Veto Rights

A minority investor in a company can be outvoted on almost anything. The investor protection rights negotiated by an AIF exist to fix that, and they come in two flavours.

Affirmative rights say: this action cannot happen without my express consent. The workbook calls that "positive control" — the power to influence corporate actions.

Veto rights say: I can stop this action. In the workbook's words, "a veto right is to oppose a corporate action even if it has the requisite majority. It is also known as 'negative control' or the right of an investor to say no more as a defence to protect his own interests".

The difference is in posture. An affirmative right makes the investor a necessary party to the decision; a veto right leaves the decision to others but lets the investor block the outcome. The workbook notes that veto powers are insisted upon by investors in some of the standard corporate actions "as an alternative to affirmative rights".

Where veto rights are used. The workbook's standard list of matters on which investors insist on affirmative rights — and on some of which a veto is negotiated instead — includes:

1. changes in capital structure through new issues, preferential allotments or buy-backs;
2. alteration of the memorandum and articles;
3. secured debt or debt securities beyond agreed limits;
4. new fund raising other than renewal of normal working capital limits;
5. an IPO, indirect listing or listing of debt instruments;
6. investments outside the ordinary course of business;
7. changes in the business plan or activities;
8. spinning off, starting or divesting subsidiaries;
9. rearrangement, reconstitution, merger or amalgamation;
10. disposal of assets above an agreed value outside the ordinary course;
11. suspension or discontinuance of business;
12. initiating winding up;
13. changes in board constitution by appointing new directors;
14. appointment or removal of auditors;
15. appointments, terminations and service condition changes of key managerial personnel.

Two specific uses the workbook describes.

• Dividends (section 7.4.2): a company may be prevented from declaring any dividend without the investor's concurrence "by providing them with an overriding right to veto the payment of any dividend".
• Down-round protection (section 7.4.4): the ratchet clause "can be used even through a veto power on further issuances of shares by the company so as to protect dilution of the investor's equity in a down round".

Where they sit legally. Investor protection rights are written into the definitive agreements, and the articles of association are amended to incorporate the shareholders' agreement so that it is enforceable.

Illustrative figures. Deccan Consumer Fund II holds 17.1% of Nagpur Agro Foods. The promoters hold 68%. The shareholders' agreement gives the fund:

• an affirmative right over any change in the business plan; and
• a veto right over any further issue of shares and over dividend payments.

Year 2 — dividend. The board proposes a Rs 25 crore dividend. The promoters' 68% comfortably passes it. The fund, which wants the cash reinvested in the new plants, exercises its veto. The dividend is not paid, although it had the requisite majority.

Year 3 — new issue. Plant delays bring a cash crunch, and a new investor offers Rs 80 crore at a pre-money valuation of Rs 500 crore — below the fund's post-money entry valuation of Rs 700 crore, so a down round. Without a veto, the promoters could approve it and the fund would be diluted from 17.1% to 17.1% × 500 / 580 = 14.7% at a lower price. With the veto on further issuances, the fund can block it — or agree only after the ratchet compensates it with additional shares.

Year 3 — business plan. The promoters want to enter the edible oils business. That needs the fund's affirmative consent; without the fund's express approval, it cannot be carried through at all, however the vote goes.

Chapter 7 (Investment Process and Governance of Funds) covers affirmative and veto rights together at 7.4.4, among the investor protection rights at 7.4, with the dividend veto at 7.4.2 and the ratchet at 7.4.3. The chapter's sample questions test what affirmative rights mean. Expect a question contrasting positive control and negative control, and one on how a veto can deliver down-round protection.

• Affirmative rights = positive control; veto rights = negative control. Swapping the labels is the trap.
• A veto works "even if it has the requisite majority". It is not a voting majority; it is a right to block.
• Veto powers are an alternative to affirmative rights on some of the standard corporate actions, not a separate list.
• An affirmative right is not a right to exit. Exit rights — ROFR, ROFO, tag along, drag along — are a different group.
• The ordinary resolution threshold the workbook uses is a simple majority of 51%. Affirmative and veto rights override it for the protected matters.
• A ratchet can be delivered through a veto on further share issues, not only through a formula clause.