There are certain decisions that are so essential to the value of their investment that investors insist on approving them. Since most Series A investors own around 20-25% of the startup, it is unlikely that they would be able to influence the majority when voting on an as-converted basis.
The Purpose of Protective Provisions
Protective provisions allow investors to have influence on some major decisions without taking a majority stake in the startup. A typical Series A term sheet includes a set of issues that require approval from a majority of preferred shareholders. These seven issues mainly relate to corporate actions that could affect the value of the preferred shares.
Types of Protective Provisions and How They Work
The company, meaning neither the management team nor the board of directors, may take the following actions without the written consent of a majority of preferred shareholders.
Liquidate, Dissolve or Wind-Up the Affairs of the Company
As an investor who has invested considerable time and money into a startup, it’s understandable to want to prevent immature liquidation or dissolution of the startup. These actions often result in a total loss of investment. If there are other ways or directions that the entrepreneurs could take before giving up on the startup, such as selling to potential buyers at a loss, the investor would want to explore them first.
Liquidation or dissolution would also trigger the liquidation preferences negotiated as part of the special rights. This liquidation could include a change of control in the company or an acquisition by another company. This is the moment that investors are waiting for, as it’s when they can make their money back. It’s not surprising that they would want to make sure the company is getting the best acquisition deal. Do not shut down or sell the business prematurely.
Adversely Change Rights of the Preferred Stock
The company cannot change the bylaws or the charter in a way that would change the terms of the preferred stock. Investors have spent significant time and effort negotiating the rights attached to the preferred shares, and the value of these shares is determined by those negotiated rights. Similarly, the founder has undergone an extensive evaluation process to determine how much of the startup they are willing to give up for a specific investment amount. The details of the rights and negotiations represent an agreement reached after formal negotiations. Any changes to these rights would impact the value of the preferred shares. Therefore, it is understandable that investors seek to protect these rights. Requiring a majority of preferred shares to approve any negative changes to the preferred shares prevents entrepreneurs from modifying these rights without approval.
Create New Securities that Have Equal or Senior Rights
The company needs the approval of the Preferred Shareholders before granting the same or better rights to other shareholders. If a new series of preferred shares is created that are senior to or equal with the existing preferred shares, this would reduce the economic potential and control for the investor. Therefore, the investors are not in favor of this happening without their approval.
Many startups are pivoting toward Web3 business models. This shift often means that the value of the company is now based on the digital token it issues rather than the company’s stock. If a company chooses to tokenize, investors will want to receive a portion of tokens for their investment in order to avoid missing out on potential value. Therefore, it is important for them to approve a token offering to protect their investment.
Declare or Pay Any Dividend
Don’t pay shareholders in the form of a dividend. Paying dividends is not a common practice in startups since a company is expected to reinvest any capital it earns to continue growing and scaling, especially while it is still young. Startup investors are not looking to make a small dividend on their investment, rather they are looking for outsized returns. So, they do not expect to receive dividends. Furthermore entrepreneurs should not use dividends to pay themselves a salary. Instead, investors expect any revenue generated from operations to be used to accelerate growth. Therefore, the declaration or payment of any dividend must be approved by a majority of Preferred Shareholders.
Take on Excessive Debt
Startups commonly incur debt, depending on the industry. Nevertheless, investors want to make sure that the company doesn’t take on debt it can’t easily pay. If the company defaults on its debt, it will liquidate, and the debt holders will be paid before the investors. As a result, it’s usual for investors to establish a limit on the amount of debt the startup can take on without their approval.
There are a number of ways that value can be stripped away from an investor by creating, holding stock in or dissolving subsidiary companies. In order to avoid this diminution of value, investors require approval for these actions.
Potential Drawbacks or Risks Associated with Protective Provisions
While protective provisions provide added security for investors, they have a negative impact for founders in the following ways:
- Loss of Control: All of the protective provisions take decisions out of the hands of the board or management team. Now, in order to take any of the seven decisions above, they need the permission of the Preferred Shareholders.
- Complexity: Keeping track of the decision rights required for any given decision can get complex, especially as more protective provisions are added in subsequent rounds. Managing who has to approve what decision can be challenging. Furthermore, gathering the requisite consent can often slow down progress on an essential decision.
It’s important for founders to carefully consider these potential drawbacks or risks before agreeing to protective provisions in their funding agreements. While they provide added security for investors, they can also impact a startup’s ability to operate effectively. As always, seeking legal advice is recommended when negotiating funding agreements with investors. If you’re looking for legal counsel, feel free to reach out to us here.
Negotiating Protective Provisions: Tips for Startups
Negotiating protective provisions with investors can be a challenging process, especially for early-stage startups that may not have much leverage. However, it’s important for founders to carefully consider these provisions and negotiate terms that work for both parties.
Here are some tips for startups when negotiating protective provisions:
- Understand the Impact of Each Provision: Before agreeing to any protective provision, founders must understand its potential impact on their ability to run the business effectively. They should also consider how it could impact future funding rounds and the company’s valuation.
- Prioritize Control: Founders should prioritize maintaining control over their company’s operations and decision-making processes. While protective provisions can provide added security for investors, they can also lead to a loss of control for founders.
- Seek Legal Advice: It’s always recommended that founders seek legal advice before signing any funding agreements with investors. A lawyer can help them understand the terms of the agreement, understand what term is standard or not, and negotiate terms that work in their favor. If you’re looking for legal counsel, feel free to reach out to us here.
- Be Flexible: While it’s important to prioritize control, founders should also be flexible when negotiating with investors. They should be willing to compromise on certain terms if it means securing funding from the right investor.
By following these tips, startups can negotiate protective provisions that provide added security for investors while still allowing them to maintain control over their business operations and decision-making processes.
Protective Provisions vs Other Types of Investor Rights
Protective provisions are a type of investor right that can be included in startup funding agreements. Other types of investor rights include anti-dilution protection, board seats and information rights.
- Anti-Dilution: This protection prevents dilution of an investor’s ownership stake in a down round.
- Board Seats: Investors with seats on the board of directors can participate in key decision-making processes and provide input on important business matters.
- Information Rights: Investors with information rights have access to important financial and operational information about the company, such as regular financial reports, board meeting minutes and other key documents. They use this information to monitor the company’s performance and make informed decisions about their investment.
Protective provisions are designed to protect investors from potential harm, while other types of investor rights focus on giving investors access to information and governance rights. Founders should carefully consider which types of investor rights they are willing to offer as part of their deal terms, as each type comes with its own set of benefits and drawbacks.
The Impact of Protective Provisions on a Startup’s Culture and Decision-Making Processes
Protective provisions can have a significant impact on a startup’s culture and decision-making. Investors gain the ability to influence key decisions, which can lead to conflicts if they prioritize short-term gains over long-term growth. This can create a sense of mistrust between founders and investors, particularly in early-stage startups where trust is crucial.
Protective provisions can also create a risk-averse mindset among management, limiting growth potential. Founders should carefully consider the impacts and negotiate clear guidelines for decision-making. Both parties must approach negotiations with care to create a funding agreement that provides security for investors while allowing the startup to thrive and grow.
The Use of Protective Provisions in Impact Investing and Socially Responsible Investing
Protective provisions are not only used in traditional startup funding agreements, but can also be found in impact investing and socially responsible investing deals. In these types of investments, the goal is to generate both financial returns and positive social or environmental impact.
Protective provisions serve an important role in ensuring that the company’s mission and values remain aligned with those of the investors. For example, protective provisions can be a mechanism for impact investors to ensure that key decisions made by the management team align with the company’s stated social or environmental goals.
However, protective provisions could also force a company to take an action that is misaligned with its mission. These provisions can be used either for good or bad.
Therefore, in order to use protective provisions to enhance your social or environmental impact, it is important that founders and investors are extremely clear about their goals. It is also important that both parties’ counsel fully understand the intent and are committed to drafting with the mission in mind.