Professional venture capital investors take large risks investing in often-untried emerging companies. In return for the money they fund, VCs want to sign agreements with young companies that document the purchase of convertible preferred stock for an ownership stake that is usually less than a majority of the economic interest of the company. Many of the terms of these agreements proposed by VCs are intended to mitigate the inherent investment risks associated with making these types of minority investments.

One of the best ways for a VC to mitigate investment risk is for it to take control of key elements of corporate governance through what are called “protective provisions,” usually inserted by the VC’s lawyer in the company’s certificate of incorporation, and sometimes also the stockholders’ agreement.  These provisions “protect” the VC by imposing additional restrictions on certain discretionary decisions otherwise typically made by management and/or the board of directors. Such provisions usually state that, as long as a minimal amount of shares of the relevant class of convertible preferred shares are outstanding, a majority in interest (and sometimes a supermajority) of the holders of those shares must give their prior approval to certain corporate decisions proposed by management and the board of directors (e.g., whether to issue new equity securities, to change management, to enlarge the stock option pool, to incur debt above a threshold amount, to make a material acquisition or divestiture, and of course, whether to sell the company and on what terms).

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