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Hi, I’m Brad Feld, a managing director at the Foundry Group who lives in Boulder, Colorado. I invest in software and Internet companies around the US, run marathons and read a lot.

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Term Sheet: Protective Provisions

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As Jason and I continue to work our way through a typical venture capital term sheet, we encounter another key control term – the “protective provisions.”  Protective provisions are effectively veto rights that investors have on certain actions by the company.  Not surprisingly, these provisions protect the VC (unfortunately, not from himself.)

The protective provisions are often hotly negotiated.  Entrepreneurs would like to see few or no protective provisions in their documents. VCs – in contrast – would like to have some veto-level control over a subset of actions the company could take, especially when it impacts the VC’s economic position. 

A typical protective provision clause looks as follows:

Protective Provisions: For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or though any merger, recapitalization or similar event, that (i) alters or changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services), (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the Company’s Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of the Company’s Board of Directors, or (viii) results in the payment or declaration of any dividend on any shares of Common or Preferred Stock, or (ix) issuance of debt in excess of $100,000.”

Subsection (ix) is often the first thing that gets changed by raising the debt threshold to something higher, as long as the company is a real operating business rather than an early stage startup.  Another easily accepted change is to add a minimum threshold of preferred shares outstanding for the protective provisions to apply, keeping the protective provisions from “lingering on forever” when the capital structure is changed – either through a positive or negative event.

Many company counsels will ask for “materiality qualifiers” (e.g. that the word “material” or “materially” be inserted in front of subsections (i), (ii) and (vi), above.) We always decline this request, not to be stubborn (ok – sometimes to be stubborn), but because we don’t really know what “material” means (if you ask a judge, or read any case law, they will not help you either) and we believe that specificity is more important that debating reasonableness. Remember – these are protective provisions – they don’t “eliminate” the ability to do these things – they simply require consent of the investors. As long as things are “not material” from the VC’s point of view, the consent to do these things will be granted.  We’d always rather be clear up front what the rules of engagement are, rather than having a debate over “what material means” in the middle of a situation where these protective provisions might come into play.

When future financing rounds occur (e.g. Series B – a new “class” of preferred stock), there is always a discussion as to how the protective provisions will work with regard to the new financing. There are two cases: (a) the Series B gets its own protective provisions or (b) the Series B investors vote alongside the original investors as a single class.  Entrepreneurs almost always will want a single vote for all the investors (case b), as the separate investor class protective provision vote means the company now has two classes of potential veto constituents to deal with. Normally new investors will ask for a separate vote, as their interests may diverge from those of the original investors due to different pricing, different risk profiles, and a false need for overall control.  However, many experienced investors will align with the entrepreneur’s point of view of not wanting separate class votes as they do not want the potential headaches of another equity class vetoing an important company action.  If your Series B investors are the same as your Series A investors, this is an irrelevant discussion, and it should be easy for everyone to default to case b.  If you have new investors in the Series B, be wary of inappropriate veto rights for small investors (e.g. consent percentage required is 90% instead of a majority (50.1%), so a new investor who only owns 10.1% of the financing can effectively assert control over the protective provisions through his vote.)

Some investors that feel they have enough control with their board involvement to ensure the company does not take any action contrary to their interests, and as a result will not focus on these protective provisions. During a financing, this is the typical argument used by company counsel to try to convince the VCs to back off of some or all of the protective provisions  We think this is a short-sighted approach for the investor, for as a board member, an investor designee has legal duties to work in the best interests of the company. Sometimes the interests of the company and a particular class of shareholders diverge. Therefore, there can be times whereby an individual would legally have to approve something as a board member in the best interests of the company as a whole and not have a protective provision to fall back on as a shareholder.  While this dynamic does not necessarily “benefit” the entrepreneur, it’s good governance, as it functionally separates the duties of a board member from that of a shareholder, shining a clearer lens on a area of potential conflict.

While one could make the argument that protective provisions are at the core of the “trust” between a VC and entrepreneur, we think that’s a hollow and inappropriate statement.  When an entrepreneur asks “don’t you trust me – why do we need these things?”, the simple answer is that it is not an issue of trust.  Rather, we like to eliminate the discussion about who ultimately gets to make which decisions before we do a deal.  Eliminating the ambiguity in roles, control, and rules of engagement is an important part of any financing – the protective provisions cut to the heart of some of this.

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