Aside from the economics of an investment, investors also care about having some degree of control over their portfolio companies. Not a draconian level of control, but rather just enough to ensure that the portfolio companies aren’t given carte blanche to make decisions without investors’ guidance or approval.
To ensure that investors have some control over portfolio companies, the company’s Certificate of Incorporation will have protective provisions. Protective provisions are company actions that require a vote of the stockholders, traditionally the preferred stockholders, prior to the company taking such actions. Often the vote threshold is set at a majority of the preferred stockholders, but it can also be higher or lower, require the vote of a certain investor (see example below), or be series-specific such that you need the consent of specific series of preferred stock for certain actions instead of the preferred stock as a whole.
Imagine that a company is raising $10 million in a financing round, $4 million of which is coming from the lead investor, and the remaining $6 million of which is coming from three non-lead investors, each investing $2 million. A majority approval, in this case, would require either: (a) the lead investor and one of the non-lead investors, or (b) all of the non-lead investors. In this case, the lead investor may request that the voting threshold is set above a majority to ensure that her consent is needed to waive or amend any protective provision or that the majority must include the consent of the lead investor.
The number of protective provisions and how broad or narrow they are is often a negotiated point between founders and investors. Below is a list of the most common protective provisions, and the typical ways in which they’re negotiated.
The company cannot liquidate, dissolve or wind-up its business without consent of the requisite preferred stockholders.
This is a provision that may become series-specific over time, thus requiring a majority of each series of preferred stock to agree to any exit by the company.
The company cannot amend the charter or bylaws.
Founders might seek to limit the scope of this protective provision by limiting it to situations in which such amendments would adversely affect the holders of preferred stock.
The company cannot (a) create, authorize, or reclassify any capital stock, or (b) increase the authorized number of shares of capital stock unless such capital stock ranks junior in rights, preferences, and privileges to the preferred stock.
This is a provision that may become series-specific over time, thus requiring a majority of each series of preferred stock to agree to any exit by the company.
The company cannot issue cryptocurrency or any form of digital tokens.
Investors might negotiate that this provision requires board approval, including the approval of at least one preferred director.
The company cannot purchase or redeem any capital stock prior to redeeming the preferred stock or distribute any dividends prior to distributing dividends to the preferred stock.
Investors might negotiate that this provision requires board approval, including the approval of at least one preferred director.
Founders will often negotiate that capital stock repurchased from former employees and consultants by virtue of the end of their services is generally excluded from this protective provision.
The company cannot amend, terminate, or adopt any equity incentive plan without consent of the requisite preferred stockholders.
Investors might negotiate that this provision requires board approval, including the approval of at least one preferred director.
The company cannot issue debt, other than equipment leases or lines of credit in the ordinary course of business, above a negotiated dollar threshold.
The threshold is often negotiated based on the company’s line of business and the stage of the company.
Investors might negotiate that this provision requires board approval, including the approval of at least one preferred director.
The company cannot own capital stock in a subsidiary that it does not wholly-own or dispose of a subsidiary’s capital stock, or substantially all of its assets.
International companies might find this protective provision difficult to comply with as some subsidiaries might be incorporated in foreign jurisdictions that do not permit whole ownership by a foreign entity. Therefore, founders may request exceptions to this provision if they have foreign subsidiaries.
The company cannot change the size of its Board, or the number of votes each director is entitled to cast.
Investors might negotiate that this provision requires the approval of at least one preferred director.
Occasionally, the company will also be prohibited from amending the protective provisions so as to weaken or remove them, thus, giving them the ability to do everything they were previously prohibited from doing without investor consent.
Arguably, this type of maneuver is already implicitly prohibited by the existing standard set of protective provisions, but nevertheless sometimes this additional, “catch all” provision is included.