Protective provisions are one of the special rights negotiated by investors participating in a company’s preferred stock financing. Protective provisions give preferred stockholders in a company consent rights with respect to key corporate actions the company seeks to take. The company will typically outline its protective provisions for investors in a series of clauses in its charter, which is the company’s central governing document. Examples of commonly negotiated protective provisions held by preferred stockholders include consent rights concerning the company’s ability to approve:
- Amending its charter;
- Creating a new class or series of capital stock, in particular when such new class or series ranks senior to or on parity with the existing preferred stock in liquidation preference, payment of dividends and redemption rights;
- Incurring debt outside the ordinary course of business;
- A merger or sale of substantially all of the assets of the company; or
- Increasing or decreasing the size of the board of directors.
While this is a non-exhaustive list, it provides an idea of what types of actions are subject to approval by investors following a typical growth financing. This segment of an impact investing transaction can be critical in an entrepreneur’s efforts to commit and stay true to their mission-driven business.
Why are protective provisions important to entrepreneurs?
Protective provisions are one component of a system of checks and balances built into investment documents to allow investors to ensure that the company is meeting business expectations related to the capital being provided. However, the process of negotiating and finalizing investor consent rights enshrined in the protective provisions can also be helpful for entrepreneurs. Founders can gain important insight into the priorities and strategic direction that investors have in mind when deciding to provide capital to the business by understanding which business decisions such investors push to have greater authority over.
Striking a balance in the alignment of economic interests between founders and investors is not always easy. However, spending time carefully curating this balance between the rights of founders versus investors can make for a successful company that stays true to the founder’s foundational vision, while also benefiting from the identification of market need and other guidance and know-how investors can provide. By understanding an investors’ priorities vis-à-vis the approval rights that are central to their negotiation, founders can draw the knowledge needed to build leverage on their end of the table. Entrepreneurs should also keep this insight in mind in order to measure an investors’ priorities against their own, and to evaluate where to give and where to take in accepting outside capital.
As a company goes through multiple rounds of financing, founders and management should also be cognizant of the different consent rights granted from one financing to the next to ensure that no investor holds consent rights disproportionate to their position in the company. In the end, it is less controversial to build on the protective provisions granted to earlier investors than it is to attempt to revoke the rights granted to earlier investors in order to keep all investors on a level playing field.
In particular, a consent right which is granted to all preferred stockholders voting as a single class can turn into a veto right where one series of preferred stockholders hold a majority of all of the preferred stock outstanding. While there may be merit to this structure based on the size and pricing of different financing rounds within a single company, a company may calculate to instead negotiate different protective provisions for each series of preferred stockholders voting separately as a class to avoid a veto right down the line. In this way, a founder’s working knowledge of market protective provisions and awareness of existing rights within his or her own company is crucial to scaling and growing without swinging the pendulum too far in favor of any one investor group.
Ultimately, protective provisions can play a key role in promoting good governance and accountability as a company grows its business and builds upon its shareholder base. Our series on protective provisions will explore how different investor consent rights can be negotiated by impact entrepreneurs in order to communicate their commitment to a company’s mission and to find investors aligned with that commitment. An understanding of how protective provisions fit into the negotiation of a financing will allow entrepreneurs to maintain a balance among the decision-making authority of founders, investors and other stakeholders in an impact company.
Additional Resources
- Daniel DeWolf, What is a Term Sheet?, MintzEDGE, http://www.mintzedge.com/blog/what-is-a-term-sheet
- Daniel DeWolf et al., Corporate Formation: The Basics, MintzEDGE (March 11, 2016), http://mintzedge.com/blog/corporate-formation-the-basics
