Anatomy of a Term Sheet - Protective Provisions

For more information on this post contact Scott Preece.

Generally speaking, venture capital investors do not take controlling interests in companies (see Anatomy of a Term Sheet - Voting) - either at the board level or the shareholder level. Therefore in order to protect their investment, it would be normal for them to demand certain veto rights over certain company activities. These veto rights/protective provisions are important as they set out how much influence the investors are looking to exert over the investee company. 

The first thing to understand about the protective provisions is that they are negative controls only. An investor cannot unilaterally approve/make decisions on a company's behalf. All corporate decisions will be determined by the board (more on this in a later post) and, if required, then approved by shareholders. The protective provisions may also mean that investor consent is also required before such decisions can be actioned.

Typically the protective provisions will cover any decision concerning an investor's shareholding, such as future fundraising (as this will be dilutive), any change of share rights or changes to a company's constitutional documents, any sale, IPO or insolvency of the company, any increase to the share option numbers, any payment of dividends or any increase to the number of board directors.

In addition (particularly in European transactions), investors may seek a veto over certain "operational matters" such as approving the annual budget, incurring expenditure over a certain level, conducting litigation, hiring, incorporating subsidiaries, changing auditors, etc.

It should be noted that there is a marked difference between Silicon Valley terms (which generally are more company friendly and tend to be lighter in respect to operational matters) as against European terms (which are more conservative).

Entrepreneurs/companies should review the protective provisions closely (particularly in relation to any operational matters) to make sure that the company can operate efficiently going forward. It will not be possible to remove certain protective provisions that protect an investor's fundamental rights (such as amending share rights), but certain items like monetary thresholds can usually be negotiated.

As well as the actual veto rights themselves, there are a couple of considerations companies should be aware of:

Approval thresholds

Typically protective matters will either require the consent of the lead investor or the consent of the holders of a percentage of the preferred shares (an "Investor Majority"). Attention should be paid when setting the approval threshold for an Investor Majority - any threshold should be achievable (but at the same give investors sufficient comfort) and designed so as to avoid any investor deadlock. Generally, speaking investors are aligned, but there are multiple scenarios (early investors v later investors, EIS funds v institutional money, etc), where interests diverge which means that a company should try to avoid a deadlock at the investor level.

Class consents v Investor Director consents

Most protective provisions for fundamental rights require consent at the shareholder/investor level. It is important to note, that shareholders have no duty to act in the best interests of the company. Therefore, it is not uncommon for a board to approve a corporate action (which they determine to be in the best interests of the company) only to have the investor veto it. Therefore, where a Term Sheet incorporates protective provisions which are more operational in nature, you should seek to have these only require the consent of a director appointed by the investor - this has a double advantage of (i) being more efficient (in that consent can easily be given at board meetings) and (ii) any director appointed by an investor must act in the best interests of the company as a whole.

The Anatomy of a Term Sheet series can be found in full here