This post originally appeared as part of the “Ask the Attorney” column I am writing for VentureBeat. Below is a longer, more comprehensive version, which is part of my ongoing series on venture capital term sheets. Here are the issues I have addressed to date:
- common mistakes dealing with VC’s
- liquidation preferences
- stock options
- exploding term sheets and no-shop provisions
- anti-dilution provisions
- Board control
Today’s post relates to protective provisions, which is something VC investors almost always require in a priced round (i.e., the issuance of preferred stock), as opposed to the issuance of convertible notes.
What Are Protective Provisions? Protective provisions grant the investors the right to veto or block certain corporate actions. Accordingly, even if the Board of Directors authorizes a particular action, the consent of a certain percentage of the preferred stockholders would be required prior to the company taking such action. The rationale for these provisions is to protect the investors (who are usually the minority stockholder following a Series A financing) from the majority stockholders.
What Are the Standard Protective Provisions? The following protective provisions are viewed as fairly standard and non-controversial (and are actually the provisions agreed-to in FourSquare’s Series B financing led by Andreessen Horowitz):
(a) a sale of the company or other “Liquidation Event”;
(b) any amendment to the company’s Certificate of Incorporation or Bylaws so as to alter or change the powers, preferences or special rights of the shares of Preferred Stock so as to affect them adversely;
(c) any increase or decrease (other than by conversion) in the total number of authorized shares of Preferred Stock or Common Stock;
(d) the authorization or issuance of any equity security having a preference over, or being on a parity with, any series of Preferred Stock with respect to dividends, liquidation or redemption;
(e) the redemption or purchase of shares of Preferred Stock or Common Stock (subject to certain exceptions);
(f) any declaration or payment of any dividends or any other distribution on account of any shares of Preferred Stock or Common Stock; or
(g) any change in the authorized number of directors of the company.
What Are Some of the Non-Standard/Controversial Protective Provisions? Investors will often push for additional protective provisions, such as the following:
(a) any hiring, firing or change in the compensation of any executive officers;
(b) the entering into any transaction with any director, executive or employee of the Company;
(c) any incurrence of indebtedness in excess of $[100,000];
(d) any change in the principal business of the company or the entering into any new line of business; or
(e) any purchase of a material amount of assets of another entity.
Founders should push back on the foregoing provisions and should indeed be able to knock most (if not all) of them out if they have strong negotiating leverage.
What Are Some of the Other Key Issues? There are two other issues founders should focus on. First, the founders should require a minimum threshold of outstanding shares of Preferred Stock in order for the protective provisions to remain in place. Thus, language should be inserted into the term sheet providing that the protective provisions would only be applicable “so long as % of the originally issued Series A Preferred remains outstanding.”
Second, founders need to watch-out for high voting thresholds, particularly upon a Series B or later financing round. Indeed, founders are often able to negotiate a single vote for all investors (i.e., the Series B or later investors would not have a separate vote for their respective protective provisions); however, the requisite consent percentage should generally not be higher than 66 2/3% to avoid the scenario where an investor holding a small percentage of shares effectively has veto rights.
Protective provisions are found in nearly all term sheets for VC equity financings. Even the so-called “Series Seed” documents, a stripped-down set of forms designed for equity seed investments, contain protective provisions. This is why, among other reasons, I strongly advise founders doing a seed financing to issue convertible notes with a cap; it’s quicker, cheaper and less onerous. As Chris Dixon, the startup guru, so aptly puts it: “Like it or not, the seed investment world runs on trust and reputation – not legal documents.”