Reading: Corporate Governance Provisions

Voting on As-Converted Basis

Remember from our discussion about the division of financial returns that VCs usually prefer to invest in preferred stock rather than common stock. However, shares of preferred stock usually do not carry voting rights. Therefore, by default, the VC would not have a say in major company decisions.

To address this concern, almost all term sheets stipulate that preferred shares vote together with common stock on an as-converted basis. Such a simple clause could read:

The Series A Preferred shall vote together with the Common Stock on an as-converted basis.

Sometimes, voting rights are also made performance dependent, such that if the firm fails to reach specific predefined milestones, the VCs receive higher voting rights. This could be achieved, for example, with an Escrow structure that issues additional shares to the VC if the firm misses a specific performance target (see the discussion about performance-dependent offering terms). Alternatively, the term sheet could stipulate that preferred shares receive multiple voting rights if the firm's performance falls behind expectations.

Class Voting Rights (Protective Provisions)

In addition to the voting right on an as-converted basis, the various series of preferred stock usually also have class voting rights for important corporate matters. This means that approval the majority (or any other defined % or number of shares ) of the respective group of shareholders is required to pass a decision.

Take, for example a company in which the founders hold 70% and the Series A Preferred the remaining 30%. For a decision subject to class vote, approval of the predefined fraction of Series A Preferred is required. This implies that Series A holders factually have a veto right on important decisions, even though they are only minority shareholders.

Which corporate decisions are subject to class vote is ultimately the result of negotiations between the entrepreneurs and the VC. Often, the following decisions are included:

• The creation or issuance of any senior or pari passu security. We have seen that these securities would affect the liquidation preference and participation rights of the existing preferred stockholders.
• An increase in the number of authorized shares of Preferred Stock;
• Any adverse change to the rights, preferences and privileges of the Preferred Stock;
• An increase in the size of the Board of Directors;
• Repurchase of Common Stock except upon termination of employment;
• Repurchase or redemption of any Preferred Stock;
• Any transaction in which control of the Company is transferred;
• Any amendment to the Bylaws or Articles of Incorporation;
• Any dividend or distribution on capital stock of the Company;
• Any sale, pledge, license or transfer of all or substantially all of the Company’s assets. 

Sometimes, class vote is also required for specific operational decisions such as:

• Hiring of top executives;
• Changes in the compensation policy;
• Change in the lines of business;
• Capital expenditures over a certain amount;
• Budget approval;
• Etc.

Clearly, these provisions make sure that, while the entrepreneur might be in control, the VCs have very direct access to important decisions, even if they are only minority shareholders. In particular, they can prevent actions by management that materially change the risk of the business or their investment.