Consider the following: Your fund is offered the opportunity to co-invest at a level of five percent (5%) in a new C round. The good news is that (i) the portfolio company has real potential, (ii) other funds (including the fund calling you with the opportunity) invested in both the A round and B round, (iii) the company's valuation has increased for each round (and those increases are supportable), and (iv) more than half of the existing A and B investors (including the lead investor in the B round) have exercised their rights to co-invest in the new C round. It all "sounds good."
But hold on. The proposed investment documents include a normal provision that a certain threshold percentage of the C round investors (say, 60%) effectively control most stockholder-level decisions for the C round investors as a whole. For example, the holders of 60% of the C shares can exercise C round stockholder approval rights, approve amendments to the investment documents, waive anti-dilution protection in a future down round, exercise mandatory conversion rights, and waive the treatment of a company sale as a deemed liquidation event in which the C round would have a preference or potentially "drag along" all of the C round investors in a transaction.
In this situation, it is critical for any new C round investor to understand the actual C round investor mix to ensure that the threshold percentage for C round stockholder-level decisions is set high enough so that any combination of existing A and B round investors cannot control those decisions without the approval of some significant percentage of new C round investors. Why, you ask? Depending on the relative investment dollars contributed in earlier rounds by the "overlapping" C round investors (i.e., A and B investors who also have invested in the C round), those investors may be motivated to make C round decisions for the benefit of their A and B round positions. Here are a couple of examples illustrating the concern:
Example 1: If a future D round is priced above the B round, but below the C round, the "overlapping" investors may want no anti-dilution adjustment to apply with respect to the C round.
Example 2: A similar issue would exist with respect to a company sale at a level high enough to deliver a healthy return to the A and B round investors if proceeds are distributed pro rata without regard to the preference of the C round investors.
Often, logistical hurdles make it difficult for co-investors to determine whether the actual C round investor positions are workable with the stated threshold percentage for C round stockholder decisions. Summary cap charts may not be sufficiently detailed. Draft cap charts may change. Final cap charts may not be available until shortly before closing. Yes, it's all true—so be careful.