What are protective provisions?
Protective provisions are the set of terms that ‘protect’ an investor's rights such as their ability to veto a decision or action that they do not agree with—e.g. the issuance of more stock, the liquidation of the company, or the acquisition of the company. Protective provisions mitigate risk for investors and help protect the interests of minority shareholders in the event that there is a disagreement regarding the best course of action for the company.
Why are protective provisions important?
Understanding the set of protective provisions your investors expect is important, because it can fundamentally alter the operations of your startup, and change the power dynamic between your founding team and your investors. For example, let’s say the founding team receives a compelling acquisition offer that they wish to pursue. After discussing it with the board, there is disagreement—the founding team wants to sell, but the board doesn’t agree with the decision. In this example, depending on the protective provisions that are in place, the board may have the ability to veto the acquisition and prevent the sale of the company.
Why do startups agree to protective provisions?
Oftentimes, protective provisions come standard as part of a term sheet. If founders decide that they do not wish to include them, they might have a challenging time attracting investors and down the road the organization will not likely have a solid foundation for corporate governance.
Where are the protective provisions of a deal found?
Protective provisions are generally outlined in a startup’s articles of incorporation—they are negotiated between the founding team and the investors prior to signing a term sheet.
What are some examples of protective provisions found in a term sheet?
- Anti-Dilution Protection (also know as an anti-dilution clause, subscription right, subscription privilege, or preemptive right) - used by investors to protect their investment in the event of a down round, or a significant dilution event, such as the issuance of new shares for a round of equity financing, or the conversion of a convertible note.
- Pro-Rata Rights - enables investors to maintain their equity stake and their voting power even when new shares are issued, without the obligation to invest in later rounds.
- Redemption Rights - give investors that hold preferred stock the right to require that a company repurchase their shares after a specified period of time. They are designed to protect investors when a company’s valuation is stagnant, and is no longer an attractive acquisition target or IPO candidate.
- Registration Rights - the ability of an investor to require a company to go public so that the investor can sell their shares. There are two primary forms of registration rights: “piggyback”, which allow investors to have their shares included in a registration (IPO) that is currently in the planning stages by the company and “demand” which allow the investor to require a company to go public even if they’re not planning to do so in the near future.
- Veto Rights - give a company’s board of directors the right to refuse to approve a proposal, thus preventing its enactment. Example proposals may include: an increase or decrease in the amount of preferred or common stock, the creation of any new series or class of shares and the acquisition of another organization.
- Voting Rights - give board members the right to vote on topics discussed in board meetings, such as a funding round, the issuance of new stock, the initiation of mergers and acquisitions and more. Without voting rights, a board member has no say in the direction of the business or the residing management team. One important note: voting rights don't have to be given equally to board members.
What are some of the protective provisions to avoid agreeing to?
- Provisions that give investors a say in the hiring, firing or change in the compensation of any of your executive officers - including the CEO and founders!
- Provisions that give investors a say if/when you decide to enter into a new line of business (spoiler: you eventually will)
- Provisions that give investors a say if/when you decide to purchase a material amount of assets of another entity (e.g. acquisitions or acquihires)
What are the common pitfalls to avoid in relation to protective provisions?
- Minimum Outstanding Preferred Shares Threshold - To avoid situations where protective provisions remain in place regardless of the amount of outstanding preferred shares, consider including language that specifies the threshold by which the protective provisions no longer apply.
- High Voting Thresholds - to ensure that you avoid scenarios where investors holding a small percentage of shares can veto decisions that you want to make, consider including language that specifies a requisite consent percentage from preferred shareholders below 66.66%.
Our thoughts on protective provisions
Protective provisions are not always a zero-sum game - they can help improve corporate governance and increase the degree of trust between you and your investors , aligning the interests of both parties. With that said, it’s critical to negotiate the protective provisions in your term sheet in order to maintain control over your business. Ultimately, like founders, investors want to see their portfolios grow—protective provisions help investors make sure they get their returns - even if that comes at your expense.
Arc’s funding is 100% dilution-free, so protective provisions do not apply! If you’re interested in growth capital, you can learn more here.