Introduction

When convertible notes are used as a replacement for an equity seed round of financing, protective provisions become a fairly typical inclusion in legal documents. This article explores the nature of these provisions, their importance, and how they differ in convertible note financings compared to equity seed rounds. We will also discuss some of the most common protective provisions seen in convertible note financings and their implications.

Understanding the Context

Convertible notes differ from traditional equity seed rounds in that they are often used as a short-term financing solution with the expectation of converting to equity at a later stage. However, when a convertible note is truly meant to be a long-term funding solution and act as a replacement for an equity seed round, protective provisions are more commonly applied. These provisions aim to ensure that key decisions affecting the company's valuation, governance, and strategic direction align with the interests of the investors.

The Nature of Protective Provisions in Convertible Notes

Protective provisions in convertible notes are usually more contractual in nature and are often included in an investors' rights agreement (IRA) rather than being part of the company's charter documents. Given that no new class of preferred stock is created in a convertible note financing, the protective provisions are not required to amend the company's charter.
When a protective provision is breached in the charter, it can affect the legal validity of certain company actions, whereas a breach in an IRA typically allows the investor to pursue contract remedies rather than making the action void. This distinction is crucial in understanding the scope and impact of protective provisions in convertible note financings.

Common Protective Provisions in Convertible Notes

Some of the most common protective provisions that often appear in convertible note financings include:

Board Size Adjustments: Any increase or decrease in the size of the board must be approved by the vote of investors who hold a specified percentage of the outstanding principal amount of the notes. Company Sale: Agreements to or the consummation of a company sale must be approved by the same specified percentage of the investors. Change in Business: Any significant change in the company's business or direction must be approved by the same percentage of investors. Intellectual Property and Asset Sales: Sales of intellectual property or other material assets must also be signed off by the same investor threshold. Equity Incentive Plan: Any increase in the number of shares reserved for the company's equity incentive plan must be approved by the specified investors. Indebtedness: The company cannot accumulate a certain amount of debt without the investors' approval. Capital Expenditures: Significant capital expenditures must be authorized by the investors. Stock Purchases and Dividends: Any purchase or dividend payment on shares must be approved by the investors. Corporate Transactions with Affiliates: The company cannot enter into transactions with directors, officers, or affiliates without the investors' consent. Accounting Changes and Officer Comp: Changes in accounting practices, senior officer compensation, and any alterations to equity incentive plans require investor approval. Duty Changes for Senior Executives: Any significant changes in the duties of senior executives must be approved by the investors.

Conclusion

Protective provisions are a critical element in convertible note financings when they are used as a long-term funding solution. These provisions help protect investors' interests and ensure that key decisions align with their expectations. Understanding these provisions and their implications is essential for both investors and startups navigating the complexities of convertible note financings.