Anatomy of a Term Sheet 6 — Protective Provisions

Welcome back to my series on the Anatomy of a Term Sheet. In this series, I am going through the model term sheet provided by the National Venture Capital Association, which you can find here.

In previous posts, I discussed provisions such as pre-money valuation, the option pool issue, dividend terms, the liquidation preference, and voting rights. Today we are going to look at protective provisions.

The protective provisions give the preferred stockholders a veto over certain actions. In order for the startup to take these actions, the preferred stockholders must take a vote to approve the action.

Here is the protective provisions term from our model Term Sheet:

[So long as [insert fixed number, or %, or “any”] shares of Series A Preferred are outstanding,] 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:

(i) liquidate, dissolve or wind‑up the affairs of the Company, or effect any merger or consolidation or any other Deemed Liquidation Event;

(ii) amend, alter, or repeal any provision of the Certificate of Incorporation or Bylaws [in a manner adverse to the Series A Preferred];

(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;

(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)]; or

 (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)]; 

(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; [or

(vii) increase or decrease the size of the Board of Directors].

Founders should negotiate to have a minimum level of preferred shares outstanding for the protective provisions to be in place. If most of the preferred shares have been converted to common stock, you don’t want to have an investor holding a token number of preferred stock to have an effective veto over any major corporate action. You can see that option in the red bracketed language above. Also, the founders will want to negotiate over the percentage of preferred shares required to authorize an action, so that the approval threshold isn’t prohibitively high.

The above provisions are fairly standard. There are some variations in (iv) and (v), where Board approval is sufficient, provided that the Series A director(s) also vote in favor of the action.

There are other protective provisions, however, that might be included and that might be more troublesome. For example, there might be terms requiring the Series A investors’ approval of:

  • any hiring, firing, or change in compensation of executive officers
  • any transaction between the company and a director, officer or employee
  • any change in the principal line of business of the company, or the adoption of a new line of business
  • any purchase of a substantial amount of assets of another company 
  • incurring debt in excess of a specified amount

The company needs to be able to operate, and board oversight should be sufficient for those types of actions. During negotiations, the company should try to have the more intrusive provisions removed. It may be tempting to overlook the protective provisions during term sheet negotiations, because these don’t directly affect the monetary aspects of the financing. They do have a material impact on how the company will operate going forward, however, and it is important that the founders maintain sufficient freedom of action.

Next time, we will look at optional and mandatory conversion of preferred shares. Thank you for reading, and feel free to ask questions or comment.

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