What Are Protective Provisions?

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• Protective provisions can help protect the interests of minority shareholders.
• They can be seen as a form of "negative control"—giving certain shareholders veto rights over specified corporate actions.
• Protective provisions are a hotly negotiated item between founders and investors. Founders are often wary about granting investors too much control, while investors are looking to protect their investments.

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Venture-backed startups often have minority shareholders. For seed and Series A startups, the minority shareholders are usually the company’s investors, as founders typically retain majority ownership at this stage (at later stages, the minority shareholders are usually holders of common stock).

As a minority shareholder, do you have any control over what the majority shareholders agree to? For example, if the founder wants to sell the company but you think the price is too low, do you have any power to stop it?

In these situations, it helps to have protective provisions.

What Are Protective Provisions?

Protective provisions are terms that allow preferred shareholders to veto or block specific corporate actions. Protective provisions can help protect the interests of minority shareholders in the event that various shareholders disagree regarding the best course of action for the company.

Protective provisions are standard in VC deals. They are designed to mitigate risk for the investor. They're also the subject of much negotiation between investors and founders.

Common Protective Provisions

The following corporate actions are often subject to protective provisions:

• Selling the company or any other liquidation event (such as a merger or dissolving the company).
• Amending the company’s charter or bylaws, especially in such a manner as may affect the rights of preferred shareholders. An example could be changing the size of the board of directors. 
• Changing the amount of authorized common or preferred stock (other than by conversion). This is a form of anti-dilution protection.
• Issuing any new class of stock that has rights equal to or better than existing preferred stock.
• Redeeming or purchasing preferred or common stock (some exceptions may apply—such employment agreements allowing the company to redeem employees’ shares if they leave).
• Declaring or paying any dividends on common or preferred stock.
  

Less commonly, protective provisions might also cover these actions:

• Hiring or firing executive officers. 
• Adjusting executive officer compensation.
• Taking on new debt.
• A significant shift in business strategy, such as entering a new line of business.
• Buying assets.
• Entering a transaction with any company executives, employees, or directors (such as providing a loan to an executive or purchasing assets from them).
  

Where Can You Find Protective Provisions?

Protective provisions are generally spelled out in a company's articles of incorporation. Founders and investors typically work them out when they’re negotiating details of the term sheet, which outline the basic terms and conditions of the deal. 

Why Do Investors Want Protective Provisions?

We’ve already touched on why investors want protective provisions—to protect their minority shareholder interests. But this leads to a natural question: Why don't investors protect their interests by negotiating more seats on the board, which must sign off on just about any action listed in the examples above? 

In some ways, protective provisions give an investor greater power with respect to the particular issue than a board member would have. The preferred shareholder with protective provisions has veto authority over any of the board’s decisions that relate to a matter encompassed by the protective provisions.

For example: Imagine a startup gets an acquisition offer from a large company. The founders are thrilled and want to take the money. The majority of the board of directors considers it a fair price and supports the transaction. But the investor—in this case, a minority shareholder—may want to hold out for a higher price that will generate a bigger return on their investment.

Why Do Founders Agree to Protective Provisions?

Some protective provisions, like the ones mentioned above, are considered industry standard. Founders will have a hard time attracting investors without giving them some influence over the company’s activities. 

Offering protective provisions can also be good corporate governance. Investors with protective provisions can serve as a safeguard against potentially poor decisions on the part of the founders.

Key Considerations for Investors When Asking for Protective Provisions

Protective provisions are hotly negotiated between founders and investors. A venture capitalist’s ability to secure protective provisions depends on their negotiating leverage—especially when they go outside the standard list of provisions. 

Understanding Protective Provisions 

Founders and early-stage investors need to understand what protective provisions are and how they work. As a company scales and iterates on its strategy, these provisions will only become more relevant.