What are protective covenants?
Takeaway: Protective covenants are a set of powerful veto rights granted to preferred stockholders, ensuring that the company cannot make fundamental strategic decisions—like selling itself or changing its core business—without the explicit consent of its investors.
When a venture capital fund invests in your startup, they are typically a minority stockholder. They do not control a majority of the company's stock, and they may not control a majority of the Board of Directors. So how do they protect their investment from being harmed by a decision made by the founder-controlled board? The answer is protective covenants, also known as protective provisions.
These provisions are a standard and usually a non-negotiable part of any venture financing. They are a list of specific, major corporate actions that the company is contractually prohibited from taking without first obtaining the separate approval of a majority of the preferred stockholders, voting as their own distinct class.
Protective covenants are, in essence, a VC's "veto rights." They ensure that even as a minority shareholder, the investor has a powerful voice in the most critical decisions that could affect the value of their investment.
What Actions Do Protective Covenants Cover?
The list of actions that require investor approval is detailed in the company's Certificate of Incorporation. A standard list will include:
Selling or liquidating the company. This prevents the founders from selling the company for a low price that would not provide a good return for the investors.
Amending the Certificate of Incorporation or Bylaws in a way that would harm the rights of the preferred stockholders.
Changing the size of the Board of Directors. This prevents the founders from "packing the board" to dilute the investor's influence.
Issuing a new class of stock that is senior to the existing preferred stock. This protects the investors' place in the liquidation preference waterfall.
Taking on a significant amount of debt above a pre-agreed upon threshold.
Paying a dividend. Startups should be reinvesting their capital, not paying it out.
Changing the core business of the company.
The Negotiation
While the existence of protective covenants is standard, the exact list and the voting threshold required to approve these actions can be a point of negotiation. As a founder, you should work with your counsel to resist any non-standard or overly restrictive provisions that could unduly hamper your ability to effectively grow the company.
Protective covenants are a fundamental part of the venture capital bargain. They provide the necessary check on the power of the majority and give your investors the assurance they need that their capital will be protected as you work together to build a valuable company.
Disclaimer: This post is for general informational purposes only and does not constitute legal, tax, or financial advice. Reading or relying on this content does not create an attorney–client relationship. Every startup’s situation is unique, and you should consult qualified legal or tax professionals before making decisions that may affect your business.