Restrictive covenants are standard features of venture capital, growth equity and private equity transactions although each investor type has its own standards. Restrictive covenants are the actions a company cannot take without investor approval. A short list of typical restrictive covenants includes:
- A sale of a Company or sale of a majority of the Company’s assets;
- Sales of new securities;
- Changes to Articles or Incorporation that change the rights and preferences of existing securities;
- Changes in Board Composition;
- Payment of dividends or any kind of not previously agreed to distributions;
- Changes to the size of option and other incentive plans;
- Incurrence of indebtedness above a certain dollar threshold; and
- Transactions with affiliates.
These covenants are described as “restrictive” because management and the board are precluded from taking these actions without the express approval of the required shareholder (or group of shareholders voting as a class). The purpose of restrictive covenants is not to “restrict” a Company from being able to operate. Rather, restrictive covenants are intended to protect investors from management/board actions that a) cause value to leak out to junior shareholders or managers without value accruing to the senior shareholders; b) change the terms of a previously agreed to investment documents, or c) cause dilution to the value of an equity holders position.
Where management and investors are aligned, these restrictive covenants are rarely (if ever) an issue. Only where a management team and investors are mis-aligned do these terms come into play. In my experience, this happens most often when an investor doesn’t want to participate in a financing and is facing a highly-dilutive financing as a result. The investor may seek to block such a financing even though they do not intend to provide the company with additional capital. A management team is totally handcuffed in cases like this and the business may be at risk of running out of money and hitting a wall. What is a management team to do if an investor is leveraging restrictive covenants as hold-up value?
- Get Re-Aligned: The best starting place is to work with your investor to re-align expectations. If your investor is of an institutional variety, chances are they will work to understand your issues and accommodate what you are working to accomplish. After all, the death knell for an investor is for word to get out that they are holding up one of their portfolio companies. Likewise, it is critical that you take the time to understand your investor’s point of view. It is possible that they are protecting you from yourself. If you have already tried getting re-aligned and failed, try again!
- Give the Investor a Hard-Choice: For example, if an investor won’t approve a financing despite the fact that they won’t/can’t participate, the best thing to do is to put a term sheet in front of the investor and ask for their approval. Take the term sheet to the board first, have it approved and then seek shareholder approval. Most times, an investor faced with the decision to either bless a financing already approved by a Board or blow it up will make the right call.
- Offer to Buy-Out the Investor: In the worst of scenarios, it may make sense to buy the investor out of their position. This is a version of a hard-choice. You may not have the cash to pay a very high price, but that is exactly the point. The fact that you can’t pay much creates huge negotiating leverage for you.
- Leave: Working for an investor backed-company isn’t indentured servitude. If an investor is holding you up via restrictive covenant, you can leave. This is the hardest of all decisions because you probably have a lot of blood sweat and tears invested in the business. Don’t do this if your business is already successful and one of your investors is just being belligerent. In that case, try options 1, 2 and 3 again and again until you crack the code. This is also not permission to leave if there is a clear fiduciary responsibility that you should carry out before departing, like winding the business down if the business is insolvent.
I’d call out that nowhere on list is “lawyer-up and figure out a loophole” in the restrictive covenants. There is probably not a loophole to jump through in the first place. Even if there were, using a loophole usually makes matters much worse and gives leverage to the uncooperative investor.
I’m not advocating for bad behavior on the part of a management team and I don’t feel any of the actions recommended above can be characterized that way. An investor that is intentionally holding up a management team without a very, very, very good reason is exhibiting the worst kind of behavior. Sometimes the only way to get to a resolution is to escalate first. Having never gotten into a tussle with a management team over restrictive covenants makes it easier to make the recommendations suggested here.