Investment contracts, whether for debt or equity, cannot possibly cover all foreseeable future contingencies. This means at varying points in the life of a company there will be bargaining situations. How well everyone does in this depends on the possibility of a hold-up, which allows one party to extract better economics for itself. The term hold-up comes from crime, meaning a robbery, but in economics it used for entirely legal situations, which might still leave you feeling as in “we were robbed.”
The classic example in equity comes when the preferred equity in a company doesn’t vote as one class (on an as converted basis) but rather by series. Then you might have the case where say the Series D in a company is controlled by a single investor (let’s call them FundX) whereas the previous series are syndicates of three different funds with none controlling a series.
Now the company has an acquisition offer. FundX feels the deal doesn’t reward them appropriately. If separate Series D approval is required for the transaction, then FundX has the potential to “hold-up” the deal. They can withhold their approval unless given better economics, which of course means worse economics for all the other investors and the team.
The investors in the syndicate are in a particularly weak bargaining position because there are several of them. The founding team wants the deal to go through. In a situation like that the only check on FundX is strictly reputational. If word gets out, then entrepreneurs and other investors might not want to work with FundX in the future. That may or may not be an effective check. For instance, FundX may be in liquidation and not care. Or FundX may not invest much in this sector to begin with. Or FundX may conclude that the minor potential damage to their reputation is worth it for the concrete immediate increase in returns.
So what does this all mean? As an entrepreneur your ideal capital structure has multiple investors in it and you only ever need a majority of them but not *all* of them (this usually means trying to get all the preferred voting as one class and not by series). That way no single investor can hold-up a transaction. Second best is to have just a single large investor – now there is a mutual hold-up between the investor and the team (after all a team too can try to hold-up a transaction).
Where this becomes particularly important is in a bridge financing. A bridge, because it is debt, generally has more control provisions than equity (where much of the governance is left to the company’s board of directors). If your bridge is controlled by a single investor, especially one that doesn’t already own a significant stake in your company, then there is meaningful potential for a hold-up.
