What are protective provisions?

August 5, 2007

Protective provisions give the preferred stock or a series of preferred stock the ability to block certain company actions.

Typical preferred stock protective provisions

Typical preferred stock protective provisions from a term sheet may include:

So long as [any] of the Preferred is outstanding, consent of the holders of at least [50]% of the Preferred will be required for any action that (i) alters any provision of the certificate of incorporation [or the bylaws] if it would [adversely] alter the rights, preferences, privileges or powers of or restrictions on the preferred stock or any series of preferred; (ii) changes the authorized number of shares of preferred stock or any series of preferred; (iii) authorizes or creates any new class or series of shares having rights, preferences or privileges with respect to dividends or liquidation senior to or on a parity with the Preferred or having voting rights other than those granted to the preferred stock generally; (iv) approves any merger, sale of assets or other corporate reorganization or acquisition; (v) approves the purchase, redemption or other acquisition of any common stock of the Company, other than repurchases pursuant to stock restriction agreements approved by the board upon termination of a consultant, director or employee; (vi) declares or pays any dividend or distribution with respect to the [preferred stock (except as otherwise provided in the certificate of incorporation) or] common stock; [or] (vii) approves the liquidation or dissolution of the Company[; (viii)increases the size of the board;] [(ix) encumbers or grants a security interest in all or substantially all of the assets of the Company in connection with an indebtedness of the Company;] [(x) acquires a material amount of assets through a merger or purchase of all or substantially all of the assets or capital stock of another entity;] [or (xi) increases the number of shares authorized for issuance under any existing stock or option plan or creates any new stock or option plan].

These protective provisions are typically contained in the certificate of incorporation of a Delaware company.  I think provisions (i) through (vii) are fairly standard (although I think some of the provisions in brackets are not necessarily standard).  I think that provisions (viii) to (xi), along with anything not listed above, are investor favorable and not as typical in West Coast venture financings.  However, all of these provisions are subject to discussion depending on the negotiation strength of the parties.

Minimum threshold to maintain protective provisions

The company should argue for a minimum number of outstanding shares of preferred stock to maintain protective provision.  For example, if only one share of preferred stock remains outstanding as a result of redemptions or optional conversions to common stock, the holder of the one share should not have the ability to block certain company actions.  However, many protective provisions say that they are effective as long as “any” shares are outstanding.

Voting threshold for protective provisions

The necessary vote to bypass the protective provision is typically set at 50%.  In many cases, the percentage is set higher, such as 66 2/3%, because the investor group consists of multiple investors, and a fund or group of funds that holds a significant amount of the preferred want to ensure that a sufficient percentage of preferred shareholders favor the action.

“Series” protective provisions

Upon a Series B or later financing, the later round may request a separate protective provision.  The company generally would prefer that the preferred stock have a single protective provision as a group, rather than each series of preferred stock having its own protective provision.  A separate protective provision may make sense in a later round of financing where the investor is also receiving a senior (as opposed to pari passu) liquidation preference.  However, the company and investors will want to ensure that a series of preferred stock that represents a small percentage interest of the company or represents a small dollar amount of investment does not receive a separate protective provision.

Board level protective provisions

In some cases, investors request additional board level protective provisions.  The board level protective provisions from the sample investor-favorable NVCA term sheet are:

[So long as [__]% of the originally issued Series A Preferred remains outstanding] the Company will not, without Board approval, which approval must include the affirmative vote of [____] of the Series A Director(s):  (i) make any loan or advance to, or own any stock or other securities of, any subsidiary or other corporation, partnership, or other entity unless it is wholly owned by the Company; (ii) make any loan or advance to any person, including, any employee or director, except advances and similar expenditures in the ordinary course of business or under the terms of a employee stock or option plan approved by the Board of Directors; (iii) guarantee, any indebtedness except for trade accounts of the Company or any subsidiary arising in the ordinary course of business; (iv) make any investment other than investments in prime commercial paper, money market funds, certificates of deposit in any United States bank having a net worth in excess of $100,000,000 or obligations issued or guaranteed by the United States of America, in each case having a maturity not in excess of [two years]; (v) incur any aggregate indebtedness in excess of $[_____] that is not already included in a Board-approved budget, other than trade credit incurred in the ordinary course of business; (vi) enter into or be a party to any transaction with any director, officer or employee of the Company or any “associate” (as defined in Rule 12b-2 promulgated under the Exchange Act) of any such person [except transactions resulting in payments to or by the Company in an amount less than $[60,000] per year], [or transactions made in the ordinary course of business and pursuant to reasonable requirements of the Company’s business and upon fair and reasonable terms that are approved by a majority of the Board of Directors]; (vii) hire, fire, or change the compensation of the executive officers, including approving any option plans; (viii) change the principal business of the Company, enter new lines of business, or exit the current line of business; or (ix) sell, transfer, license, pledge or encumber technology or intellectual property, other than licenses granted in the ordinary course of business.

These provisions are not common in West Coast venture financings, but are more common in East Coast venture financings, and standard in venture financings for Cayman incorporated Chinese companies.  As a practical matter, almost all of these provisions will require board approval anyway for good corporate governance.  The issue is whether the Series A director(s) should have the ability to veto these actions despite majority board approval.  This type of control might be reasonable in the context of a joint venture, but may not be reasonable when the Series A director only represents a small fraction of the outstanding shares.

Board level protective provisions are usually placed in the investor rights agreement or document other than the certificate of incorporation.  If these provisions were placed in the articles of incorporation of a California company, the California Secretary of State would reject the articles on the theory that this gives the Series A director more power than other directors.

Drafting issues

Investors wanting protection through protective provisions must make sure that the provisions are drafted carefully and clearly.  In the WatchMark (2004) and Benchmark (2002) cases in Delaware, the certificates of incorporation clearly required the consent of the opposing stockholders to amend their terms as contemplated by a proposed financing. However, the same approval was not necessary for an amendment effected through a merger (with a subsidiary).  Thus, the companies were allowed to achieve a result indirectly that was otherwise prohibited under the protective provisions.  To avoid this result, the certificates of incorporation should have specifically prohibited changes to preferred stock terms “whether effected, directly or indirectly, by means of an amendment, merger, consolidation or otherwise.”

All rights in preferred stock provisions, even if considered standard or customary, must be “expressly and clearly stated.” Courts in Delaware will not imply or presume meaning or language from other provisions of the charter.

In addition, most certificates of incorporation contain a “no impairment” clause. These clauses are provisions that generally prohibit a company from seeking to avoid or impair the rights of the preferred stock. The WatchMark court held that no impairment clauses, like other preferred stock provisions, will be interpreted very strictly. A generic “no-impairment” clause will not provide the preferred stock with any particular protection beyond what is specifically provided in the certificate of incorporation.