editione1.1.4
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caution While most protective provisions are not negotiable, many founders do not realize the control dynamics these provisions create. In most significant priced rounds following the seed, the company will have to agree to protective provisions. Too often, founders inaccurately believe ownership percentage is the ultimate driver of control dynamics. But protective provisions, while they shouldn’t be considered backdoor mechanisms for investors to sneakily exert control, can absolutely compel you to compromise on big decisions for your company. It is critical for you to know what decisions you will have to consult your investors on after agreeing to protective provisions.
important You’re likely to spend a lot of time here with your lawyer. Despite appearing as a single term, the protective provisions section of your term sheet will typically outline up to 12 decisions investors can veto.
Here are some of the situations commonly covered by protective provisions:
Changing the certificate of incorporation or bylaws of the company. This term is usually not negotiable. Good counsel will push to alter this provision to allow the preferred stock to vote on any change that “adversely affects the rights” of preferred stockholders, but not any change to the certificate of incorporation or bylaws. Anyone seriously considering converting their company to a B corporation should take note that, after this provision is in place, their investors can veto this conversion.
Changing the authorized number of shares of preferred or common stock. Any change in the number of either type of share would affect the value of investors’ stock, so it’s no surprise they’d want a say in this.
Issuing stock senior or equal to the new class of preferred. This provision is relevant when a company wants to acquire another company and use stock in the transaction. The target of the deal will often end up with common stock, but each acquisition is a negotiation. In some cases, the entire preference stack is modified. In any case, the VCs will want a say in how the deal gets structured.The vote here would be on creating a new class of preferred stock that is junior to the investors but senior to common stock.
Buying back any common stock. This provision governs when the company can buy shares back from employees or other shareholders. Founders should fight for some carve-outs here—that is, contingencies where the provision would not apply: repurchase rights, rights of first refusal, and certain other decisions the board would want to approve. In the case of repurchase, you’ll want to buy back any unvested stock in the event that an employee or founder leaves. Finally, you want to specify, in writing, a carve-out for the board to approve any one-off repurchase as part of a settlement in the case of a separation agreement.
Selling the company. Preferred stockholders will definitely want to have a say when it comes to selling your company. This also applies to mergers.
Borrowing, loaning, or guaranteeing any money. Investors will definitely want a say in decisions related to bringing on significant debt, or lending out money.
Changing the number of directors on the board. Changing the number of directors on the board can effectively change who controls the company, making this term non-negotiable.
Declaring or paying any dividend. While dividends are usually a separate term, a protective provision almost always exists to govern whether a company can declare a dividend or not.
Creating or issuing any kind of cryptocurrency or token. As of 2018, this protective provision is standard in most term sheets.
Declaring bankruptcy. In the unfortunate circumstance that you’re considering declaring bankruptcy, investors will want to know and have a say in how the company liquidates.
Licensing away the IP of the company. On one hand, this provision is there to protect naive entrepreneurs from structuring licensing agreements in a manner which can dramatically hurt the company. On the other hand, the protection is for investors in the case that an entrepreneur tries to set up a separate company, which they own all of, and then license the IP of the company the investors own part of to the new company that the entrepreneur owns all of (yes, people have done this).
Option pools are usually agreed upon and allocated before a financing takes place. Companies usually create an option pool before the first employees are hired, but option pools also get refreshed, or new option pools get created, before subsequent financings. This is important, because if the pool is allocated after an investment, then the new investor(s) will be diluted with the founders and prior investors.
important Investors will almost always negotiate for the pool to be allocated before the investment takes place. Founders should make sure to understand how the option pool will impact their ownership* (visit our primer on ownership for more details). Founders should also be sure investors aren’t using the option pool to manipulate the optics of the deal.*
Option pools are part of the pricing dynamic in a negotiation, and founders should be clear whether they are required to create or refresh an option pool prior to or after the round of financing they’re raising.