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VC Term Sheet: Protective Provisions and a Note on Liquidation Preferences

Bradley Feld, Managing Director and Jason Mendelson, Of Counsel, Mobius Venture Capital


This article was originally published in Brad Feld's blog located at http://www.feld.com.
January 18, 2005

As Jason and I continue to work our way through a typical venture capital term sheet, we encounter another key control term - the "protective provisions." Protective provisions are effectively veto rights that investors have on certain actions by the company. Not surprisingly, these provisions protect the VC (unfortunately, not from himself.)

The protective provisions are often hotly negotiated. Entrepreneurs would like to see few or no protective provisions in their documents. VCs - in contrast - would like to have some veto-level control over a subset of actions the company could take, especially when it impacts the VC's economic position.

A typical protective provision clause looks as follows:

"Protective Provisions: For so long as any shares of Series A Preferred remain outstanding, consent of the holders of at least a majority of the Series A Preferred shall be required for any action, whether directly or though any merger, recapitalization or similar event, that (i) alters or changes the rights, preferences or privileges of the Series A Preferred, (ii) increases or decreases the authorized number of shares of Common or Preferred Stock, (iii) creates (by reclassification or otherwise) any new class or series of shares having rights, preferences or privileges senior to or on a parity with the Series A Preferred, (iv) results in the redemption or repurchase of any shares of Common Stock (other than pursuant to equity incentive agreements with service providers giving the Company the right to repurchase shares upon the termination of services), (v) results in any merger, other corporate reorganization, sale of control, or any transaction in which all or substantially all of the assets of the Company are sold, (vi) amends or waives any provision of the Company's Certificate of Incorporation or Bylaws, (vii) increases or decreases the authorized size of the Company's Board of Directors, or (viii) results in the payment or declaration of any dividend on any shares of Common or Preferred Stock, or (ix) issuance of debt in excess of $100,000."

Subsection (ix) is often the first thing that gets changed by raising the debt threshold to something higher, as long as the company is a real operating business rather than an early stage startup. Another easily accepted change is to add a minimum threshold of preferred shares outstanding for the protective provisions to apply, keeping the protective provisions from "lingering on forever" when the capital structure is changed - either through a positive or negative event.

Many company counsels will ask for "materiality qualifiers" (e.g. that the word "material" or "materially" be inserted in front of subsections (i), (ii) and (vi), above.) We always decline this request, not to be stubborn (ok - sometimes to be stubborn), but because we don't really know what "material" means (if you ask a judge, or read any case law, they will not help you either) and we believe that specificity is more important that debating reasonableness. Remember - these are protective provisions - they don't "eliminate" the ability to do these things - they simply require consent of the investors. As long as things are "not material" from the VC's point of view, the consent to do these things will be granted. We'd always rather be clear up front what the rules of engagement are, rather than having a debate over "what material means" in the middle of a situation where these protective provisions might come into play.

When future financing rounds occur (e.g. Series B - a new "class" of preferred stock), there is always a discussion as to how the protective provisions will work with regard to the new financing. There are two cases: (a) the Series B gets its own protective provisions or (b) the Series B investors vote alongside the original investors as a single class. Entrepreneurs almost always will want a single vote for all the investors (case b), as the separate investor class protective provision vote means the company now has two classes of potential veto constituents to deal with. Normally new investors will ask for a separate vote, as their interests may diverge from those of the original investors due to different pricing, different risk profiles, and a false need for overall control. However, many experienced investors will align with the entrepreneur's point of view of not wanting separate class votes as they do not want the potential headaches of another equity class vetoing an important company action. If your Series B investors are the same as your Series A investors, this is an irrelevant discussion, and it should be easy for everyone to default to case b. If you have new investors in the Series B, be wary of inappropriate veto rights for small investors (e.g. consent percentage required is 90% instead of a majority (50.1%), so a new investor who only owns 10.1% of the financing can effectively assert control over the protective provisions through his vote.)

Some investors that feel they have enough control with their board involvement to ensure the company does not take any action contrary to their interests, and as a result will not focus on these protective provisions. During a financing, this is the typical argument used by company counsel to try to convince the VCs to back off of some or all of the protective provisions We think this is a short-sighted approach for the investor, for as a board member, an investor designee has legal duties to work in the best interests of the company. Sometimes the interests of the company and a particular class of shareholders diverge. Therefore, there can be times whereby an individual would legally have to approve something as a board member in the best interests of the company as a whole and not have a protective provision to fall back on as a shareholder. While this dynamic does not necessarily "benefit" the entrepreneur, it's good governance, as it functionally separates the duties of a board member from that of a shareholder, shining a clearer lens on a area of potential conflict.

While one could make the argument that protective provisions are at the core of the "trust" between a VC and entrepreneur, we think that's a hollow and inappropriate statement. When an entrepreneur asks "don't you trust me - why do we need these things?", the simple answer is that it is not an issue of trust. Rather, we like to eliminate the discussion about who ultimately gets to make which decisions before we do a deal. Eliminating the ambiguity in roles, control, and rules of engagement is an important part of any financing - the protective provisions cut to the heart of some of this.

Note on Liquidation Preferences

This article was originally published in Brad Feld's blog located at http://www.feld.com

I received a number of comments, private emails, and a few links to my post on Venture Capital Deal Algebra. The consistent theme was "tell me more about how VC investments work." As a result, I'm going to write a series of posts on the structural and financial components of a typical venture capital investment. I'm going to use a bottom up approach - talking about individual components over time and then tying them together in a comprehensive term sheet.

An important place to start is the concept of a liquidation preference. Fred Wilson hints at it in his post on valuation. A liquidation preference is a standand (and rarely negotiable part) of a VC investment. It's the downside protection on an investment that VCs expect to have as a baseline of any equity investment.

The vast majority of VC investments are structured as preferred stock. It's called preferred because it "sits in front of" the common stock (or is "preferred to the common") where common stock is the plain vanilla stock that a company has. Typically in VC investments, founders receive common stock, employees receive either common stock or options to purchase common stock, and the VCs receive preferred stock. This preferred stock has a series of special rights which almost always include a liquidation preference. The liquidation preference means that the VC will have the option - in a liquidity event - of either receiving their liquidation preference as their return or converting into common stock and receiving their percentage ownership as their return.

Consider the following example. Acme Venture Capital (AVC) makes an investment in an established company called Homer Software that has been bootstrapped by the founders. Homer Software has shipped a product in an exciting market and generated $3m of revenue in the past 12 months. AVC invests $5m at a $10m pre-money valuation. As part of this investment, AVC and the founders of AVC agree to a 20% option pool for new employees that are going to be hired to be built into the pre-money valuation (see Venture Capital Deal Algebra if this doesn't make sense). The result is that AVC owns 33.3% of the company, the founders own 46.7% of the company, and 20% is reserved for options for employees. In this example, AVC purchases Series A Preferred Stock that has a liquidation preference.

Now - consider two outcomes.

  1. Homer Software continues its rapid growth and is acquired for $100m. AVC has a choice - either receive the liquidation preference ($5m) or convert to common and receive 33.3% of the proceeds ($33.3m). Easy choice.
  2. Homer Software struggles and is acquired by a competitor for $9m. AVC again has a choice - either receive the liquidation preference ($5m) or convert to common and receive 33.3% of the proceeds ($3m). Again, easy choice.

When cash or public company stock is used in an acquisition, the valuation can be mathematically determined with certainty. However, when the acquirer is a private company, the valuation is much harder to determine and is often ambiguous as it depends on the value of the private company and the type of stock (common, preferred, junior preferred, or some other special class) being used. In these cases, the use of the liquidation preference is less clear cut and it's critical that the company have objective, outside (independent) directors and experienced outside legal counsel to help with determining valuation.

One exception to the liquidity event is an IPO. Typically, an IPO will force the conversion of preferred stock to common stock, eliminating the liquidation preference. In most cases, the IPO event is an "upside liquidity event" so the need for the liquidation preference (and corresponding downside protection) is eliminated (although this is not always the case).

Next up - To Participate or Not (Participating Preferences) - an often maligned and typically hotly negotiated issue that is a more complex form of liquidation preference.