Right to Veto Clauses In Partnership Agreements Causing Startup Headaches

Sunday, October 8th, 2017 at 4:19 pm, by Jason Auman

Small technology startups often form as partnerships to enjoy governance norms of equal profit sharing and equal management roles. Without much need yet for outside equity, co-founders may reason that it is simpler to avoid the hassle and costs of incorporation. Given that co-founders both own and manage the company, their interests are perfectly aligned with those of the partnership startup, and they avoid agency costs that are inherent in corporations. Yet, to preserve the equality of partners’ interests and representation, many partnership agreements include a “right to veto” clause, which allows any individual partner to veto a major business decision.

Startup co-founders may not realize some of the hidden gridlock costs that they may incur in maintaining “right to veto” clauses should their individual interests diverge, as underscored by a recent judicial decision in Total Recall Technologies (TRT) v. Oculus. Thomas Seidl and Ron Igra founded TRT as a partnership in 2010 to develop virtual reality (VR) technologies, and shortly thereafter hired Palmer Luckey to make a prototype VR headset. Luckey left TRT in 2012 and founded his own company Oculus VR with crowd-sourced funding. Oculus went on to become one of the leading VR companies in the American market, was eventually sold to Facebook for $2.3 billion, and is now a household name due its ground-breaking Oculus Rift headset.

However, while TRT alleged that Luckey violated the confidentiality clause in his contract and stole the VR headset prototype, co-founders Seidl and Igra could not agree on the proper course of action. Igra commenced a lawsuit against Luckey, but Seidl opposed the suit, believing that it would be smarter in the long run to not burn bridges with Luckey. Judge William Alsup of the Northern District Court of California ultimately ruled that the lawsuit could not proceed because of a “right to veto” clause written into the TRT partnership agreement. The clause granted Seidl the right to veto any major business decision, including initiating a lawsuit. Explaining the difference between shareholder suits in corporations and partnerships, Judge Alsup writes, the “law allows a single shareholder to bring a derivative action on behalf of a corporation subject to strict demand, adequacy, and procedural rules. The same is true for limited partnerships (which are like corporations but in partnership form, mainly for tax. pass-through reasons). Cal. Corp. Code §§ 800, 15910.02. Significantly, however, derivative actions are not allowed for general partnerships.”

Benefits of Unanimity

As long as co-founders still share a similar vision for the company, the “right to veto” clause ensures absolute agreement on tough issues. Imagine a situation in which five founding partners form a partnership to develop a new self-driving car prototype. As they succeed and expand, they face many tough decisions, including whether they should continue to grow organically or sell the entire company to an established competitor, like Alphabet or Uber, for a huge profit. The requirement for unanimity ensures that the interests of each co-founder are taken into account. Therefore, any decision that they reach reflects broad consensus.

Gridlock and the Anticommons

As the TRT v. Oculus decision highlights, however, when veto power is held by several decision-makers, it becomes much easier for hard choices to devolve into gridlock. Michael Heller termed this type of dysfunction “The Tragedy of the Anticommons” in which several stakeholders have the ability to prevent other stakeholders from using a shared resource, resulting in the resource not being used to its socially optimal level. In the self-driving car partnership example, even if the best business decision is to continue to grow the company, one greedy partner who wants to make a quick profit from an exit can effectively stymie the actions of the partnership as a whole. Although it is difficult for friends who are jointly starting a partnership to consider such a negative outcome, TRT v. Oculus illustrates the need for healthy skepticism before it is too late. After all, the consequences of one simple governance clause can be immense, potentially costing the partnership billions of dollars.

Conclusion

When forming a startup, it is worthwhile to seek legal advice on how to structure the company. While founders are in agreement about the future of the company, it may be hard to conceive of a situation in which their interests are so divergent that they are left in a state of gridlock. If founders can anticipate potential discord, they may be able to avoid a similar fate as Seidl and Igra of TRT. Other governance forms, such as limited partnerships or corporations, can avoid the deadlock by delegating management decisions to a smaller group of individuals with relative expertise. After all, a “right to veto” clause has the potential to be a double-edged sword that can enable consensus building or that can facilitate gridlock.