Managing Investor Protections: What you need to know


All VC deals come with features and provisions that are designed to  help investors get comfortable making a multi-year, completely illiquid investment into your highly risky startup.

Typical protective provisions include things like:

Liquidation preference: On exit, the investor has the choice of getting their capital back or converting their pref shares into common and just getting their portion of the exit price.

Redemption: Some kind of mechanism to enable the investor to get their capital back after some period from time. This could range from the benign (you agree to convene a committee of the board X years from now to determine – with no obligation to act – whether it’s time to sell the company), to the non-trivial (the investor can force the company to buy back their shares, likely triggering a variety of unnatural events up to and including the sale of your company).

Anti-dilution: If you sell shares in the future at a price below that which the investor pays now, they get free shares so that their % ownership in the company does not go down.

Investor approvals: Notwithstanding the make up of your board, your VCs will have an effective veto over certain things such as:

  • The issuance of new shares that are “better” than theirs
    • Increasing the size of the ESOP
    • Exec team changes
    • Material changes to the budget
    • The decision to raise more capital
    • The decision to exit
    • Changing the size of the board

There are three things to bear in mind when it comes to these provisions:

Plain vanilla terms rule the day

If you see lots of cute terms that result in your interests being different than the investors’, that’s bad. Almost all investors will want pref shares. But things like multiple liquidation prefs (where they can take out some multiple of their investment before you see anything), double dips (where they can take back their cash, or a multiple of it AND take their % of the remainder) are to be avoided.

Remember – whatever terms you give on this round will become the floor for what investors ask for in all future rounds.

Leave the running of the business to management and the board

While it’s inevitable for investors to have some veto rights, these should be exclusively limited to things that negatively impact their investment. If you decide to double the size of your board and appoint your friends to that board, that’s bad. If you decide to triple the ESOP and give yourself a big grant for doing a great job, that’s bad. It’s perfectly normal for investors to be able to block these actions.

But, things like approving the budget, deciding to take on “reasonable” levels of debt, changes to your exec team, raising more capital at a higher price than the last round, selling the company at some minimum price, are all decisions that should be for the full board to weigh in on, not just the investors.

Protections are for the downside, not return enhancement

An example here is a cumulative dividend, where x% per year accumulates on top of the invested capital and is payable on liquidation. The only situation where this works IMHO is as a downside protection to provide some minimum return. ie. if an investor owns 10% of your company at exit, they would only get the dividend if adding the dividend to the amount they invested is greater than 10% of the sale price.

You should never agree to things like this if they just boost returns on an already positive investment.

None of this is to be navigated alone. This is sophisticated stuff and should be managed in close coordination with your lawyers and advisors.

Good luck!