“Protective provisions” provide rights to preferred stockholders to approve certain decisions made by, or with respect to the company. These approval rights are of critical importance to a company and its investors and often involve significant negotiation.
The preferred stock typically votes with the common stock, except if a special class or series vote is required by the “protective provisions” in a company’s certificate of incorporation or by applicable law. A list of typical protective provisions includes:
- Increases or decreases to the authorized number of shares of common stock or preferred stock
- Amendments to any provision of the certificate of incorporation or bylaws
- Issuances of any new class or series of shares having rights, preferences or privileges senior to or on parity with the preferred stock
- Redemptions of any shares of preferred stock or common stock (other than pursuant to equity incentive agreements or employment agreements giving a company the right to repurchase shares upon the termination of services)
- Payments or declarations of any dividend on any shares of common stock
- Any merger, other corporate reorganization, sale of control, or other transaction in which holders of a company’s voting securities prior to such transaction hold less than 50% of the company’s voting securities upon the closing of such transaction, or a sale of all or substantially all of the assets of the company
- Increases or decreases the size of the board
- Waivers or amendments of any price-based anti-dilution adjustment
Whether a particular group or percentage of investors receives some or all of these protections depends on the nature of the transaction and the stockholders’ negotiating strength. Startups should consider carefully whether or not a separate preferred series vote, as opposed to a vote by the all preferred stock voting together as single class, is appropriate for the approval of significant transactions or events in light of the existing and anticipated investor profile. In many cases, a particular class voting provision for a designated transaction or event may be superfluous, as applicable law would impose the same class vote. Separate series and super-majority protective votes may cause difficulties for a company trying to quickly raise subsequent rounds of capital as the stockholder base expands, if the interest of minority investors diverge from the interests of other stockholders.
Minority investors who no longer wish to participate in the company or who wish to liquidate their investments may even use voting and protective provisions in a manner that operates against the company and the other investors. Such a divergence is more likely to occur in a company with a longer path to a liquidity event or in a company that has encountered difficulty along the way. In many cases, divergent investor views can be as much a function of the state of the venture fund with its limited partners as the state of the company. In extreme cases, protective voting provisions that provide votes to minority stockholders may paralyze a company by precluding subsequent financing and causing liquidation.
Protective provisions are one of the key terms negotiated and provided for in connection with the issuance of preferred stock. Therefore, startups should exercise extra care when drafting such provisions and ensuring that they understand how these provisions will impact decision making in the future.