What are Protective Provisions in a Term Sheet?

Protective provisions are specific clauses within a shareholders agreement designed to safeguard an investor’s rights. These rights might include the ability to veto decisions or actions that the investor disagrees with, such as issuing more stock, liquidating the company, or pursuing an acquisition. By establishing clear guidelines and limitations, protective provisions work to minimize risk for investors. They also play a vital role in defending the interests of minority shareholders, particularly when disagreements arise about the optimal direction for the company.

Why are protective provisions important?

They are essential for safeguarding the interests of preferred shareholders, giving them control over key business decisions that could impact their investment value.

Investors seek protective provisions as a way to safeguard their minority shareholder interests, especially in scenarios where they may not have control over the board of directors. But why not simply negotiate for more board seats, since the board usually must approve the actions listed in the examples above?

The answer lies in the distinct advantage that protective provisions offer. These provisions can grant an investor, even as a minority shareholder, veto power over specific board decisions that pertain to matters covered by the protective provisions. This means that the investor has a unique and significant influence over certain crucial issues without needing a majority on the board.

Why do startups agree to protective provisions?

Startups often agree to these provisions to attract investment and build trust with investors, who might otherwise be hesitant to invest in a newer, higher-risk venture.

Where are the protective provisions of a deal found?

Protective provisions are typically located in the term sheet, as well as in more detailed legal agreements such as the Shareholders’ Agreement or the Articles of Association.

Examples of protective provisions

What are some examples of protective provisions found in a term sheet?

• Anti-Dilution Protection: Also known as an anti-dilution clause, subscription right, subscription privilege, or preemptive right, this provision is used by investors to safeguard their investment during a down round or significant dilution event, like the issuance of new shares for equity financing or the conversion of a convertible note.
• Pro-Rata Rights: This provision enables investors to preserve their equity stake and voting power even when new shares are issued. Unlike other provisions, it doesn’t obligate the investors to invest in later rounds.
• Redemption Rights: These rights allow investors holding preferred stock to demand that the company repurchase their shares after a certain period. It serves as protection when the company’s valuation is stagnant, making it an unattractive acquisition target or IPO candidate.
• Registration Rights: This provision grants investors the ability to compel a company to go public, enabling them to sell their shares. There are two primary types: “piggyback” rights, allowing investors to include their shares in a planned IPO, and “demand” rights, enabling an investor to require a company to go public, even if it’s not planning to do so imminently.
• Veto Rights: These rights enable a company’s board of directors to reject a proposal, blocking its implementation. Examples of proposals that might be vetoed include changes to the quantity of preferred or common stock, the creation of new share classes, or the acquisition of another organization.
• Voting Rights: These rights provide board members with the authority to vote on key issues such as funding rounds, issuing new stock, initiating mergers and acquisitions, and more. It’s crucial to recognize that voting rights don’t necessarily have to be distributed equally among board members, allowing for variations in influence and decision-making within the business.

What are some of the protective provisions to avoid agreeing to?

It is wise to be cautious with provisions such as:

• Unlimited veto rights for investors
• Excessive control over daily operational decisions
• Restrictive clauses that limit future fundraising opportunities

What are the common pitfalls to avoid in relation to protective provisions?

Some common pitfalls include:

• Failing to properly negotiate or understand the terms
• Overlooking long-term impacts of the provisions
• Not seeking expert legal advice when needed

Two Types of Approval

Preferred Stockholder Approval

This involves obtaining approval from holders of preferred stock for major decisions, reflecting their investment interests.

Preferred Director Approval

Actions Requiring Approval of the Preferred Director

The preferred director is a significant board member appointed by the preferred stockholders, with specific responsibilities for approving major actions taken by the company. The actions requiring the preferred director’s consent encompass:

1. Incurring Extraordinary Debt: Ensuring that long-term debt exceeding a specified limit is agreed upon by investors, as this can significantly impact the company’s financial stability.
2. Guaranteeing Debt: Approving the company’s guarantee of another entity’s debt to prevent unwarranted financial risks.
3. Making Loans to Other Entities: This provision guards against risky loans to other companies or employees, directors, or consultants, ensuring that financial decisions are in the company’s best interest.
4. Personnel Decisions: This includes hiring, firing, or changing the compensation of executives to avoid conflicts of interest and ensure a fair compensation structure.
5. Budget Approval: The preferred director’s agreement on the annual budget ensures realistic financial planning and spending controls.
6. Capital Expenditures (CapEx): This ensures responsible spending on major purchases like machinery, property, vehicles, and intellectual property that could significantly impact the company’s cash flow.
7. Owning Securities of Another Company: This restriction ensures that any ownership of another company’s securities aligns with sound business purposes.
8. Changing the Business Model: This provision requires approval for any significant business model changes, ensuring that the preferred director agrees with major shifts in business direction.
9. Intellectual Property (IP) Transfers: Protecting the company’s key assets, like trademarks, patents, and trade secrets, by requiring the preferred director’s consent for any sale or transfer.
10. Material Agreements: The preferred director must approve significant contracts or agreements that exceed a specified amount to prevent unwise financial commitments.

In summary, the preferred director’s approval on these actions ensures that the company’s decisions align with the best interests of the company and its preferred stockholders, adding a layer of protection against potential conflicts of interest and financial mismanagement. It safeguards crucial aspects of the business such as cash flow, intellectual assets, strategic direction, and significant financial obligations.

Actions Requiring Approval by the Preferred Stockholders

The actions that necessitate approval from the preferred stockholders, rather than the preferred director, typically pertain to the fundamental structure of the company. This includes aspects like modifying the composition of the board of directors, issuing or repurchasing stock, altering the company’s charter documents, implementing stock incentive plans, and other related matters. While these considerations might seem legalistic and complex, their importance in maintaining the stability and integrity of the company cannot be overstated.

• Changing the Number of Directors: To prevent dilution of the preferred director’s vote, the number of directors cannot be increased without consent.
• Paying Dividends: To avoid draining cash balances, the company needs approval to declare or pay dividends, except if mandated by the certificate of incorporation.
• Repurchasing Stock: Since buying back stock can be a significant drain on cash, preferred stockholders must approve it.
• Changing Charter Documents: Both the board and stockholders must approve changes to essential documents like the certificate of incorporation and bylaws.
• Changing the Number of Authorized Shares: As this can lead to legal complications, any change in the maximum number of shares needs approval.
• Issuance of New Securities: Preferred stockholders must consent to the creation or issuance of new common or preferred stock, or convertible securities, to prevent unexpected dilution.
• Changing Preferred Stock Rights: The rights of various financing rounds (e.g., Series A, B, C) cannot be altered without prior approval.
• Issuing Senior Securities: Preferred stockholders must approve the issuance of stock with equal or better rights to ensure protection.
• Creating Subsidiaries: As subsidiaries can lead to complex issues, the company must obtain approval before forming any or undertaking substantial contracts.
• Entering into Affiliate Transactions: To guard against conflicts of interest, advance approval is required for transactions with founders or corporate stockholders.
• Liquidating the Company: Oversight by preferred stockholders ensures the orderly shutdown of the company and proper handling of assets.

These actions include significant events such as mergers, liquidations, or changes to the company’s charter.