Protective Provisions are separate class voting rights for a company’s investors holding shares of preferred stock. The protective provisions provide investors greater control over the company, even if they don’t own a majority of the stock.

 

One of the great lies that startups tell, in this case tell themselves, is that if the founders own at least 51% of the company’s stock, they will maintain control. When everyone owns the same class of stock, this will generally be the case. Sophisticated angel invetors and venture capital funds do not own common stock like the founders and management do, however, they own preferred stock for the very reason that it can give them greater control when they don’t own a majority of the shares. See related blog post Structuring Your Financing as the Purchase and Sale of Preferred Stock .

What are Protective Provisions?

Protective provisions are class voting rights that run in favor of the holders of preferred stock. When negotiating and setting up preferred stock, investors will place these protective provisions into the company’s certificate or articles of incorporation. The protective provisions are essentially veto powers, giving the investors a blocking position over certain material company transactions where they want to have a say. In other words, in order to do the things that are spelled out as the protective provisions, the company must obtain the approval vote of the holders of a majority of the shares of preferred stock, voting separately as a class and not together with the holders of the commmon stock (founders and management).

Commonly Used Protective Provisions

Here is a list of protective provisions that you might see in an angel or early-stage VC term sheet, stating that the company may not, without the consent of the holders of preferred stock, voting as a separate class:

• change the rights, powers or privileges of the preferred stock (this is an automatic protective provision. It is essentially repeating what is in the corporations code)
• increase or decrease the authorized number of shares of preferred stock (this is an automatic protective provision. It is essentially repeating what is in the corporations code)
• sell assets, merge or effect any change of control transaction (this is a fairly standard protective provision)
• authorize or issue any security that is senior to or pari passu with the shares of preferred stock (this is a fairly standard protective provision)
• liquidate, dissolve or wind up the company (this is a fairly standard protective provision)
• redeem any shares of common stock (this is a fairly standard protective provision)
• pay or declare a dividend on the shares of common stock (this is a fairly standard protective provision)
• increase or decrease the size of the board of directors (this is a fairly standard protective provision)
• amend the corporation’s Equity Incentive Plan or create any new stock option or equity incentive plan (this protective provision is less standard. For example, it is not included in the Series Seed form Amended and Restated Certificate of Incorporation)
• grant a security interest in all of the corporation’s assets (this protective provision is less standard. For example, it is not included in the Series Seed form Amended and Restated Certificate of Incorporation)
• amend the corporation’s certificate of incorporation or bylaws (this protective provision is less standard. For example, it is not included in the Series Seed form Amended and Restated Certificate of Incorporation)

As you can see, protective provisions cover major corporate transactions, in particular those that will affect the expected returns of the investors on their investment. In laymen terms, these provisions give the investors greater control over selling the company, changing the terms of the preferred stock financing, allowing founders and management to get liquidity for their shares before the investors do, selling more shares on terms that they are not happy with, or changing the way in which the company is run. Protective provisions do not generally get into the day-to-day management of the company’s affairs, although some times you might see protective provisions regarding capital spending limits, borrowing funds and approving the annual budget and business plan of the company. These are big ticket items, so investor control of the company through protective provisions can be substantial, even when the investors own a very small percentage of the stock of the company (theoretically as little as 1 share).

Where to Get the Legal Documents with Protective Provisions

The protective provisions will normally be drafted into a preferred stock financing term sheet and into the certificate of incorporation in the full set of preferred stock financing documents.

Reprinted by permission.

Image credit: CC by Juan Andrés López