Whether you’ve only recently decided to seek out capital for your business or you’ve already received (or made) your first offer, the term sheet (or “letter of intent”) is an integral part of the process.
In this series we’ll look to shed some light on the legal language contained in that term sheet by taking a “deep dive” into the most often used terms and how choices made in selecting those terms can affect both Company and Investor. Check out an overview here.
Last week, we discussed one of the primary governance rights given by a Company to its Investors: board representation. This week, we talk about the other primary governance right: “protective provisions”.
Under most state laws, a corporation (or an LLC) cannot take certain significant actions without getting the approval (or “consent”) of the holders of the company’s equity. Generally, this right is held by a majority in interest of all such holders.
The term “protective provisions” is a fancy way of saying (in legalese) that in addition to getting majority approval, the Company must also get the approval of a set percentage of the Investor class in order to take certain of these actions. In other words, the Investors are “protected” from the Company’s doing certain things without their having agreed.
The concept is described generally in the NVCA model term sheet as follows (edited for clarity):
In addition to any other vote or approval required under the Company’s Charter or Bylaws, the Company will not, without the written consent of the holders of at least [__]% of the Company’s Series A Preferred, either directly or by amendment, merger, consolidation, or otherwise [do any of the following actions]:
While variable across transactions, the approval threshold (left in blank above) is often set based on a presumption of ensuring the inclusion of the “lead” or “primary” investor in the consent process. This can generally be calculated as the inverse of such investor’s ownership. For example, if the “lead” investor is going to hold 30% of the Series A preferred after investment, the protective provision approval threshold might be set at 75%; requiring the lead investor to consent to any protected action as all other Series A holders would only account for ownership of 70% on their own.
In addition, though not described as such in the term sheet, the threshold established in respect of the protective provisions is often used as a baseline for the thresholds ultimately used in other areas of the definitive documents. This is the case because if the Investor class at issue must approve (or waive) of something in such documents, it is generally advisable for the thresholds to match in most instances.
(The NVCA model also includes bracketed language not quoted above that establishes that the protective provisions are only to obligate the Company for so long as a set percentage of Series A preferred remains outstanding. While useful and often included as a concept in the definitive documents, in my experience most term sheets do not include such level of detail at this stage.)
The NVCA model then goes on to include a number of example protective provisions which I will comment on below:
(i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any merger or consolidation or any other Deemed Liquidation Event
This is one of the most standard protective provisions and it is easy to see why. The Investors have absolutely no interest in seeing the Company dissolve or merge into another entity without their being included in the discussions.
(ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred]
This is another staple protective provision. As in the case of a liquidation, the Investors have every interest in ensuring that the Company does not change its “constitution” (which of course describes the rights afforded to the Investor stock itself) without approving of the change.
The bracketed language included here is one that often results in a negotiation point between the parties. The Investors generally would like to see such bracketed language struck as its inclusion only gives the Company an avenue to argue that a given change was not “adverse”. The Company, on the other hand, has an incentive to pursue the ability to make technical or other changes which do not affect the Investors’ bottom line. Given the reasoned (and reasonable) stances available to each side on such point, it is often heavily discussed.
(iii) create or authorize the creation of or issue any other security convertible into or exercisable for any equity security, having rights, preferences or privileges senior to or on parity with the Series A Preferred, or increase the authorized number of shares of Series A Preferred
This provision limits the ability of the Company to issue additional stock in the class which the Investors are purchasing or which is superior to that class. Again, the term is fairly self-explanatory as the Investors do not wish to see their investment diluted, at least not without approving of the dilution. The Company generally does not object, though it is worth noting that such a provision makes additional capital fundraising marginally more difficult (as the present Investors now get a seat at the table).
(iv) purchase or redeem or pay any dividend on any capital stock prior to the Series A Preferred, [other than stock repurchased from former employees or consultants in connection with the cessation of their employment/services, at the lower of fair market value or cost;] [other than as approved by the Board, including the approval of [_____] Series A Director(s)]
A bit to unpack here. The basic provision should be read as limiting the ability of the Company to pay money to stockholders with rights junior to those of the Investor class. Simple enough.
The first bit of bracketed language offers an exception to that restriction (i.e., a class of cash distributions that can be made by the Company to junior stockholders without Investor approval). That exception is for redemptions of service provider stock (most often seen in connection with incentive programs or offers of employment). This is a standard exception to the provision and one I see given in almost all circumstances as both Company and Investor have interests in making sure that those service providers who are no longer aiding the Company in its growth do not get to participate in such growth after the fact.
The second bit of bracketed language is an exception that can be added to most protective provisions (not just this one). It states that the consent of the Investor class will not be required if the action is approved by the board of directors including the Investor director. In other words, if the designee of the Investors on the board approves the transaction there is no need for the Investors as stockholders to approve that same transaction. Makes sense, right? Why isn’t that a standard exception to all the protective provisions, you might ask. The answer is because of a board member’s fiduciary duties.
As I discussed in my Start-Up Entrepreneur Series post on boards of directors and officers, the members of a board of directors have a fiduciary duty to take actions in the best interests of the corporation and its stockholders. An Investor designee then, when faced with a decision that is in the best interest of the Company, but not, as may be the case, in the best interest of the Investor stock (say, for instance, the approval of a transaction which the Company needs for capital, but which will obliterate the value of the Investor shares) will have to approve that transaction to comply with his or her fiduciary duties.
That same individual, however, when responsible for voting the Investor shares held by him, her, or the fund they represent, can vote against such same transaction despite the fact that they approved of it as board member, as shareholders do not have fiduciary duties (to the same extent) and can vote their shares solely in their own best interest. So a good lawyer (and the good folks they represent) needs to consider circumstances in which an Investor may have incentives that are not aligned with the “good” of the Company overall. That is why the Board approval exception is a negotiated one and not a standard across all protective provisions.
(v) create or authorize the creation of any debt security [if the Company’s aggregate indebtedness would exceed $[____][other than equipment leases or bank lines of credit][unless such debt security has received the prior approval of the Board of Directors, including the approval of [________] Series A Director(s)]
This is a standard protective provision, but not one seen in all transactions. At its most basic, it states that the Company will not go into debt greater than $X without the approval of the Investors. Another common way that this is stated is to bifurcate individual transaction indebtedness and aggregate indebtedness. That is to say that the Company cannot incur debt in any one transaction of more than $[100,000], or more than $[250,000] in the aggregate, in each case without the approval of the Investor class. In the above example then, the Company would be permitted to enter into five $50,000 debt transactions without the consent of the Investors, but not six.
The primary exception stated is in respect of equipment leases (standard) and bank lines (not as standard). If I were drafting the NVCA model I might recommend clarity around the bank lines description; perhaps revising it to make clear that we are only talking about “uncalled” lines, etc.
We also see the board exception as a possible inclusion.
(vi) create or hold capital stock in any subsidiary that is not a wholly-owned subsidiary or dispose of any subsidiary stock or all or substantially all of any subsidiary assets
This is a non-standard protective provision that bars the Company from effectively operating a non-wholly-owned subsidiary (without Investor consent). The concern here is that the subsidiary form may allow the Company to exercise certain powers not otherwise permitted at the primary Company level. In other words, if the Investors are negotiating rights at the Company level, they do not want to permit a “loophole” that would allow the Company to operate independently solely due to owing a partial interest in another entity. It is a more technical protection sought by Investors particularly sensitive to this kind of maneuvering.
(vii) increase or decrease the size of the Board of Directors
Another standard protective provision. It locks in the size of the Board as the various rights of the Investors are predicated on a specific board size (1 member of a 5 person board is very different than 1 member of a 19 person board after all).
With all of the above said, it is worth noting that, like in our discussion of board composition, the NVCA model here should really be read as more of a sample than an exact recipe for rights. Protective provision terms can be as short or as long as are deemed warranted by the parties, and can include a vast array of different rights and obligations.
Other potential actions which are commonly subject to protective provisions include:
- Changes in the business of the entity
- Changes in the compensation of the entity’s officers
- Hiring or firing of entity officers
- Exclusive licensure of company intellectual property
- Undertaking certain strategic transactions
- Declarations of bankruptcy or insolvency
From the perspective of the Investor, the protective provisions are an important piece of the “control” powers they are buying with their shares. From the perspective of the Company, they are equally important, as they represent additional votes which will need to be discussed and acquired in order for the Company to take some of its most significant corporate actions.
Throughout this series, I will be basing my discussion in part on the order and prominence of certain terms set forth in the National Venture Capital Association (“NVCA”) Model Term Sheet. I’ve attached a copy to this post, but you can find additional copies (as well as versions of the definitive documents used to evidence these terms) here.
As always, if you’d like to discuss this post or your own company’s financing experiences please don’t hesitate to leave a comment down below or contact me at firstname.lastname@example.org.