What are protective covenants?
Takeaway: Protective covenants are things that a company cannot do without first getting investor consent - usually a majority of the shares of preferred stock. They are typically added to the company’s charter in a preferred stock financing and include things like selling the business, increasing the authorized shares (i.e., conducting a financing), taking on debt, etc.
As startups grow and attract venture capital investment, it is essential to establish guidelines that protect investors' interests and ensure the company's long-term success. One such safeguard is the inclusion of protective covenants in a startup's charter, which outline certain actions that require investor approval. The National Venture Capital Association (NVCA) provides a set of model documents, including charters with common protective covenants. In this post, we will discuss the concept of protective covenants, their significance in startup charters, and the most common covenants in NVCA model agreements.
What are Protective Covenants?
Protective covenants are provisions in a company's charter that restrict the company from taking specific actions without obtaining the prior approval of certain investors or a specified percentage of preferred stockholders. These provisions help protect investors' interests by giving them a degree of control over significant decisions that could impact their investment.
Common Protective Covenants in NVCA Charters
The NVCA model charter includes several common protective covenants that are widely accepted in the venture capital industry. Some of these key provisions include:
Liquidation, Merger, or Sale: The company must obtain the approval of preferred stockholders before entering into any agreement that results in a liquidation, merger, or sale of a significant portion of the company's assets. This approval ensures that investors have a say in significant transactions that may affect their investment.
Changes to Charter or Bylaws: Any amendments to the company's charter or bylaws that adversely affect preferred stockholders' rights must receive their approval. This covenant protects investors from unfavorable changes to the company's governance structure.
Stock Issuance: The company must obtain preferred stockholders' approval before issuing new shares of stock that are equal or senior to the preferred stock in terms of dividend or liquidation preferences. This covenant helps prevent dilution of investors' ownership stakes and maintains their preferential rights.
Dividends: The company cannot declare or pay dividends on common stock without obtaining the consent of preferred stockholders. This provision ensures that the company's resources are allocated appropriately and that preferred stockholders receive their agreed-upon dividends before common stockholders.
Debt Financing: The company must seek approval from preferred stockholders before incurring a significant amount of debt or entering into a debt financing agreement. This covenant helps manage the company's debt levels and ensures that investors have a say in significant financial decisions.
Changes to Board Composition: Any changes to the company's board of directors that impact preferred stockholders' representation require their approval. This provision ensures that investors maintain their influence on the board and are involved in key decision-making processes.
Why are Protective Covenants Important?
Protective covenants play a crucial role in safeguarding investors' interests and maintaining a stable and collaborative relationship between startups and their investors. These covenants provide investors with a degree of control over significant decisions that could impact their investment, while also promoting transparency and accountability in the company's operations.
Conclusion
Protective covenants are essential provisions in startup charters that serve to protect the interests of investors, particularly in venture capital investments. The NVCA model documents provide a comprehensive and widely-accepted framework for including these covenants in startup charters. Understanding the purpose and implications of protective covenants is crucial for both investors and startups, as it enables them to negotiate fair and balanced agreements that foster long-term success and a healthy relationship between all parties involved.