Ask a MoFo: Protective Provisions

The following article is part of our "Ask a MoFo" series, where we address some of the frequently asked questions our MoFo startup team is asked during the course of business. These questions span the entirety of the startup lifecycle – from questions relating to incorporation, to tips for a successful exit. We encourage you to submit questions you would like to see answered as part of this series to ECVCevents@mofo.com.

This article is one in a series of articles explaining various terms commonly seen in term sheets issued by venture capital funds in connection with equity financings.

What are protective provisions?

Protective provisions are a list of actions or events that a company cannot take or consummate without first obtaining a specified approval by investors (either at the stockholder level or board level). As discussed in additional detail below, these minority protections are generally targeted at some combination of key actions and areas where the interests of investors and founders may not be aligned.

Why have protective provisions?

At least in the early stages of a Company’s growth, the investors typically represent a minority of the outstanding shares of the company in which they have invested. Absent charter and/or contractual protections, the investors would therefore not have a meaningful ability to directly influence the outcome of most key shareholder votes. Institutional investors have a duty to protect their investments and therefore have a strong interest in making sure that they have a say, typically in the form of a veto right, in governance including key corporate events.

How do protective provisions work?

Protective provisions are most often found in the company’s charter (i.e., the certificate of incorporation in Delaware) and provide that, so long as a certain number of preferred shares are outstanding, the company must obtain approval of a defined percentage of investor shares before it can proceed with one of the listed actions. (The defined percentage is typically the holders of “a majority” of shares of outstanding preferred stock but can vary.) Put another way, even if a majority of the members of the board and/or the holders of a majority of shares of voting stock are in favor of one of these specified actions, the investors can stop the company from acting.

What types of actions can protective provisions protect against?

There is technically no limit on what could be included as a protective provision, as it is a matter of negotiation between the company and its investors, but there are some market standards. Some of the most typical preferred stockholder protective provisions are:

• Any type of liquidation of the company such as a sale, merger, or dissolution of the company.
• Changing the company’s charter or bylaws in an adverse manner as to the investors.
• Issuing new equity unless the new equity ranks below the specified investors’ equity in terms of the rights, preferences, and privileges of the new equity.
• Changing the number of directors on the board of directors.
• Granting dividends.
• Increasing the authorized capital of the company.

Some investors may ask for additional protective provisions, aside from key economic and governance protections, that are more operationally focused. These operational protective provisions are usually administered at the board level rather than the stockholder level. For example, the following proposed company acts, including the approval of the director(s) appointed by the investors, may require board approval:

• Taking on an amount of debt that exceeds a specified threshold.
• Changing the executive officers of the company or their compensation.
• Other significant changes to the business, such as entering a new line of business.

Conclusion

Protective provisions are one of the most significant governance aspects to consider in a venture financing. It is important for entrepreneurs to understand that, while investors have a valid interest in obtaining protections as minority investors, the founders and/or management are sacrificing a certain level of control over the long-term direction of their business. Finding the right balance given the dynamics of the deal and the parties involved is something with which experienced legal counsel can assist.