Guest post by Seth Gottlieb, Partner, Cooley LLP
Very often founders raise the concern about protecting against dilution. Specifically, they are concerned that, as they grow their business and issue stock to investors, employees, and advisors, their shares, and therefore their voting power, will be diluted. They want to know how they can protect themselves, and their company, from losing control. Often, this conversation leads to “Super Voting Common Stock.”
The basic structure is for the common stockholders, or a group of holders (e.g. founders), to receive a separate class of shares that have multiple votes per share. The number of votes per share can range from 2 to infinity, but the most common is 10 votes per share. To illustrate, take the following simple cap table:
|Key Employee 1||50||5%|
|Key Employee 2||50||5%|
|All other employees||700||70%|
In the example above, while the founders have 30% of the company, a sizable position by any standard, that is not enough to control any stockholder vote. While they could put voting agreements and drag alongs in place, those are tricky and no employee friendly founder wants to enforce those agreements. With Super Voting Common, Founder 1 and Founder 2 can issue themselves, when they form the company, Class B Common Stock, each of which has 10 votes per share. All other employees and service providers will get Class A Common Stock, with 1 vote per share. This is commonly referred to as a “dual class” common stock structure. So, while the outstanding cap table, and everyone’s share of the economics, looks like it does above, the voting power, will look like this:
|Votes||% Voting Power|
|Key Employee 1||50||1.32%|
|Key Employee 2||50||1.32%|
|All other employees||700||18.42%|
Seems great, right? With this structure, the founders can maintain control while still giving equity to employees. The challenge arises when the time comes to raise money, especially from VCs and other institutional investors. If things are going well, investors will put up with a high valuation and other company-friendly terms. But early on, history shows that they are unlikely to invest in a structure where one or two unproven founders completely control the company’s destiny. As a result, we often see dual-class common stock structures unwound when the first round of VC financing comes in. Moreover, having this structure in place in an early stage company may scare off investors who don’t want to battle with what they may, rightly or wrongly, think is an arrogant founding team. There are of course exceptions to this, typically with proven, repeat entrepreneurs who have one or two “hits” behind them. When advising founders, we usually walk them through this scenario and the end result is that very few companies implement dual class stock structures when they are formed.
Right now you are probably thinking, but what about Facebook, Google, Snap, Zynga, Yelp!, Tableau, Workday, Pure Storage, and a whole host of other companies that have dual, and in some cases multi, class stock structures? With few exceptions, those structures are implemented later in the company’s lifecycle. After the company has become successful and the founding team has proven themselves to be the “visionaries” they are, investors may be more than willing, perhaps even enthusiastic, to implement a dual class structure.
The most common way to implement a dual class structure is to do so in advance of an IPO, sometimes a year or so before, but very often days before. The “super voting” shares are given to all pre-IPO holders and the “single” vote shares are sold to the public in the IPO. When pre-IPO holders start selling their shares to the public, those shares automatically convert from Class B (super vote) shares to Class A (single vote) shares. The result is that, as shares convert from high-vote to low-vote stock, the largest pre-IPO holders who do not sell shares after the IPO, will have their voting power go up, and thereby potentially control or significantly influence, any stockholder vote.
There are of course many flavors of multi class structures and, when implementing, the Board and management team should very carefully consider their fiduciary duties and the justification for the structure. While these structures can be great, they have also recently been the subject of significant investor scrutiny and stockholder litigation. So it is crucial that you consult experienced legal counsel before implementing a structure like this.
Seth Gottlieb, Partner, Cooley LLP
Palo Alto3175 Hanover Street
Palo Alto, California 94304-1130
+1 650 843 5864
What I do:
I counsel high growth companies throughout their lifecycle – from startup through acquisition or IPO and beyond. I love the fact that I can work with the most innovative companies in the world to help them solve their problems and reach their goals.