Worst case founders can just run away with the money.

They can also kick the VC rep from the board since they own majority share.


Shareholder protection laws

The basic defense against "just run away with the money" is the laws that prevent a shareholder paying out "common company" money to themselves personally at the expense of minority shareholders. If the company under their control violates the rights of the minority shareholder(s), they are entitled to compensation from the majority shareholder(s) and/or the company, and they can and will sue them for that. Furthermore, any accounting irregularities, misrepresentations, faked reports, etc done during that process may easily push it from a mere civil claim into criminal charges.

Investor agreements and company bylaws

"They can also kick the VC rep from the board since they own majority share." will be prevented by an investor rights agreement and modifications to the company charter and bylaws that mandate (for example) that a particular board seat will be controlled by that VC, and that this board seat will have a veto right over certain types of decisions - so the majority can't do whatever they want. The majority shareholders will also generally have a binding contractual agreement that they must vote in a particular way in certain aspects.

Due diligence

A key part of most investment is due diligence review of the company current situation - the founders would be expected to agree to an invasive, thorough audit of their operations by the investors. This will include a review of any legal clauses, liabilities, etc. In addition, often the founders (personally) will be expected to sign so-called representations that affirm these details, and that they have disclosed all material aspects, and that they'll be personally liable for misrepresentations and omissions. In case of outright fraud (taking the money and running away) this will also be evidence in a criminal case that some misrepresentation was not just an accidental omission but an intentional act.

Tranches and clawback provisions

It's not that uncommon to have money disbursed in tranches conditional upon meeting certain provisions, and for any money that goes directly to founders it's not uncommon to see clawback provisions that state that the consequences of any misrepresentations will be taken out of these funds, possibly with large part of that money held in escrow for some time to cover that.

  • Thank you for the great and thorough answer! – user1034912 Sep 1 '19 at 13:13
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    @GeorgeWhite Here's a random example of a shareholder's agreement in California sec.gov/Archives/edgar/data/789356/000078935603000003/… ; see 7.1 "Each Shareholder shall vote all of its shares, and shall take all other necessary and desirable actions within such Shareholder’s control". My understanding of "binding" here is that they can vote otherwise and the vote would technically be valid, however, that shareholder who voted this way would be breaching the contract and the investor would sue them for damages and seek a court injunction to stop the board change. – Peteris Sep 2 '19 at 8:02
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    @GeorgeWhite And I have no specific opinion on California law, but looking at the the California Corporations Code, § 706(a) (codes.findlaw.com/ca/corporations-code/corp-sect-706.html) explicitly allows shareholders to contract on how they will vote their shares. – Peteris Sep 2 '19 at 8:07

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