Protective Provisions: 5 Things to Know About VC Terms Sheets and Provisions
Venture capital protective provisions should be no surprise to anyone entering a private investment relationship. Investors want to make sure their interests are protected, including how those interests are affected by the company’s decisions. In practice protective provisions definition includes terms that give the investors a veto or power block on specific types of corporate activity or action.
For example, if the company’s Board of Directors decided to go down a path of activity specified in the protective terms, they couldn’t go ahead after a majority vote. Instead, the vote would need to have a specific percentage of support from the preferred stockholders (investors) before anything can move forward. This is a typical but powerful protective term effect that allows the investors who get a minority share in the company the ability to hold back the majority owners, who are typically the ones needing the investing, but don’t always share the same interests in direction.
Types of Protective Provision Terms
First, protective provisions often appear in one of two forms: standard and controversial. In most cases, the language tends to be boilerplate and non-controversial, but they are always present. After all, a company trades investment ownership to get ready cash from investors, so those investors want to be sure that cash will come back at some point in the future.
Controversial terms should be avoided where possible; they only lead to conflict. These are often injected in one-sided affairs that may create immediate power but long-term bad blood, and that can kill a company's magic early before fruition. No one needs the genius walking out the door who invented the product everybody wants before it gets to market.
Ownership Changes & Protective Provisions
Second, protective provisions will always go after the predictable first which includes any kind of influence or change on ownership or dilution of ownership. That includes any kind of major asset sale or liquidation event, any change to the certificate of incorporation or the rules that dictate company ownership such as the bylaws, any modification to ownership or leadership powers, and any change to the value of the preferred stock that would adverse in nature.
Third, terms are often written to focus on any kind of quantity change in ownership equity as well. For example, one of the ways that Facebook management was changed early one was by a subtle but quick redefinition of specific ownership shares. The change was immediate, placing Zuckerberg and his prime investors in charge and removing the early supporters from any practical control whatsoever. Equity preference, parity changes, dilution, and percentage shifts are all possible otherwise. Additionally, redirection of dividends, forced liquidations or redemptions, and other change to preferred stock can come into play without protections.
While not what one would consider a need for a protective order, investors frequently want to have some discussion about big changes in infrastructure or critical assets as well. Big purchases or asset acquisitions through direct purchase or financing are frequently involved. After any big investment it’s natural to expect a company to grow and bring critical assets; that’s why investments are needed in the first place. However, investors are not keep on just handing their money over and then sitting silently, so any such equity-influencing action should be anticipated by protective terms to screen before anything goes forward.
A Limit to Influence
For the company there is language that ensures that protective provisions don’t go on forever, limiting the ability of investors when they no longer have a major stake in the ownership. This occurs when preferred stock drops below a minimum percentage of outstanding shares in most cases, i.e. the investor has been redeeming shares on his or her own. Typical preferred stock redemption rights language is going to include phrasing such as, “at any time that originally issued Series A Preferred Stock is outstanding not redeemed, an investor shall retain powers of …” This sort of clause places an objective, clear limit and draws the line for everyone involved.
To keep a company in position to maintain its momentum of growth, especially when the market introduction is hot, it’s critical to not allow management to squander valuable investment, but it’s also important not to restrict leadership so much that it can’t work the magic that make the company work. Protective terms don’t have to be one-sided but they are, traditionally, included to protect the investor side. Crafted right, they can do so but they can also be written to avoid hamstringing the business as well.
Learn more about private equity and venture capital through the leading firm, Angel Kings. You can also purchase the #1 ranked book on venture capital and startup investing here. Expert on private equity and VC, Ross Blankenship, has also written extensively about the provisions that make a great startup.