Cumulative voting gives minority shareholders the opportunity to be represented on a company’s board of directors. To understand it, you first have to know what it means when a company does not have cumulative voting.

When a company sets its number of directors — say, three for example — each shareholder is entitled to one vote per share for each director position.  If I own 60 shares and you own 40, my 60 votes will beat your 40 votes for the first position; my 60 votes will beat your 40 votes for the second position; and my 60 votes will beat your 40 votes for the third position.

Net result:  I, as the majority shareholder, have the power to elect the entire board of directors.  You, as the minority shareholder, have no power at all. Some might legitimately wonder why I should get a 100% say when I only own 60% of the company.

Cumulative voting solves this perceived unfairness.

Cumulative voting allows each shareholder to aggregate the votes to which the shareholder is entitled and then cast them in whatever number the shareholder chooses.  Thus, following our example, I would have a total 180 votes (60 shares for three positions) and you would have a total 120 votes (40 shares for three positions).  I can cast my 180 votes among the three open seats however I choose.  And you can do the same with your 120 votes.

Now what happens?  If you are smart, you will realize that you can guarantee yourself at least one representative on the board of directors by casting no less than 61 of your votes for a single individual.  After all, I cannot allocate more than 61 of my 180 votes for more than two individuals.

And just like that, you as a minority shareholder now have a say on the board.

Where does this right of cumulative voting come from?  A company’s articles of incorporation (sometimes called a certificate of incorporation) is key.  In the State of Washington, for example, cumulative voting is implied unless the company affirmatively “opts out”  in its articles of incorporation.  In the State of Delaware, by contrast, the right does not exist unless the company affirmatively “opts in” in its certificate of incorporation.

Of course, all may not be lost in the absence of cumulative voting.  Indeed, many companies that are formed with the help of a capable corporate lawyer routinely exclude cumulative voting in favor of a well-drafted shareholder agreement.  And that is another topic for another day.

A question asked frequently is why a young, energetic group of founders  should worry about complying with securities laws.  A lawyer’s standard answer is that every officer, director, and principal shareholder of a company risks criminal and civil sanctions for violating state or federal securities laws.

Put simply, to stay out of jail and protect your personal bank account, you are wise to make compliance with state and federal securities laws a paramount concern.

The standard response may be a bit more bluster than reality, however. Criminal or civil sanctions from securities regulators, while a real possibility, is seldom wielded against those flying below the radar.  Its like speeding on the freeway at “5 over.”  Yea, you’re breaking the law, but will law enforcement notice?   (I say this and, yet, just last week the owner of a local movie theater found itself on the wrong side of state securities regulators.)

In reality, the standard “scare response” tells only half the story, and it may be the least important half from the perspective of founders driven to success.

Here’s the important half.

While early investors tend to be more cavalier concerning a company’s compliance with various rules and regulations, later investors, especially those in an underwritten initial public offering, demand absolute vigilance.

And they will flatly refuse to make any investment unless the issuer can demonstrate a solid history of compliance, or repair past mistakes.

Why is that?  A company’s previous investors who buy securities in violation of the law have a right to receive their money back — a right of rescission. This means that investors who buy securities offered in violation of the securities laws are really buying an option:  they’ll keep their money in so long as there is the promise of upside but may demand its return when things sour.

And here’s where the rubber hits the road.  A later group of savvy investors are not anxious to put their money in just to see it go back out ahead of them to a company’s earlier investors.  This is true whether the later offering is an IPO, a late stage private equity round, or an early VC round.  What matters is that the professional investors and their advisors know better — while the founders did not.

But that’s not you.  Now you know, too.

A company’s articles of incorporation are analagous to its “constitution.” The articles set forth the legal foundation on which the rights of its owners (the “citizens,” so to speak) and the duties of its officers and directors (the “elected representatives,” to continue the analogy) are ultimately built.  (In some states, like Delaware, the “articles of incorporation” are called the “certificate of incorporation,” but they are effectively the same thing.)

In most states, the articles of incorporation must address certain issues and may address others. In the State of Washington, for example, the articles must state, at a bare minimum:

  • The name of the company;
  • The number of shares of capital stock the company may issue;
  • The number of directors or the process by which that number will be fixed;
  • The name and address of the company’s initial registered agent; and
  • The name and address of each incorporator.

At the same time, most states (including Washington) imply certain governing matters by default, unless the articles expressly “opt out.” Thus, a company’s articles must opt out of any unwanted but otherwise implied provisions. In the State of Washington, critical among these “opt-out-or-deal-with-it” provisions are the following two:

  • Shareholders enjoy a “preemptive right” to acquire unissued shares; and
  • Directors are elected by cumulative voting.

Finally, while the articles of incorporation may deal with a wide array of other matters, several key ones are accessed in the State of Washington only if expressly “opted in,” like:

  • The company’s ability to provide expansive indemnification for officers and directors without prior shareholder approval; and
  • The authority to take shareholder action without a meeting by non-unanimous recorded consent.

In the end, the founders of a company must make a number of choices about how to “frame” the company’s “constitution,” to return to the opening analogy. Many of these choices are obvious and not controversial, particularly for a small closely-held business that will never be a candidate for outside investment. But many other choices are not so obvious and yet may have a material impact on the company’s future governance and, by extension, its ability to attract equity investors.

A capable corporate lawyer can help you work through these choices.

1.  Will Reg A Offering Limits Increase Six-Fold?

From the National Venture Capital Association:

Today the House Financial Services Committee will hold a hearing to examine “A Proposal to Increase the Offering Limit Under SEC Regulation A”.  The proposal seeks to raise the offering limit from $5 million to $30 million under which companies can be exempted from certain regulatory requirements when accessing the public markets.  The current $5 million dollar limit has been in place since 1992.

via NVCA Supports SEC Increasing Offering Limit.

2.  Bad Tech Support.

The Securities and Exchange Commission has filed charges against Jeffry J. Temple, a former “information systems” employee for a Delaware-based law firm.  The SEC alleges that he:

accessed material nonpublic information in the course of his employment and then traded in advance of at least 22 merger and acquisition public announcements involving 20 companies that retained his former employer as counsel in some capacity.

via SEC Charges Former Law Firm Technology Manager and Brother-in-Law in Serial Insider Trading Scheme (Press Release No. 2010-240; December 7, 2010.

Keeping an eye on your “i.t. guys”?

3.  No Bylaw Band Aid

The Delaware Supreme Court recently ruled in Airgas, Inc. v. Air Products and Chemicals, Inc. (Nov. 23, 2010) that shareholders cannot effectively reduce the uncompleted term of a director by amending its bylaws.  The case ensured that Airgas, Inc. can continue using staggered terms as a ploy for fending off an unwelcome takeover.

Late last week the Federal Trade Commission testified in Congress that it wants to enable consumers to opt out of having their activities on the internet tracked — a common practice that enables businesses to serve targeted advertisements.  According to the press release:

The [FTC] … supports giving consumers a “Do Not Track” option because the practice is largely invisible to consumers, and they should have a simple, easy way to control it. The FTC proposes that Do Not Track would be a persistent setting on consumers’ Web browsers.

The testimony states that such a mechanism could be accomplished through legislation or potentially through robust, enforceable self-regulation.

via FTC Testifies on Do Not Track Legislation.

Almost as if on cue, the Wall Street Journal reports on a growing industry focused on tackling the problem:

Seeking to head off escalating scrutiny over Internet privacy, a group of online tracking rivals is building a service that lets consumers see what information those companies know about them. … Called the Open Data Partnership, it will allow consumers to edit the interests, demographics and other profile information collected about them. It also will allow people to choose to not be tracked at all.

via Some Internet-Use Tracking Firms to Reveal What They Know –

With the FTC focused on the issue, one would guess that the businesses participating in the Open Data Partnership are positioned in a sweet spot. Either way, the developments may well impact many businesses that now rely on such tracking data.

Update 12/7/2010 ….

Timing is everything.  From Techflash:

Microsoft today announced plans to roll out new functionality in connection with its Internet Explorer 9 browser which allows users to control how much personal information that they share with Web sites. The service — dubbed Tracking Protection — allows Internet users to decide which third party sites are permitted to track browsing activities online and block those which are deemed undesirable. Dean Hachamovitch, corporate vice president of Internet Explorer, says the technology is the equivalent of the “Do Not Call” list for the telephone.

via Microsoft’s ‘Tracking Protection’ brings new privacy settings to IE9.