What are Protective Provisions in a Term Sheet? 

Another common investor control provision, known as protective rights, requires voting approval (either majority or unanimous vote) by a class of preferred shareholder for certain events, such as pursuing an exit event. These rights allow the preferred shareholder the ability to thwart or hold up certain corporate action. The company will establish the minimum number of authorized shares and the voting threshold (majority, super-majority, or unanimous approval) that must be present for the protective rights to apply. For example, if a very small percentage of a single class of preferred share is outstanding, the company does not want this class of shares to be able to control company decisions through their voting rights.

Common Protective Provisions in a Term Sheet? 

The parties may select many types of events that require preferred shareholder approval. Common protective provisions allowing for preferred shareholder approval include:

• Modification of Articles or Bylaws - If any such modification would change the rights or preferences of that series or preferred shareholder,
• # Of Authorized Shares - Changes in the number of preferred shares in any class,
• Class of Shares - Creating any other class of preferred shares with dividend, liquidation, or voting preferences different than those of the outstanding preferred,
• M&A - Approving Any merge, sale or reorganization of the corporation,
• Share Repurchases - Any acquisition of common stock, other than repurchases pursuant other than a board-approved repurchase pursuant to buy-sell provision or agreement,
• Dividends - Pays or declares any distribution to common or preferred shareholders (except as previously stated in the articles),
• Dissolution - Approving dissolution of the company,
• Board Size - Increasing size of the board
• Security Interests - Granting a security interest in a substantial percentage of company assets,
• Major Asset Acquisitions - Particularly if assets are acquired through merger or acquisition,
• Stock Option Plan - Establishing a new option plan or authorizing new shares as part of an option plan,
• Board-Specific Approval- The preferred shareholders may request any number of special protective rights requiring board approval (by directors elected by the preferred shareholders or by a designated percentage of directors) of certain actions, such as:
  • Loans or distributions of cash or stock to other entities (unless a wholly-owned subsidiary),
  • Loans or advances to individuals outside of the ordinary course of business,
  • Any guarantees or sureties outside of the ordinary course of business,
  • Any corporate investments (other than prime securities), such as investment in other companies, with long-term maturity,
  • Incurring indebtedness outside of the approved budget (an outside of the ordinary course),
  • Transactions with key employees or insiders that exceed a predetermined amount (except as in the ordinary course, pursuant to reasonable needs of the company, and under reasonable, board-approved terms),
  • Executive Matters - Hiring, firing, or changing compensation (including options plans) of executives,
  • Operational Matters - Major changes to the companies current lines of business,
  • Intellectual Property - Transactions affecting intellectual property rights done outside of the ordinary course of business,

Protective provisions are generally reserved within the articles of incorporation to make it more difficult to change or amend. 

The Articles will generally contain a no impairment clause restricting the ability of shareholders to impair the rights of preferred shareholders through any number of methods. The board-specific approvals are generally in the bylaws or shareholder agreements in an attempt to avoid legal restrictions in state corporate governance law (e.g., California Corporations Code). Note that the articles of incorporation must authorize each particular class of shares. Each series of preferred share may have different protective rights. Companies generally seek to establish uniform protective rights across preferred shareholders, but later round shareholders may negotiate superior rights for their class of shares.