a longstanding invitation to join the Board, instead choosing to stay as a board observer so that he would not have to act as a fiduciary. Not being a fiduciary resulted in him being able to act in his own self-interest at the expense of the other shareholders.
He began to make comments to anyone who would listen about “ineffective management”, despite their generating strong sales growth, and gaining FDA approval for the technology he invented. His end-game was to commit corporate grand theft. He planned on accomplishing this by strangling the company and not allowing them to close on a Series A round. He confided in people that he wanted to kill the company, so he could repatriate the product license and start a new company where he was the sole owner. He actively blocked management’s efforts to bring in new outside investment in a Series A round, and hired a lawyer to threaten cancellation of the original license agreement for the technology.
These events would have been a disaster for the company, and the other 14 shareholders, if the activist angel was successful — but he didn’t fully assess the battlefield before starting the war. He didn’t understand that the company owned the other necessary assets related to the technology — including machinery, tooling, and the FDA approval. These assets were essential for him to start a new company, and he couldn’t cancel the license and start a company without them.
As a result, he adopted an entitlement strategy as a back-up. He and his lawyer claimed that since he invested the most money of anyone, he had a right to all assets since he “paid for them.” They intentionally didn’t recognize that 14 other investors also put money into the company, and the original product had generated more than $2,000,000 in revenue contribution. By taking this strategy, the investor overplayed his hand. It’s illegal for a shareholder to try to seize assets from a company they invested in for any reason. Investor status does not give someone the same standing as a creditor. In this case, the shareholder claimed that his equity value had decreased, despite the company having secured a Series A term sheet for a valuation that was triple the valuation of the seed round, and because of that, the company owed him. What he was attempting was the equal to an AT&T shareholder going into a retail store and saying the store owes them an iPhone for free because they lost $1,000 in stock value. That is not ethical, and typical public company investors would never imagine doing that.
The company used the investor’s plan against him, and ultimately negotiated a cashless deal for him to take back his technology and the assets he needed to start a new company in exchange for him surrendering 100% of his equity. The company was already entrenched in the market with the original product, and achieving strong sales growth. Completing a cashless transaction to eject the activist investor from their cap table was the best outcome for the rest of the shareholders. The company survived a near-death experience. Even successful companies can become subject to irrational investor attacks, and all shareholders will feel the impact — especially if the company has to shut down.
Warning Signs You are at Risk for an Activist Angel Investor
- A single investor owns at least 51% of any class of shares, meaning they control the voting agreement and veto rights
- The investor with control refuses to accept an invitation to join the Board, meaning they do not have to vote for decisions that maximize value for all shareholders, and can act in their own self-interest
- The investor speaks negatively about management, even though results are good
- They hire a lawyer to engage with management even after they have signed they signed the investment and voting agreements, so they can assert more control
- The investor withholds follow-on working capital investment unless the company gives him more control, or more veto rights
Company Action Items
- Never allow a single investor to control 51% or more of a share class
- Spread the decision-making and veto rights among 3 or more investors so that you can insure against self-dealing
- Insist that your larger investors join the Board of Directors; force them to be a fiduciary
If you are unsuccessful at managing your cap table and board composition, you are increasing risk for your shareholders. Founders need to take every precaution they can, and consider not accepting an investment if alarm bells are ringing. You might want to believe that you can manage the relationship with your key angel, and thus accept the higher risk investment. You should only accept the money if you recognize the risk, and your other investors are all willing to accept the risk too. With start-up companies, investors have nowhere to place blame for any problems, except with founders / management. Protect yourself and get written acknowledgment of the risk from all your smaller investors if one investor insists on being the “big dog.” It could save you later should an investor decide to take legal again against the founders because of a failure to disclose a risk that another investor might behave badly.