Professional venture capital investors take large risks investing in often-untried emerging companies. In return for the money they fund, VCs want to sign agreements with young companies that document the purchase of convertible preferred stock for an ownership stake that is usually less than a majority of the economic interest of the company. Many of the terms of these agreements proposed by VCs are intended to mitigate the inherent investment risks associated with making these types of minority investments.
One of the best ways for a VC to mitigate investment risk is for it to take control of key elements of corporate governance through what are called “protective provisions,” usually inserted by the VC’s lawyer in the company’s certificate of incorporation, and sometimes also the stockholders’ agreement. These provisions “protect” the VC by imposing additional restrictions on certain discretionary decisions otherwise typically made by management and/or the board of directors. Such provisions usually state that, as long as a minimal amount of shares of the relevant class of convertible preferred shares are outstanding, a majority in interest (and sometimes a supermajority) of the holders of those shares must give their prior approval to certain corporate decisions proposed by management and the board of directors (e.g., whether to issue new equity securities, to change management, to enlarge the stock option pool, to incur debt above a threshold amount, to make a material acquisition or divestiture, and of course, whether to sell the company and on what terms).
Depending upon how protective provisions are drafted, they may be investor-favorable or more company-favorable. It is up to the company’s lawyer to know the difference and understand what the applicable market parameters are for such provisions.
Protective provisions have become typical in funding rounds by sophisticated angel groups as well. Sometimes angel groups will water-down these provisions in documentation referred to as “preferred light,” i.e., convertible preferred stock documents that contain less onerous protective provisions than those typically imposed by professional venture capital investors.
Some words of caution, however, for the founder/entrepreneur: increasingly sophisticated angel groups are becoming better organized and are insisting on protective provisions like those proposed by institutional VCs, but sometimes without the centralized organization or experience to participate in complicated governance decisions quickly and decisively. It is understandable why any investor, professional or angel group, may want control over corporate decisions to mitigate the investment risk it takes on. It is important for the entrepreneur, however, to assess the investor’s capacity to act competently, quickly and decisively, as is often required in an emerging company.