Nivi · August 2nd, 2007
“AOL almost sold to Compuserve in 1991 for $60M. The VCs wanted to sell. [Steve] Case won by 1 vote. 10 years later, [AOL was] worth $100 billion.”
Summary: Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. They protect the preferred, who are minority shareholders, from unfair actions by the common majority. However, the preferred shouldn’t use protective provisions to serve their other interests.
Protective provisions let preferred shareholders veto certain actions, such as selling the company or raising capital. Roughly, they state that
“The Company requires the consent of the holders of at least X% of the Company’s Series A Preferred to (i) effect a sale or merger of the company, (ii) sell Series B Preferred with rights senior to or on parity with the Series A, (iii) et cetera…”
To understand why investors want protective provisions, you first need to understand how the preferred and common classes control the company.
The board mostly controls the company.
The common and preferred classes control the company through
- Board seats, which require each board member to serve the interests of the company as a whole. Board members cannot simply serve the interests of their particular class of stock.
- Shareholder votes, where the preferred vote as if they held common shares. In legal-speak, the preferred vote on an as-converted-to-common basis. The preferred usually gets one as-converted-to-common share for each of their preferred shares. The preferred and common use shareholder votes to serve their own interests.
- Class votes, which require a majority of the preferred and a majority of the common. We will cover this mind-numbing topic in a future hack. The preferred and common use class votes to serve their own interests.
- Protective provisions, which allow the preferred to veto certain actions, such as selling the company or raising capital. In some companies, each series (Series A, Series B…) has their own protective provisions. In other companies, all of the series exercise their protective provisions as a class.
After the common and preferred classes select their representatives on the board, the board takes it from there. The board, not the shareholders, usually approve management decisions. (We previously showed you how to hack the allocation of seats on the board.)
However, some major actions require shareholder votes and class votes in addition to board votes. For example, Delaware corporations require a shareholder vote to sell the company or raise money.
Protective provisions protect the preferred minority from the common majority.
The preferred usually owns 20%-40% of the company after the Series A. If the common is united, the preferred can’t influence shareholder votes—they don’t own enough shares. Nor can they influence board votes if a united common controls the board (e.g., the board consists of two common seats, one preferred seat, and no independents).
If the common controls a Delaware corporation’s stock and board, the preferred need protective provisions to stop the common from:
- Selling the company to the founder’s cousin for $1 and wiping out the preferred stock.
- Selling $1M of the founder’s shares to the company so he can get a great haircut.
- Issuing a bazillion shares to the founders and diluting the preferred to nothingness.
Protective provisions protect the Series A minority from unfair actions by the common majority. That’s why they’re called protective provisions. In future rounds, protective provisions can also protect each series of preferred stock from the other series of preferred stock.
Investors argue that protective provisions encourage good governance.
Some investors claim that they need protective provisions because they can’t use their board seat to serve their own interests. They correctly argue that board members have to serve the interests of the company as a whole, not the interests of their class of stock.
These investors will claim that protective provisions let them serve their interests as investors, so they can serve the interests of the company through their board seat:
Say the company receives an offer to acquire the business. Management thinks it’s in the company’s interest to sell. The board defers to management since management is doing a good job running the company. But the investors think the company is the home run in their portfolio—they don’t want to sell the company now. So the investors use their board seat to vote for the sale and use their protective provisions to veto the sale.
Investors should use protective provisions to protect themselves, not to serve their interests.
We don’t agree that investors need protective provisions to serve on the board without succumbing to their own interests.
In fact, any investor who makes that argument is raising a big red flag. They’re implying that they can’t fulfill their duty as board members without additional veto powers. They’re implying that the interests of their fund can outweigh the interests of the company.
Your response to this argument goes like this:
“I don’t think you mean that you can’t serve the interests of the company without these additional protective provisions. I’m sure you will use your board seat to do the right thing for the company, always.
“You control the company through (1) board votes where you serve the interest of the company and (2) share and class votes where you serve your own interests.
“Protective provisions protect you against the common majority. But they’re not a tool to serve the interests of your fund at the expense of the company.”
We would rather have an “evil” investor who uses his board seat to serve his interests, than an investor who planned to use protective provisions to do anything other than protect himself. At least the “evil” investor’s power as a board member is in proportion to his share of board seats—his protective provisions give him a blanket veto that is wildly out of proportion with his ownership of stock and allocation of board seats!
The next few hacks will show you how to attenuate the protective provisions, reduce this mis-alignment, and leave enough protective provisions in place to protect the preferred.
Image Source: Jennifer Juniper (License)
Topics Board of Directors · Future Financings · M&A · Protective Provisions
My first experience with what you call protective provisions, was with “investor preferences.”
I asked the CEO of a large office supplies company to invest $250K, for a 10% share. A week later, the term sheet arrived including 13 pages of “preferences” (about 10 point type).
I managed to use some tactics similar to those you’ve provided to whittle the list down to only 4 pages, and 31 preferences. Took 3 weeks, but we closed. As careful as I was, one “intricate preference” escaped my and my lawyers’ attention/understanding. It had to do with senior rights.
30 days after this (our first outside coporate /strategic partner investment), we had 3 top-drawer (Sandhill Road types) VCs around the table, all jockeying to give us $3.8 for 38% of the company (June 1994). On our terms. B^)
It seemed like so much at the time…
Unexpectedly, our corporate investor hung up the closing by not relinquishing its seniority rights to the new VC investor. After 4 weeks of getting nowhere, the VC almost walked away. I had to give an additional 10% in cheap warrants to get our “strategic partner” to let us get further funded, and then agree with the VC’s demand to eat it all. It was after all, a bed we’d made before their acquaintance.
And in hindsight, I must acknowledge that this “strategic partner” was totally supportive of us from that point forward ($250K/year in contracts), and its investment had clearly been the spark that ignited the race for ecommerce. Even with the 4 week delay, we’d closed on $3.8M in 60 days.
Good Luck trying to convince Investor’s to drop or modify Protective Provisions.
I am looking forward to the next installment where you guys suggest strategies to counter protective provisions.
One approach would be to ask the Investor to clearly elucidate the situations where they would like to have a veto right. For example, they should not have a veto right when less than 1% of stock is to be sold (ESOP sale by employee).
Thanks,
Santosh
I think this site needs a disclaimer like the show Jackass on MTV.
WARNING: This web site features hacks performed either by experienced entrepreneurs or under the supervision of experienced lawyers. Accordingly, Venture Hacks must insist that no one attempt to recreate or re-enact any hack performed on this site without adequate supervision.
Readers need to understand that all hacks are not equal and that arguing for certain hacks may decrease negotiating credibility. Working the option pool shuffle is a reasonable hack. Trying to attenuate typical protective provisions generally strikes me as a losing argument.
🙂
We really do need to prioritize the hacks at some point and talk about how to use them in an overall negotiation.
But we have attenuated protective provisions before. And I have seen other entrepreneurs do it. I have even seen an (east coast!) investor argue that protective provisions aren’t really necessary as long as the board is neutral, e.g. 1 preferred, 1 common, and 1 independent that can be removed by either party.
One of our prospective Series A investor wants the right to veto the entrance of new partners and raising capital, as a protective provision against the entrance of possible partners he doesn’t trust, and also to prevent us from selling the company or diluting his capital if he thinks we should grow more before doing it.
He says the founders should not deal with capital raising anyway since this distracts us from running the company, and that he knows more than us about this stuff, which is, of course, true.
So he demands full rights for searching and choosing Series B investors (and all investors after that) when he think it’s necessary, and he says we’ll also have the right to veto the ones he chooses.
He’s as an honest person, and we like him. But we don’t think this is reasonable. It’s the only point of divergence, but he says it’s a deal breaker if we don’t accept. What would you say?
Read Brad Feld’s article on protective provisions. There are more details but Brad will get you off on the right foot.