Board seats, voting rights and who controls a startup

Who controls a startup?

Control sits in the board of directors and in the votes of shareholders. The board makes the day-to-day decisions about strategy, hiring the chief executive and spending. Shareholders vote on the largest matters, such as changing the company's rules, issuing new shares or selling the company.

At the start the founders hold nearly all the shares and fill the board. Each funding round adds investors, and with them come seats, voting rights and consent rights. The founder's real control after a few rounds comes from the combination of these three, not from the share percentage alone. A founder with 25 per cent of the shares can still run the company in practice, if the board and the agreement allow it.

How are board seats usually shared?

A common pattern at seed is a board of three or less: two founders and one investor, or two founders and an independent. After a Series A, a board of five is typical: two founders, one or two investors and one independent director, who is a person not tied to either side. As rounds add more investors, boards often grow, but large boards slow decisions.

Under the Companies Act, 2013, a private company must have at least two directors, and a company can appoint up to fifteen without a special resolution. At least one director must have stayed in India for 182 days or more in a year. Investors get their seat through a nomination right in the shareholders' agreement, which says that a given investor can appoint and remove a named number of directors.

What is an observer seat?

An observer sits in board meetings, receives board papers and takes part in discussions, but does not vote. Smaller investors, or those who want to track a company without taking on the duties of a director, often take this seat.

Observers are useful for founders too, because the investor sees how decisions are made and can help. But an observer is not covered by the legal duties of a director, so companies usually have them sign a confidentiality agreement. Some companies also reserve the right to ask the observer to leave when privileged legal advice, or matters involving a conflict of interest, are discussed.

What are voting rights and how do preference shares vote?

Ordinary shares carry one vote each. Preference shares issued to investors, such as compulsorily convertible preference shares (CCPS), usually vote as if they had already converted into ordinary shares. Under the Companies Act, 2013, preference shareholders have more limited statutory voting rights on their own, but the shareholders' agreement can give them voting rights on specific matters, and conversion terms often decide the effective vote.

Some companies create shares with different voting rights, and for private companies that is allowed under the Companies Act, 2013, and the rules made under it. Listed companies have tighter limits: SEBI has permitted superior voting rights shares only in specific cases for technology companies before listing, with conditions. Details can change, so a lawyer should check the current position.

What are protective provisions, veto rights and drag-along?

Protective provisions, also called reserved matters or affirmative rights, are a list of decisions that need the investor's consent. Typical items are issuing new shares, changing the company's business, taking on debt above a limit, selling the company, paying dividends, changing the board size and approving the annual budget.

Even a small investor can hold these vetoes, which is why they matter more than the share percentage. Founders should read the list carefully. A long list slows the company because every item needs approval. A good practice is to set sensible money thresholds, so day-to-day spending does not need consent, and to tie the vetoes to investors who hold a minimum stake.

Two more clauses affect control in a sale. A drag-along lets a group of large shareholders force the others to sell on the same terms, so that a buyer can purchase the whole company. A tag-along gives smaller shareholders the right to join a sale by a large holder on the same terms.

Founders should check who can trigger a drag-along and at what minimum price. A drag-along held by investors alone could force founders to sell below the price they want.

What happens when founders and investors disagree?

The agreement should say how deadlocks are broken. Typical tools include escalation to the chairperson, mediation, and, in a serious case, a right for one side to buy out the other. Some agreements allow investors to force a sale of the company after a number of years if no exit has happened, which is called a drag-along right.

Another tool is the right to remove a founder as chief executive. This is usually limited to cases such as fraud, serious breach or a long failure to meet agreed goals, but its wording is a common point of dispute. Several Indian startups have seen public boardroom fights, so founders are wise to read these clauses with care.

What is the role of an independent director?

An independent director is a board member who has no financial or family tie to the company's founders or investors. Their job is to give fair views, particularly in a dispute. For a startup, a trusted independent can be the person who breaks a tie between founders and investors.

Under the Companies Act, 2013, some public companies must have independent directors, and listed companies must have them too. A private startup does not have to, but investors increasingly ask for one at Series A or B, and especially before an IPO, when the rules for listed companies come into view.

How should founders protect themselves?

Keep the board small and balanced. Negotiate the veto list and set clear thresholds. Make sure the founders can still appoint a majority of directors, or at least keep a deciding vote, until a later round. Understand what will change at an IPO, when most special rights are removed and the company follows the rules for listed companies.

This guide is general information. The Companies Act, 2013, and SEBI listing rules change from time to time. Please check with a lawyer or company secretary before agreeing to any control terms.

How does control change at an IPO?

Going public changes the rules of control. A listed company must follow SEBI's listing rules, which set requirements for the share of independent directors on the board, audit and nomination committees, and approval of related-party deals. Investor vetoes are mostly dropped, and the articles of association are rewritten.

Founders usually keep the right to be named as promoters, which carries duties and a lock-in on their shares. Investors who stay on the register after listing hold shares like any other holder, and may keep a board seat only if the company and shareholders agree under the listed-company rules. So a founder who gave wide vetoes in private rounds often finds the control picture simpler after listing.

Read next

• The term sheet, clause by clause
• What is a cap table?
• What is Series A funding? A guide for Indian startups
• Liquidation preference, explained with numbers
• Co-founders and how to split equity