Protective Provisions and Investor Vetoes

Protective Provisions are a set of voting rules that give the investors special veto powers over key business decisions. These prevent the founders and the management to suddenly change the course of the business, the overall voting rights or dilute any existing shareholders through new, unapproved fund raises.

Businesses are run by its management, the board of directors and the shareholders – in that order. The shareholders have the most power since they own the company, but in daily life their influence is relatively indirect. And that is especially true in startups. This is because founders will likely own the majority of shares. They also hold most director positions and run the day to day affairs as C-level employees.

Protective Provisions safeguard investors from founders going rogue. Think of the following power dynamic. Share issuances are governed by management, which is governed by directors, who are governed by shareholders. That means without protective clauses, founders who will likely have control at each level. They could easily issue new shares at nominal prices to themselves, diluting everyone else. The same is true for salaries, loans, consulting agreements etc. All of these transaction could legally (to a large extend at least) enrich founders to the detriment of investors. And even if the founders don’t try to siphon off money, they might simply get overconfident. Imagine them making huge bets changing the nature of the business without a say from investors. Or think of selling the intellectual property, or buying other companies etc. You get the point!

Lets look at some of the more common protective provisions that might show up in deal terms.

Common Protective Provisions

The following is an overview of common Protective Provisions with and explanation of their purpose. At the bottom of this post we highlight a sample text from an actual term sheet.

Some of these provisions are very much essential. Think of those relating to share issuances, changes to the composition of the board or sale of the company. Others may be added specifically early in the life of a startup. Especially when the founders don’t have a track record of managing funds, yet, safeguards are even more warranted. This could relate to restrictions on maximum salaries or consulting agreements.

However, some of the below items may be dealt with in a specific board vote. As long as the vote requires non-founder directors to participate, part of the protective effect can be achieved. That can help to avoid huge administrative hurdles when the company has existed for a while. Obtaining a slew of investor approvals can be very time consuming as the number of shareholders is increasing.

Amendments to the memorandum and articles of association

The M&A governs essentially all major business dealings including share issuance and director changes. Especially if there are no additional rulings in the shareholders agreement, changing the M&A would allow the founders to execute substantial governance changes that could affect nearly anything that drives value.

Increasing the issued share capital of the company and allotting shares

Changing the issued share capital and allotting shares could be used to dilute certain shareholders artificially or execute preferential share sales with related parties such as family members or related holding companies. Additionally one could issue shares of subsidiaries to Founders until they hold the majority of these.

Changes to share capital and share allotments will typically be governed by special resolutions and approvals for specific events such as fund raises or the establishment of an option pool. Hence founders should not have the sole right to manage these.

Paying a dividend

Obviously a dividend is a significant cash event for any company. While a regular dividend will be paid out in equal parts to all shareholders there can also be special dividends benefiting only individual shareholders. As such there should be a strict approval mechanism put in place. Especially since in startups dividends are highly uncommon anyways: All available funds should typically be used for growing the business.

Repurchasing of Stock (specifically ordinary/founder shares)

The repurchase of stock is another major transaction impacting overall shareholdings and the cash positions of a company and hence should be managed with oversight. Without restrictions, Founders could try to sell part of their shares to the company, e.g. to withdraw cash after a recent fund raise.

Liquidating, dissolving or winding-up the Company

This part maybe less intuitive as one might think as there seems to be no value in liquidating a company as opposed to growing or selling it.

Think of this scenario: Just after a fund raise (and in the absence of a liquidation preference rules) all funds would be distributed equally across all shareholders. That would benefit the shareholders who hadn’t paid-in funds in the most recent funding round(s) more than those who did. E.g. if one VC pays US$1m for 30% of a company, and assuming there is no other cash in the banks and no liabilities outstanding, the US$1m would be distributed equally across 100% of the shares. Hence the VC would loose US$700k right away. Of course the liquidation preference rules are another important safeguard for such a scenario, but with added complexity of cap tables in subsequent rounds its good for investors to have a further say in this case.

Additionally, the decision to wind-up a struggling startup is never clear cut and the exact timing is never fully definitive. For example the company may still have enough money to continue to operate at a significantly scaled back level under new management. But the founders may just want to liquidate whatever cash is still left and be done with it. This safeguard at least allows the investors to have a conversation. And provided the investors are not putting in new money the topic of liquidation will come soon enough.

Issuing any equity or quasi equity securities with either preference in liquidation or preferential voting rights

As mentioned above regarding regular equity, issuing new equity in any shape or form significantly impacts voting rights, power dynamics and also financial payouts in exits or liquidation of the company. This is also true for issuing new preferred shares who as the name suggest are even more valuable than ordinary shares. As such their issuance should not be in the hands of just the founders.

Incuring indebtedness (including lease finance, and the provision of a bank guarantee or security)

Incurring debt first and foremost is a major cash transaction and it changes the risk and payout structure under any exit or liquidation. Debt by nature ranks higher in a liquidation, some forms of debt might have conversion into equity built-in and in some cases debt might need to be repaid prior to any exit or fund raise. Hence there is a clear need to consider governing any type of debt transaction with the right safeguards. Of course this can be again managed either by the board of directors with a vote that includes non-founders or simply the protective provision vetoes.

Selling equity in any group company

This is another major transaction impacting the business of a company. One could sell parts of or entire group companies for too low of a price to related parties of founders. Additionally, any uneconomical transactions are detrimental to all shareholders of the group and hence need to be governed properly.

Investing surplus funds

Surpluses in a startup typically are expected to be reinvested into growing the business. Investing funds either in the stock market or by investing it into other new subsidiaries or even startups needs to be well planned and controlled. If such transactions occur, they need to be jointly agreed to avoid wasting or diverting of the provided funds.

Entering into any acquisitions or mergers

Again M&A transactions have a very significant impact on the overall strategy of a startup and its cash and equity position. While they of course can be very beneficial, investors need to be able to have a say. Otherwise its again a passageway to siphon off funds or reallocate wealth. Additionally, in many cases its probably a good idea if first time founders get a few additional pairs of “eyes” to safeguard such significant strategic decisions.

Loan or advance funds to any person, including, any employee or director, except advances and similar expenditures made in the ordinary course of business

Especially in early stage startups there are not many reasons why a company should use investor money to pay loans or advances to individual employees, especially founders and directors. Its of course a prime way to withdraw funds from the coffers of a startup. In regards to salary advances, think of a scenario prior to the next funding round when the company is starting to run short on money: Clearly not a good time to pay salary advances to its management.

Approving the appointment of a director

Adding directors has a significant impact on the overall power relationships of a company. One additional director position might already sway majority powers and render certain board vote protections ineffective. Hence usually there will be a maximum number of board seats prescribed and appointment of specific people can be vetoed by investors, if there occurs a change or addition to the board of directors.

Approving the remuneration of Management, directors or any employees for any remuneration in excess of US$XXX per year, any consultancy projects in excess of US$XXX per year, any pension or stock option plans; terminate the service contract/s of the management, director/s or key employees;

This is a clause particularly useful in the early days of a startup when there is no money management track record of a founder team and when there is not much cash in the business, yet. Although founders and directors typically don’t take huge salaries in startups anyways, not having appropriate safeguards for remuneration opens the door for all kinds of unintended discussion as to what is “appropriate” down the road. Be aware that there are many forms for founders to remunerate themselves, be it salary, pension fund contributions or consultancy side-agreements.

Appointing a new CEO

This rule grants the investors a say in any new CEO appointment. Its less significant and, depending on the scenario, of debatable need. The reason being that Founders won’t just step down from the CEO role without also selling their shares, which is governed separately. Also lets not forget, shareholders decide on the directors and management anyways, but based on their regular shareholdings. So one might argue, basing this decision on shareholdings already provides adequate say for investors. Then again its not a significant administrative burden to have the anyways rare occasion of CEO change be approved by investors.

Changing the nature of the Company’s business

While significant, this part might be a little bit harder to enforce as it is difficult to define and to determine what the consequences are. E.g. is it a change of business to establish another (related) revenue stream? And what would one sue for, if a team of software developers suddenly switches the product pre-Revenue? Loss of “expected” revenue?

It does however provide for a psychological barrier and most founders would surely ask for permission to maintain good relationships at a minimum.

Changing the Company’s auditors or changing materially its accounting policies

Changing accounting policies can have significant impact on company valuation by way of adjusting revenue recognition for example. In addition, accounting and its governance plays a critical role in preventing fraud. Hence any change especially in auditors should be supervised. That is true even more so, if the change is to a less known audit firm that might have unknown relationships or is even related to Founders or employee shareholders.

Adopting or revising an annual budget, including capital expenditure and investment projections, with a threshold of US$XXX difference from the approved budget

The agreed financial plans serve the purpose to ensure the company is working towards a pre-agreed common goal. Fund raises are executed for a projected time frame of 12-24 months. If a company starts spending faster or slower, this may significantly harm its growth trajectory or its ability to raise subsequent funds. As such its reasonable to put safe guards in place that ensures that (inexperienced) founders can’t randomly change their budgets.

Voting on Protective Provisions

Voting on Protective Provisions naturally should fall into the hands of Investor shareholders. This can however be executed in many different ways. For example votes can be determined as a simple majority or a specifically high majority (2/3 or 75% vote). This can be useful if one investor otherwise gets too much power.

Secondly the voting group can be defined by share class. This could be by all preferred shares or only Series A preferred shares or by nature of the shareholder. For example one can define an “investor group” in the agreements including certain share classes or individual share holders. Also, there maybe a case were non-founder employees hold ordinary shares if they joined very early. Another variation could be that the founders have substantial wealth and might join investment rounds. So the veto vote could be by “Non-Founders” or by “Non-Founder Investor”. The second variation excludes employees, if they are not supposed to join the vote.

Sample Protective Provision

Below please find a sample Protective Provision clause as it could be used in a term sheet. Please note the full Protective Provisions in a Shareholders Agreement or in the Memorandum and Articles of Association (M&A) may be more detailed. Also the below does not constitute legal advice. You should certainly have an experienced lawyer draft your agreements.

Protective Provisions:
The consent of 50% of the votes held by the non-Founder shareholders, consisting of this round of investment and future rounds of investment (excluding Founders) shall be required before the Company may:
- amend the articles and memorandum of association of the Company or of any group company, where the amendment would have an adverse effect upon the rights of the Investor Group;
- increase the issued share capital of the Company;
- pay a dividend on or repurchase any Ordinary Shares;
- recapitalize, reorganize, merge or sell/transfer substantially all of the Company’s assets or those of any subsidiary;
- liquidate, dissolve or wind-up the Company;
issue any equity or quasi equity securities with either preference in liquidation or preferential voting rights to the Series A Shares;
- incur indebtedness (to include lease finance, and the provision of a bank guarantee or security) in excess of the amounts disclosed in the Company’s board approved business plan and budgets;
- sell equity in any group company;
invest surplus funds (i.e. funds in excess of those required for the Company’s agreed use of proceeds);
- enter into any acquisitions or mergers;
- loan or advance funds to any person, including, any employee or director, except advances and similar expenditures made in the ordinary course of business;
- approve the appointment of a director;
- approve the remuneration of Management, directors or any employees for any remuneration in excess of US$100,000 per annum, any consultancy projects in excess of US$20,000 per annum, any pension (except MPF in the normal course) or stock option plans;
- terminate the service contract/s of the Management, director/s or key employees; appoint a new Chief Executive officer of the Company;
- change the nature of the Company’s business;
- change the Company’s auditors or its change materially its accounting policies; or
adopt or revise an annual budget, including capital expenditure and investment projections, with a threshold of US$10,000 difference from the approved budget.

Sample Short Form Protective Provision

Another option to deal with protective provisions is to simply assume is that all parties will agree on theses anyways. If that’s a fair assumption one might just write one brief sentence that “typical Protective Provisions will apply”. The advantage of this is you are shortening your termsheet by easily half a page. Shorter termsheets means faster signing of termsheets! Termsheets are typically designed to be not legally binding anyways, so their purpose is to document commitment and set a price.

The only downside of this is it creates additional potential of conflict during the drafting of the binding deal agreement. That means right at the time of closing the deal might get stuck on a technicality.

An example of such a clause could be as short as follows:

Protective Provisions:
Usual and customary for transactions of this type.

Conclusion

The protective provision are an essential part of any fund raise. They provide investors clear cut vetoes over essential business transactions. Without them investors are at the mercy of majority decisions. They usually don’t have majority at board nor shareholder level. As many protective provisions can be considered standard, one could defer their determination to the binding deal agreements. Simply write “Usual and customary for transactions of this type.” under Protective Provisions.

Disclaimer
This guide is not intended to and does not constitute legal or tax advice, recommendations, mediation or counseling under any circumstance. This guide and your use thereof does not create an attorney-client relationship with Startupvaluationschool.com or Ed.Pres Limited. The guide solely represents the thoughts of the author and is neither endorsed by nor does it necessarily reflect Ed.Pres Limited’s belief. Ed.Pres Limited does not warrant or guarantee the accurateness, completeness, adequacy or currency of the information in the guide. You should seek the advice of a competent attorney or accountant licensed to practice in your jurisdiction for advice on your particular problem.

Table of Contents

Protective Provisions and Investor Vetoes

Common Protective Provisions

Voting on Protective Provisions

Sample Protective Provision

Sample Short Form Protective Provision

Conclusion

Drag-Along Rights

Right of First Refusal (ROFR)

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