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.
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.
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.
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