This post is the sixth in a series giving practical advice to startups with respect to understanding and negotiating a venture capital term sheet.
In the prior five posts, we provided an introduction to negotiation of the term sheet and discussed binding and non-binding provisions, discussed valuation, cap tables, and the price per share, discussed dividends on preferred stock, explained how liquidation preferences work, and discussed the conversion rights and features of preferred stock. This post will explain how voting rights are typically addressed in a venture capital transaction as well as describe customary investor protection provisions.
Delaware corporate law, by default, requires that each class of stock vote and approve any amendment to a corporation’s certificate of incorporation. The NVCA model legal documents override this, and provide that generally all the shares vote together as a single class on an “as-converted basis” (see our previous post on what that means). The most important application of this is that no separate approval of the preferred stockholders is necessary to approve an increase in the number of authorized common shares as long as a majority of all stockholders approve the change. However, venture capital investors typically require that they have the power to elect a certain number of seats on the company’s board of directors. The number of board seats is typically a matter of negotiation and depends on the overall size of the board as well as the size of the investment being made.
In addition to the right to appoint a certain number of board seats, in venture capital deals investors often secure other rights that protect them from changes being made that could potentially harm them or reduce the value of their investment. These provisions typically require that a certain percentage (often a majority, but sometimes a supermajority) of the preferred stockholders vote to approve certain actions. The actions typically included are:
- dissolving the company;
- making any changes to the certificate of incorporation or bylaws that adversely affect the preferred stockholders;
- authorizing or issuing new stock on parity with or senior to the preferred stock;
- purchasing or redeeming any stock prior to the preferred stock;
- taking on debt;
- engaging in certain transactions involving subsidiaries of the company; and
- changing the size of the board.
In addition, you will also typically find provisions that require the vote of one or more of the directors appointed by the investors in order for the board to take any of the following actions:
- making any investments (either debt or equity) in any other companies;
- extending any loans to any persons, including employees and directors;
- guaranteeing any debt;
- making investment decisions inconsistent with approved policies;
- incurring indebtedness in excess of a certain amount other than in the ordinary course of business;
- entering into any other transactions with any director, officer, or employee;
- hiring, firing, or changing the compensation of executive officers;
- changing the principal business of the company;
- selling, assigning, licensing, or using as collateral to a loan any of the company’s material intellectual property, other than in the ordinary course of business; and
- entering into any strategic relationship involving any payment or contribution in excess of a certain amount.
The protective provisions are often overlooked by founders when they negotiate term sheets, perhaps with the exception of the number of board seats the investors are getting. Since they don’t impact the economics of the deal in any direct way, they are often deemed unimportant. Most of the protective provisions involve company decision-making in one way or another and at least initially, the founders typically envision involving their investors in major decision-making. Early on, it would usually be unthinkable for the company to take a major action that its largest investor opposes. However, after a number of investment rounds, there could be any number of potential vetoes of company actions and the governance process may become unwieldy. Some of the protective provisions, such as a requirement to get the investor-appointed director’s approval for any strategic relationship involving a payment or contribution in excess of $X, may give one particular investor too much ability to veto new opportunities for the company that were not envisioned early in its life.
In addition, founders should pay attention to how the protective provisions interact when there have been multiple rounds of financing. For instance, if there have been five rounds (e.g., Series A, B, C, D, and E), it would probably not be appropriate to require the approval of a director appointed by each series to approve every license of material intellectual property. Therefore, when a company takes on a new investment round, the company’s management should look at making appropriate changes to the previous round’s investor’s protective provisions. Often, the new investor can be helpful in this process by making such changes a condition of closing the new round.
In the next post, we’ll discuss anti-dilution provisions.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.