Rights of Owners
As discussed in the previous lecture, control and ownership are separate concepts in a business ventures. Control, itself, is a right that may be bestowed unto owners. Control is generally determined by the type of entity and the position held in that entity. For example, a partner is assumed to have extensive control in a partnership, while a shareholder in a corporation is presumed to have little or no control over the organization. The issue of control is addressed further in our Startup Legal Resources Library.
Ownership in a business entity generally entails two rights:
- entitlement to profits of the business, and
- voting rights for business decision-makers.
Entitlement to Profits
In a startup venture, any potential profits are generally reinvested in the business in order to obtain a higher level of growth. The reinvested profits ultimately produce a higher return on investment at the point of sale (exit). Equity investors understand this principle and expect the business to lose money during the initial period of growth (generally 3-5 years). Owners and new employees must be made aware of this aspect of the startup venture. Perhaps a co-founder who is less familiar with the principles of growth-based entrepreneurship or a new employee who acquires an equity interest in the business may not understand why the business reinvests every penny of potential profit and, generally, reports a significant loss during the early years. These team members should me made to understand early on the nature of the business and the fact that there should be no expectation of distribution of profits during the business’ growth phase.
Equity owners of a business generally have a right to vote for the board or members of the business who will be in charge of decision-making. In a corporation, the shareholders vote for the board of directors that is vested with the major decision-making of the business. In an LLC or Partnership, each member has the ability to vote in accordance with the terms of the LLC or partnership agreement. This situation primarily becomes an issue when outside equity investors (angel investors or venture capitalists) wish to exercise control over the business. This is an understandable position for the equity investor, who wishes to protect his or her investment. For this reason, it is important to establish early on the voting and decision-making authority of equity owners. One way of limiting the voting rights of equity investors is to assume a corporate entity status and to issue outside investors alternative types of ownership interests. For example, the business may provide equity investors with preferred stock that has no voting rights, but has some other preferential treatment (such as priority in the payment of dividends or the ability to convert the ownership interest to debt). In any event, co-owners may have varying degrees of understanding of their ability to control business decision-making through their voting rights. Planning accordingly, through the issuance of ownership and detailed ownership agreements, will prevent issues of voting rights from becoming a point of contention in the business.