The veto in shareholder agreements
One of the most discussed points in shareholder agreements is the way in which certain types of agreements, commonly known as reserved matters, are adopted.
This includes aspects such as the extent and typology of such reserved matters, quorums and majorities, the types of shares or company shares affected or the body in charge of their adoption.
Among all these elements, the right of veto, which has traditionally been defined as the right of an investor or group of investors to prevent the adoption of a decision by the company, stands out.
How does the right of veto work in shareholder agreements?
In practice, the veto right acts as a super-qualified voting right, as it allows the beneficiary shareholder to impose its decision on the rest of the shareholders, even majority shareholders, always in the negative; this means that the veto right, at least in theory, does not allow the rest of the shareholders to accept a decision contrary to their interests: it is not a right to impose an agreement, it only allows them to vote against agreements proposed by third parties.
However, the reality is quite different. In conflict situations, the right of veto is an optimal mechanism for a shareholder – or a minority group of shareholders – to impose its criteria on the rest of the shareholders, in exchange for voting in favour or abstaining from using its veto in a critical decision for the company.
For example, the shareholders’ agreement provides that a minority shareholder (5% of the share capital) can veto capital increases. This means that this shareholder can decide who invests in the company, at what valuation, or even allow him to force the other shareholders to ensure that no one other than him can invest in the company, at the valuation he deems appropriate in each case.
Thus, when faced with an investment proposal from a new strategic investor at a valuation of, for example, 10 million euros to deal with a difficult cash flow situation, the shareholder with veto power could prevent the transaction by offering the same amount at a valuation of 1 million euros and diluting the other shareholders tenfold, in exchange for not causing the liquidation of the company.
Of course, in such cases, minority shareholders could vote against this proposal, even if it would mean the death of the company.
The same can happen with other decisions such as the hiring of management personnel, indebtedness or the transfer of the company’s address.
This is why we say that vetoes cause misalignment and perverse incentives: because whenever a single shareholder or a small group of minority shareholders has the power to veto an agreement that may be critical for the company, there is a risk that they will end up demanding negative considerations for the other shareholders, in exchange for not exercising their right.
How to avoid negative effects?
When a shareholder demands a veto right, the two most common negotiation strategies are as follows:
- Limiting the veto right: this consists of establishing specific cases within the general framework in which the veto right will not be applicable, because it is deemed that the company’s interests are more important than the shareholder’s individual interests. For example, the veto on investment transactions can often only be exercised when these transactions do not fulfil certain conditions of amount, valuation or adhesion.
- Replacing the veto with reinforced majorities: in this case, we seek to ensure that the adoption of the agreement requires a very qualified percentage of the share capital, such as more than half of the votes of all classes of investors, or a majority of the founders and investors who participated in the last round.
The right of veto is a weapon which, in the wrong hands, can paralyse decisions or transactions critical to a company’s future, or even lead to its liquidation without remedy.
Sometimes it is even advisable to carry out an investment transaction for the sole purpose of expanding the cap table and breaking the deadlock caused by a poorly configured veto right. The fact of having several investors, in this case, is favourable for the company, because it makes it possible to play with reinforced majorities in a way that eliminates doubts about the motivations behind the adoption of a decision, protecting in any case the interest of the majority of the share capital.
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