Term Sheets: What do I need to know about protective provisions?

This week we continue our series on key VC financing deal terms.

This week’s question: What do I need to know about protective provisions?

Our answer: Protective provisions grant your investors veto rights to certain major decisions. Although these provisions are meant to protect investors from actions that could significantly impact their investments, they restrict the decision-making power of founders and other stockholders. To strike a functional balance between investor security and the ability to make big decisions, we recommend negotiating for relatively low thresholds (e.g., majority of the preferred shares), limiting protective provisions to common ones, and including workarounds such as letting preferred director approval override the need for stockholder approval of certain protective provisions.

Common Protective Provisions

1. Issuing New Shares. A startup can’t issue new securities (including convertible securities) with equal or superior rights to the current preferred stock. This protects your investors from having their ownership and the value of their investment diluted by new stock issuances or changes to the capital structure that could affect their preferred status.

2. Amending the Charter or Bylaws. By blocking changes to the Charter or Bylaws that are adverse to preferred stockholders, your investors ensure your startup’s governance and financial structure (especially an investor’s preferential treatment) remain aligned with the terms agreed upon in the financing.

3. Change of Control Transactions. This provision gives your investors greater control over exit events such as a dissolution, merger, substantial asset sale, etc to ensure they are not at a disadvantage in such transactions. 

4. Debt. Issuing debt exceeding a specified threshold may increase risk, so your investors want to ensure the company remains financially sound before entering into such arrangements.

5. Dividends and Repurchases. This prevents the repurchase of or payment of dividends on capital stock before the preferred holders so that the company does not distribute capital to other stockholders or repurchase stock before preferred investors are compensated.

6. Board Composition. An change in the size of the Board is limited to maintain investor influence over your startup’s governance and strategic direction.

7. Subsidiaries. Creating or holding capital stock in a non-wholly owned subsidiary or disposing of subsidiary stock or assets often entails a major strategic decision that could impact the company’s value, so investors want to have a say.

Why It Matters

Negotiating protective provisions wisely helps you maintain control and keep investors feeling protected. The key is balance – your startup should remain flexible enough to make decisions, while providing investors with reasonable protection.