Startup 127: Term Sheet – Voting Rights and Protective Provisions

This is the latest in a continuing series of posts about venture capital term sheets.  The first three dealt with term sheet issues around ownership, dilution and the impact of Valuation, Liquidation Preferences, and Anti-dilution.   You might want to start with those three posts before diving into this latest which covers Voting Rights and Protective Provisions that venture capitalists require in their term sheets.

Voting Rights – What’s the Big Idea?
Voting Rights are pretty straightforward.   The language you will find in a term sheet usually looks something like this:

The Series A Preferred Stock shall vote together with the Common Stock on an as-converted basis, and not as a separate class, except (i) the Series A Preferred as a class shall be entitled to elect [_______] members of the Board (the “Series A Directors”), and (ii) as required by law.

Voting on “an as-converted basis” means that in the case of any shareholder votes except for the Board Seats and assuming there have been no triggers for anti-dilution, the preferred shares convert on a 1:1 ratio and everyone votes based on their company ownership and the majority rules.  But of course, it’s not as simple as that. And while Board seats are very important, before you think about how to structure a startup board, there is something even more important to understand which are called Protective Provisions.

Protective Provisions – What’s the big idea?
In general, the Board of Directors approves most strategic management decisions.  And for most decisions requiring a shareholder vote, everyone votes based on the number of shares they own.  However, there are certain things that investors get to decide (or at least must consent to) regardless of their ownership stake or make up of the Board of Directors.  These include:

• Any sale or dissolution of the company
• Issuing new shares of stock
• Changes to the size of the Board of Directors
• Creating, owning or selling any subsidiary
• Any change to the certificate of incorporation or Bylaws.
• Changes to any rights of other shares which give the same or better rights as their preferred shares
• Purchases or any dividends on stock before the preferred shares
• Issuing any debt

In many ways, Protective Provisions are as important, if not more important, to understand as how to organize your Board of Directors (which will be the next post). Investors include them so that when the preferred share holders are a minority, they are protected against certain actions of the majority such as a the possibility that a majority of the shareholders being able to sell the company to a family member for $10 and as result, wiping out the investors.  In general, they are reasonable protections when they serve as protections as opposed to control.

Protective Provisions – How do they work?
Protective Provisions are actually pretty straight-forward.  There is the list of decisions to which the preferred shareholders have to agree or consent before the company can act.  There is some negotiation for items such as taking on debt, as usually there is some threshold below which the company can take on debt without consent.  Though most of the items are not very negotiable.

However, what is negotiable is how the Protective Provisions work when you raise multiple rounds of funding.   They can either work in such a manner such that all the preferred shareholders vote together as a class regardless of when they invested or alternatively each series of preferred shares have the right to vote separately for each series on the protective provisions.  As I will explain, having all the preferred shareholders vote as a class is in the company’s best interest.

Let’s take the example of a company that has raised one round of funding, called a Series A, in which the preferred shareholders own 30% of the company.  In this case, the preferred shareholders have to vote on any of the itemized protective provisions and it’s simple.

Now what happens in the case that you raise two additional rounds of funding, a Series B and a Series C? Each time you raise a new round, it’s in the best interest of the company that the preferred shareholders vote all together and share the protective provisions otherwise you could have a small minority shareholder that has veto rights over what are big decisions.  For example, let’s assume the Series B owns 15% and the Series C owns 5% of the company. If the Series C had their own protective provisions, then a 5% shareholder could veto a decision to sell the company even if 95% of the rest of the shareholders voted to sell the company.  This is an example of how a protective provision can become a controlling provision.

Additionally, there is one other twist, which is the threshold for the voting in the protective provisions.  In general, it is in the best interest to have a majority or close to a majority, such as 60% because again, this is supposed to be a protective provision and not a controlling provision.

In summary, while a company may think that the make up of the Board of Directors is the most important item, it turns out that the protective provisions  give the preferred investors quite a bit of power over key decisions. Does this mean that the Board does not matter? Absolutely not, and that will be the topic of the next post.

I am also going to interview Bill Gurley of Benchmark Capital this week. Send me your questions for him via the Contact form.

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More info and References

• Startup 124: Term Sheet – Valuation and Dilution
• Startup 125: Term Sheet – Liquidation Preferences
• Startup 126: Term Sheet – Anti-Dilution
• Download sample Term Sheet from National Venture Capital Association
• Ballot Box photo from http://www.flickr.com/photos/thomasroche/