Should the Series B have separate protective provisions?
Takeaway: In general, no. Subsequent series of preferred stock are generally added to the majority of all preferred stock threshold for purposes of waiving any of the protective covenants. As a reminder, protective covenants are certain things listed in the company’s charter that the company cannot do without investor consent (e.g., acquisitions, financings, etc.).
When startups raise capital through multiple financing rounds, they often issue different series of preferred stock to investors, such as Series A and Series B. Each series of preferred stock comes with its unique set of rights and preferences, including protective provisions that grant certain veto rights to preferred stockholders. A key question that arises is whether Series B preferred stock should have separate protective provisions from Series A. This post will explore the implications of separate protective provisions and whether it's a practical approach for startups and investors.
Understanding protective provisions
Protective provisions are specific rights granted to preferred stockholders to protect their interests in a company. These provisions typically require the company to obtain the consent of preferred stockholders before taking certain actions, such as amending the company's charter, issuing new securities, or entering into significant transactions.
The case for separate protective provisions
There are some arguments in favor of having separate protective provisions for Series B preferred stock:
Tailored protection for different investor interests: Series B investors might have different priorities and concerns compared to Series A investors. By creating separate protective provisions, the company can address the unique needs and interests of each group of investors.
Flexibility in negotiations: Having separate protective provisions allows for more flexibility in negotiations, as the company can offer different terms to Series A and Series B investors without affecting the rights of the other group.
The case against separate protective provisions
However, there are strong arguments against having separate protective provisions for Series B preferred stock:
Complexity in decision-making: Separate protective provisions for Series A and Series B investors can create complexity in decision-making, as the company may need to obtain the consent of both groups for certain actions. This could slow down the decision-making process and create potential conflicts between different investor groups.
Inefficient management: Having separate protective provisions for Series A and Series B can lead to inefficient management of the company, as the management team may need to spend significant time and effort navigating the differing interests of each investor group.
Deter future investors: Future investors might be deterred from investing in the company if they perceive the separate protective provisions as an indication of potential conflicts or complexities in managing the company's affairs.
Subsequent Series Rights: Later series of preferred stock would likely demand the same series-specific protective covenants.
Striking a balance: Common protective provisions
To avoid the potential drawbacks of separate protective provisions, many startups opt for common protective provisions that apply to both Series A and Series B preferred stockholders. This approach simplifies decision-making and ensures that all preferred stockholders have the same level of protection, fostering a sense of fairness among investors.
Conclusion
While there may be some reasons to consider separate protective provisions for Series B preferred stock, it's generally not considered the best practice in the startup world. Instead, a common protective provisions approach, where both Series A and Series B preferred stockholders share the same protective provisions, is often seen as the most efficient and fair solution. This approach simplifies decision-making, ensures fairness among investors, and promotes efficient management of the company.