Protective Provisions

What are protective provisions?

Protective provisions (German: Zustimmungsvorbehalte der Investoren) are an agreed list of resolutions and transactions of the company that are permissible only with the investors' consent. They are also called a consent catalogue (Zustimmungskatalog) and, in contracts with a British influence, reserved matters. As a rule, the consent of a certain investor majority is sufficient. The provisions secure for investors, who usually hold a minority, influence over decisions that materially affect their rights or the value of their holding.

The catalogue is laid down in outline in the term sheet, the declaration of intent at the start of a funding round. It is implemented in the articles of association, in the shareholders' agreement (the contract between the shareholders alongside the articles) and in the rules of procedure for the management. The parties involved are investors, founders and management and, where applicable, an advisory board, that is, a voluntary body for advising or supervising the management.

Protective provisions are the most important contractual form of investor veto rights. They differ from the general concept of veto rights in three respects: they belong only to the investors, mostly as a group. They rest on the articles of association and contract, not on statutory majorities. And they cover a fixed list of topics that extends down to individual transactions of the management.

Origin and transfer to the GmbH

The term comes from the US market and is found there, for example, in the model documents of the NVCA (National Venture Capital Association), the trade association of US venture capital investors. There the consent rights are in the company's charter (certificate of incorporation). For certain measures they require a separate vote of the holders of preferred stock, that is, the investors' shares equipped with preferential rights. The German Limited Liability Companies Act (GmbH-Gesetz, GmbHG) knows no statutorily structured share classes of this kind. The articles of association can, however, equip shares with different rights, in practice for example as preferred GmbH shares of the investors of a round. Their rights are set out in the articles of association and the shareholders' agreement, and the consent rights operate on two levels.

Shareholder level

For certain shareholder resolutions, the articles of association require, in addition to the statutory majority, the consent of an investor majority, for example for capital measures and amendments to the articles. If the reservation is in the articles of association, it operates directly on the resolution. If it is only in the shareholders' agreement, the shareholders undertake by contract not to vote for the measure without the investors' consent.

Management level

The second part is a catalogue of transactions requiring consent. The managing directors may undertake certain measures only after prior consent of the shareholders' meeting, in which the investor majority must agree, or of an advisory board. The basis is Section 37(1) GmbHG, under which managing directors must observe the restrictions that the articles of association and shareholder resolutions impose on them. These restrictions have no effect externally (Section 37(2) GmbHG): a contract concluded without consent is generally effective. The breach has consequences internally, ranging from liability under Section 43 GmbHG through removal to termination of the service agreement.

Typical content of protective provisions

• Capital and structure: capital increases and capital reductions, issue of convertible and option rights, new classes of shares, amendments to the articles of association, changes to the rights of the investors' shares, reorganisations and winding up.
• Exit and material assets: sale of the company or of material parts, transfer or exclusive licensing of material intellectual property rights, acquisition of stakes and formation of subsidiaries.
• Finance: resolution on the annual budget (budgeting), borrowing and security above agreed amounts, distributions and transactions outside the budget.
• People and contracts: appointment, removal and remuneration of the management, participation programmes for employees, contracts with shareholders and related persons and material contracts above an amount threshold.

Structuring and negotiation practice

Who must consent

The consent of the investor majority is common, that is, a simple or qualified majority of all investor shares, which decide jointly as one group. The threshold is often set so that the lead investor can decide alone or together with one further investor. A separate consent per funding round is critical: then an investor of an early round, who now holds only a small share, can prevent measures that all other investors support.

Thresholds, budget and procedure

Amount thresholds for loans, investments and contracts should fit the size of the company and grow with it. A budget rule is customary: measures contained in the approved annual budget are deemed consented to. The vote thereby shifts to the annual budget resolution. The procedure includes the form and deadline of the consent. Some agreements provide that consent is deemed granted if the investors do not object within a certain period.

Lapse of the provisions

Protective provisions are tied to the shareholding. They often lapse if the investor shares fall below a minimum percentage, and at the latest with an IPO. If several rounds are completed, the parties generally merge the catalogues into a single catalogue with a joint investor majority.

Protective provisions in due diligence and exit

In due diligence, new investors and acquirers check whether all required consents were obtained in the past. If they are missing, the contracts concerned usually remain effective, but claims against the management can arise. If a consent to a shareholder resolution provided for in the articles of association is missing, the resolution can be challenged. Both must be dealt with before closing, often by subsequent approval.

On an exit, the consent right on the sale of the company gives the investors influence over timing and price. It must be coordinated with the obligation to co-sell. The agreement should make clear that the investors cannot withhold their consent if the conditions of the drag-along rights are met.

Practical example: investor consent to venture debt

A GmbH that offers logistics software has annual recurring revenue of EUR 6 million and three investors. The Series A lead investor holds 18%, a co-investor of the same round 7% and an investor of the first round (seed) 5% of the share capital. The investor shares together amount to 30%. Loans and contracts above EUR 500,000 that are not in the budget require the consent of the investor majority. The management wants to take on venture debt of EUR 2 million, that is, a loan from a lender specialising in growth companies. It is not provided for in the budget.

• Investor majority as a simple majority of the investor shares: the lead investor holds 18 / 30 = 60% of them and can consent alone.
• Investor majority of 75%: the lead investor needs a partner. With the co-investor, (18 + 7) / 30 = 83.3% come together, with the seed investor (18 + 5) / 30 = 76.7%. Both combinations suffice.
• Separate consent per round: the seed round decides on its own. The seed investor, with 5 / 30 = 16.7% of the investor shares, can prevent the financing alone.
• A three-year hosting contract with a total value of EUR 600,000 that is included in the approved budget, by contrast, needs no separate consent.

The management's ability to act is therefore decided not only by the list of topics but by the question of who must consent. Depending on the way of counting, the lead investor decides the same financing alone, needs a partner, or an investor with 5% of the share capital can prevent it.

Distinctions: protective provisions, information rights and covenants

• Information Rights: give investors knowledge of the company's position but no decision-making power.
• Board Seat: influence through a seat on a body such as the advisory board. Consent rights also operate without a board seat.
• Covenants: conditions in loan agreements by which lenders make certain measures dependent on their consent. They secure repayment, not the rights of a shareholding.

Common mistakes

• Separate consent per round. It gives small investors of early rounds a blocking position that does not correspond to their share.
• Rigid amount thresholds. Thresholds that were appropriate at the seed financing make everyday transactions subject to consent after two rounds.
• Individual operational measures in the catalogue. Consents for hires below the management level or for individual marketing expenses slow the management down without any gain in protection.
• No budget rule. Without one, the management must submit measures that have already been planned and approved a second time.
• No procedure. If form and deadline for the consent are missing, a measure in case of doubt stays on hold until all investors have responded.
• No lapse when the shareholding falls. If an investor keeps its reservations even with a very small share, this disturbs later rounds and the exit.

Frequently asked questions

Which protective provisions are typically in the term sheet?

Usually capital measures, amendments to the articles of association, changes to the investor rights, the sale of the company or of material parts, winding up, distributions and loans above a threshold. The term sheet often names the topics only as a list. Amount thresholds, budget rule and the competent investor majority are set out in detail only by the articles of association and the shareholders' agreement.

Are protective provisions effective against third parties?

As a rule, no. The management's power of representation is unrestricted externally. A contract that the management concludes without the required consent in principle still binds the company. The consequences fall on the management internally.

Which investor majority must consent?

Often the simple or a qualified majority of all investor shares, counted together (investor majority). Founders and later investors view separate majorities per funding round critically, because they give small investors of early rounds a blocking position.

What is the difference between protective provisions and veto rights?

Protective provisions are a subcategory of veto rights. They denote the agreed catalogue of topics of the investors, which extends down to individual transactions of the management. Veto rights additionally include statutory blocking minorities, increased majorities in the articles of association and special rights of individual shareholders, such as the founders.

Do protective provisions continue to apply after an IPO?

As a rule, no. Shareholders' agreements provide for them to end with the IPO. In the articles of association of a stock corporation, comparable reservations can in any case be anchored only to a limited extent because of the strictness of articles under stock corporation law (Satzungsstrenge).

Is the catalogue renegotiated in every funding round?

As a rule yes. New investors bring their own requirements, and the existing catalogues are merged. This is also the opportunity to adjust amount thresholds to the company's increased size.

The Roemer Capital view

Roemer Capital reads the consent catalogue with a view to the managing directors' day-to-day work. It places the amount thresholds next to the budget and the financial model and checks how many ordinary transactions of a year would become subject to consent. If the thresholds are too low, Roemer Capital brings this into the negotiation with figures before the documentation is finalised.

In later rounds, Roemer Capital makes sure that the catalogues of several rounds are merged into one rule with a joint investor majority. The legal implementation in the articles of association, shareholders' agreement and rules of procedure rests with the company's law firm.