Venture Capital Financings: Protective Provisions

​Here’s a scenario inspired by real events that I have experienced:  a startup telecom company was all the rage and the company’s Series A preferred stock financing was heavily oversubscribed.  As a result, the deal was “take it or leave it” for investors and the Series A preferred stockholders invested without obtaining many of the normal provisions protecting their investment.  The company raised significantly more money than they needed at that stage.  With all this cash burning a hole in the company’s pocket, the company decided to buy some land and build itself a new headquarters building.  The company also gave management huge raises and bonuses and lavishly spent on marketing (sponsoring a race car and hiring a celebrity spokesperson), office décor, company retreats and parties.  Not surprisingly, the company blew through all of its cash very rapidly, with little progress to show for it.  The company then tried to raise another round of financing but couldn’t agree with investors on valuation (the investors wanted a very low valuation) and the company went out of business.
 
Moral of the story: If the investors in the financing described above had obtained protective provisions, this financial debacle may not have occurred.
 
This blog post is about protective provisions.

 Protective provisions require the company to obtain the consent of the preferred stockholders (professional investors such as venture capitalists) before the company can take certain actions.  Stated another way, protective provisions place restrictions on the Company so that the Company can’t take certain actions without the approval of the preferred stockholders.  Protective provisions are standard in preferred stock financings but are often heavily negotiated.
 
 
Two Types of Approval: Preferred Stockholder Approval and Preferred Director Approval
 
As an initial matter, there are two types of preferred stockholder approval:

• Approval by the preferred stockholders; and
• Approval by the board, including the preferred director.

 
There are practical reasons why there are two types of approval, which are discussed later in this post.
 
The protective provisions needing approval of the preferred stockholders typically relate to legal or stock-related matters, such as changes to the company’s certificate of incorporation (the company’s governing document that is filed with the state), issuing new shares, redeeming shares and the like.
 
The protective provisions needing the approval of the board, including the yes vote of the preferred director, typically relate to financial and operating matters, such as borrowing money, executive hiring and firing, executive compensation, and more.  Let’s first look at these financial and operating protective provisions.
 

Actions Requiring Approval of the Preferred Director
 
The preferred director is a board member that is appointed by the preferred stockholders.  For more on preferred stock board representatives, see the post “Preferred Stock Financings: Board and Board Observer Rights.”
 
The actions requiring the approval of the board of directors, including the yes vote of the preferred director, include the following:

• Incurring Extraordinary Debt.  This provision provides that the company can’t incur extraordinary debt in excess of an amount negotiated by the company and the investors.  Extraordinary debt is typically money borrowed from banks or other lenders for long periods of time (over one year).  This doesn’t cover normal trade debt, which occurs when suppliers and vendors provide goods and services to the company allow the company to pay them on some schedule (usually within 30 days).  This also doesn’t cover debt that has been previously approved by the board (and the preferred director) as part of an annual budget or operating plan. 
  • Note that in the example at the beginning of this post, if the preferred stock investors had this protective provision, the company wouldn’t have been able to buy the property and take out a huge mortgage (debt) without the yes vote of the preferred stockholders.
• Guaranteeing Debt.  If a company guarantees the debt of another company or person, the company is on the hook if the borrower defaults on the loan.  Because of this, investors want to make sure the company’s guarantee of another company’s debt is a wise thing to do.
• Making Loans to Other Companies.  The company can’t make loans to other companies (except wholly-owned subsidiaries of the company).  This protection guards against the company making an ill-advised commitment to loan money to another company as part of a joint venture or other collaboration, making loans to troubled suppliers or customers, as well as management “going rogue” and lending money to an entity that they own or control.
• Loaning or Advancing Money to any Employee, Director or Consultant.  Making loans or advancing money to employees, directors or consultants can lead to problems, and so need to be considered carefully.  This protective provision ensures that the preferred director agrees with the loan.
• Hiring, Firing or Changing Compensation of Executives.  A company’s board of directors will typically make personnel decisions for the company’s top management team.  By requiring the consent of the preferred director, the investors have a check on the board’s actions relating to executives.  For example, if the founder controls the board, the founder could set his/her own salary and benefits; the protective provision protects against this.
  • Note that in the example at the beginning of the post, the company wouldn’t have been able to give management the huge raises and bonuses if this protective provision had been in place.
• Budget.  Companies will typically prepare an annual operating and financial budget at the end of a year, which budget projects the company’s growth over the next year.  These budgets are very useful exercises and provide a benchmark to evaluate the company’s performance.  By having a requirement that the preferred director approve the budget, the investors have comfort that the budget is realistic.
  • Note that in the example at the beginning of the post, if there had been a budget in place, the company would have had a harder time spending on things (like wildly exceeding the marketing budget and sponsoring a race car and hiring celebrity spokespeople).
• CapEx.  Capital expenditures (“CapEx”) are purchases by the company for things like machinery, equipment (computers), property, buildings, company vehicles (trucks), intellectual property and more.  CapEx can have a big impact on the company’s cash flow and financial position, so investors want to know that the monies are being spent in a responsible manner.
  • Note that in the example at the beginning of this post, if this protective provision had been in place, the company wouldn’t have been able to buy the property without the preferred director’s consent.
• Owning Securities of Another Company.  This restriction prevents the company from owning securities in another company (other than a wholly-owned subsidiary), such as owning stock or warrants of strategic partner.  The reason for this is to make sure that any such transaction has a sound business purpose.
• Changing the Business.  Sometimes companies have to change their business model in a radical fashion, known as a “pivot.”  This is a very significant event, and this protective provision ensures that the preferred director understands and agrees with this move.  Companies will sometimes enter into new lines of business or exit one or more existing lines of business.  This protective provision also ensures that the preferred director agrees with these moves.
• IP transfers.  A company’s intellectual property – trademarks (the company’s name and logo), patents, trade secrets (think the formula for Coke) – are key assets of the company.  This protective provision ensures that the preferred director is aware of, and agrees to, any sale or transfer of these key assets to another company. 
  • Here’s another scenario inspired by my real experience.  A startup developed a famous character to be the focus of the company’s marketing efforts.  This famous character had lots of value.  The founder of the company controlled the company’s board (and no IP protective provision) and the company transferred the IP for this character to a subsidiary that was controlled by the founder.  The company went bankrupt and the founder walked away with this very valuable asset.  If there had been a protective provision requiring the preferred director consent to any IP transfer, this could have been avoided.
• Material Agreements.  Material contracts are those in excess of amount negotiated by the company and the investors.  The idea is that significant contracts must be approved by the preferred director.  These agreements include joint ventures or other strategic alliances where the company contributes assets (usually IP) to the effort.

 
These preferred director protective provisions work together.  The idea is that big events are approved by the preferred director.  There are other preferred director protective provisions, but the ones discussed above are the most common in my experience.
 
Note that as the company grows, there may be more than one preferred director, and so these provisions may require the approval of only one of the preferred directors, a majority of the preferred directors, or all of the preferred directors. 
 
These protections are typically found in an Investors’ Rights Agreement.

 
Actions Requiring Approval by the Preferred Stockholders
 
The actions requiring approval by the preferred stockholders (as opposed to the preferred director) generally relate to structural matters, such as changing the composition of the board of directors, issuing new stock or buying back stock, changes to the company’s charter documents, stock incentive plans and more.  These are pretty legalistic, but they’re important.
 
The consent of the preferred stockholders is required before the company can do any of the following:

• Change the Number of Directors.  This protective provision ensures that the vote of the preferred director isn’t diluted by increasing the number of directors without the consent of the preferred stock.  For example, if there’s a board of three directors, with 2 appointed by the common stockholders and one appointed by the preferred stockholders, this protective provision will prevent the board being expanded to five, effectively diluting the vote of the preferred director.
• Pay Dividends.  The company can’t declare or pay cash or stock dividends without the approval of the board, unless the dividends are mandated by the company’s certificate of incorporation.  This is to prevent the company from draining its all-important cash balances by paying a dividend.
• Repurchase Stock.  Repurchasing, or “redeeming” stock, occurs when the company buys back its stock from its stockholders.  This can be a big drain on cash, and so before this can be done, the preferred stockholders have to approve it.
• Change Charter Documents.  The company’s charter documents (the certificate of incorporation and bylaws) are the “constitution” for the company.  The charter documents contain provisions relating to dividends, voting, preferred stock conversion rights, anti-dilution, redemptions and more.  By law, both the board and the stockholders have to approve changes to the certificate of incorporation.
• Change the Number of Authorized Shares.  A company designates in its certificate of incorporation the maximum number of shares that it can issue.  This maximum number of shares is called the “authorized” shares of the company.  If a company mistakenly issues shares of stock in excess of this maximum authorized number of shares, bad things happen (I know – I’ve seen it happen!).  This is an additional protection to the protective provision relating to changes in the company’s certificate of incorporation.
• Issuance of New Securities.  This protection requires the company to obtain the consent of the preferred stockholders before they can create or issue any shares of common or preferred stock, or any security that would convert into stock, such as Simple Agreements for Future Equity (SAFEs), convertible notes and warrants.  The exception to this is that the company can issue stock options under a previously approved stock option plan.  This ensures that the preferred stockholders understand and approve of any new stock issuances that could impact the value of their stock or dilute their ownership position.
• Change Preferred Stock Rights.  An early-stage company will raise money in various preferred stock financing rounds.  Each of these preferred stock financing rounds is given a name – Series A (usually for the first round from professional investors such as venture capital funds), Series B, Series C and on.  The preferred stockholders don’t want any changes made to the rights of any of the series of preferred stock unless they approve it in advance.
• Issue Senior Securities.  Similar to above, the preferred stockholders want to approve the issuance of any stock that has the same or better rights than the preferred stock they own.  This is usually included even when there’s a protective provision for issuance of new securities – extra protection.
• Create Subsidiaries.  Bad things can happen with subsidiaries.  In some cases, companies have formed subsidiaries and transferred crucial assets, such as intellectual property, to the subsidiary and then undertaken transactions with other third parties without the board of directors of the parent company knowing about it.  Preferred stockholders protect against this by requiring the company to obtain their approval before forming any subsidiary or before the subsidiary enters into any material contract.
• Enter into Affiliate Transactions.  Sometimes companies will enter into transactions with founders, such as for the licensing of IP, or with corporate stockholders, which can lead to conflicts of interest.  Preferred stockholders protect against this by requiring advance approval for these transactions.
• Liquidate the Company.  This provision requires the consent of the preferred stockholders before the company can liquidate the company’s assets.  This way the preferred stockholders can oversee the shutting down of the company and how the company’s assets are handled.

 
Note that there are other protective provisions, but the above are the most common.
 
These protective provisions are usually found in the company’s certificate of incorporation.
 
Vote Threshold.  Depending on the negotiations, the percent approval by the preferred stockholders can be a simple majority (51%) or some “super-majority” such as 66.6% or higher.
 

Termination of Protective Provisions
 
Protective provisions typically expire when the company is sold or goes public.  Also these provisions typically expire when the number of outstanding shares of preferred stock falls below a certain level.  For example, the provisions may terminate when the outstanding preferred stock falls below 25% of
 

Preferred Director vs Preferred Stockholder Approval:  Why the Difference?
 
Why do some protective provision require only the approval of the preferred director, while others require the approval of all of the preferred stockholders?  In my view there are several reasons.

• Hassle.  Obtaining the consent of the preferred stockholders can be a hassle and lead to delays.  I know – I’ve experienced this.  While a board has a few members (usually five in start-ups), there can be dozens of preferred stockholders.  Most of the preferred stockholders will be “institutional” – venture capital funds, family offices, strategic (corporate) investors, foundations, endowments, and the like -- and these investors have their own internal approval process that can delay getting an approval back to the company in a timely manner.  Board members have a duty to the company to act quickly when board consents are needed, and so board consents are relatively easy and fast for the company to obtain.
• Knowledge.  The board knows the company’s business and finances very well, and so it makes sense to have the financial and operating protective provisions dealt with by the board instead of the less-informed stockholders.  If the company had to obtain stockholder approval for a financial matter could lead to big time lags due to educating the stockholders about the issue.  So the board deals with most financial and operational protective provisions.
• Sensitive Information.  The company may not want to disclose sensitive company information (such as detailed financial information, customer information, trade secrets and the like) to the stockholders, so having the protective provisions relating to the company’s finances and operations limited to the board makes sense.
• Legal.  As stated above, the protective provisions requiring stockholder approval typically relate to the company’s certificate of incorporation, and by law changes to the company’s certificate of incorporation require the approval of the stockholders.  So it makes sense that these protective provisions require stockholder approval.

 
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Negotiating Protective Provisions: Balance
When negotiating these protective provisions, there’s a balance that must be struck.  Too many restrictions can interfere with the day-to-day operations of the company.  Too few can lead to the preferred stockholders not being adequately protected.  It’s important to involve your investment and/or legal advisors in these negotiations.
 
 
 
© Allen J. Latta. All rights reserved. ​