Reserved Matters: What You Need To Know

What You’ll Read

• Why corporate governance is important
• Types of reserved matters
• Potential pitfalls of reserved matters
• Balancing governance with effective decision-making

Key Takeaways

• Corporate governance is a top priority for all companies, both startups and incumbents
• As one of the means to practice good corporate governance, investors and entrepreneurs utilize reserved matters for certain decisions that require approval from specific stakeholders 
• In the United States and other developed private market ecosystems, there's been a decline in the utilization of board and shareholder reserved matters as a means of exerting control over company decisions
• However, when approached thoughtfully, reserved matters can create a balanced framework for decision-making and overall corporate governance hygiene  
• Reserved matters should not be used as a means to exert your influence as a stakeholder

Background

Running a company is hard work. Whether you’re a high-growth startup or an existing enduring business with stable cash flow and customers - business leaders are tasked with making key decisions at every turn. 

Most day-to-day decisions are left for the senior executives of the company to decide. However, some decisions are so impactful to the company, that the company’s investors or board members may want a say. 

Companies around the world use a structure called “reserved matters” to identify certain situations that would require approval from a specific group of people at the company, often requiring a minimum number of Board Directors or a specified ownership percentage of the preferred shareholders. 

In the US, there's been a notable decline in the utilization of board and shareholder reserved matters as a means of exerting control over company decisions, however, these mechanisms continue to play an important role if utilized effectively.  

But what are reserved matters exactly and what do they mean for companies?

Introduction

Reserved matters are meant to protect the interests of certain stakeholders on certain decisions, outlined by a set of key decisions that must be made with the approval of a select group of board members or shareholders. Reserved matters can include decisions like changing the rights of existing shares of the company, approving the business’ annual budget, or changing the company’s auditor. 

These reserved matters are outlined in the company’s shareholders’ agreement or other investment documentation when the company raises capital from new investors - a topic that is often negotiated with a lead investor. These are important clauses to focus on given the impact they may have on decisions within the company.

Types of reserved matters

There are generally two types of reserved matters: Shareholder Reserved Matters and Board Reserved Matters. We’ll get into both below 👇

Shareholder Reserved Matters

Shareholder reserved matters are intended to protect the interests of the shareholders of the company. These protections are commonly negotiated between the lead investors of a fundraising round and the company. The importance of determining which circumstances qualify as shareholder reserved matters is significant in the negotiation process as these are meant to de-risk part of an investor’s consideration for investing in a company. Shareholder reserved matters can include, but are not limited to:

• Changing any rights related to existing shares of the company
• The issuance of a new class of shares
• Changes to the employee option pool
• Changes to the company’s auditors

These are only a handful of the many shareholder reserved matters that a company and its investors may agree upon. Shareholder reserved matters are events that typically impact the company’s capitalization table or the characteristics of an investor’s shares. 

Board Reserved Matters

Board reserved matters are intended to protect the interests of the company itself. These reserved matters require the approval of the majority of elected board members and can include a number of different circumstances, including:

• Approving or changing the company’s annual budget or business plan
• Changing compensation policies for the company’s senior-level employees
• Approving employee option awards
• Entering into a certain amount of indebtedness

These reserved matters represent only a subset of the possible board reserved matters that companies might have. Most board reserved matters relate to any financial or business matters that may impact the health of the company. 

Potential pitfalls of reserved matters

Reserved matters are intended to improve the governance practices of a corporation. By requiring approvals from specific groups of a company’s stakeholders, executives can ideally better manage the risks of all parties involved while running an organization. 

However, sometimes reserved matters can result in the opposite outcomes than originally intended. They can, at times, inadvertently slow down the decision-making process and progress at a company, 

“Deadlock” is when a group or person uses their power to stall a major decision by withholding an affirmative vote. In board reserved matters, this can be the case when the minority-represented board member vetoes a given decision, “deadlocking” the decision-making process and slowing progress at a company. 

This circumstance is often preemptively addressed in investment documentation to limit the number of failed board votes that a company can have to a maximum of two meetings before requiring the board to act in good faith to resolve the matter at hand.

Other unintended consequences include a single person or group of stakeholders exercising too much control over a particular matter. Without thoughtful consideration while drafting your reserved matters, it’s possible that certain stakeholders could end up with unnecessary leverage over certain decisions.  

As a rule of thumb, reserved matters should only be used to protect an investor’s interest and risk. It’s a balance between encouraging sustainable growth and empowering the company to lead.

Balancing governance with effective decision-making

All companies have governance considerations when it comes to making both day-to-day and long-term business decisions. As a bootstrapped entrepreneur, these decisions are fairly simple as they typically come down to just the opinion of one person. 

When an entrepreneur decides to raise investment capital, the governance topic becomes even more important as a company now has more stakeholders involved in its existence. 

An effective governance structure is one that fairly represents the stakeholders involved in a business to arrive at the most optimal decision-making outcome.  

It’s crucial to practice good governance hygiene in a way that allows companies to make decisions quickly when necessary and remain nimble, particularly in startup businesses. 

What does this mean? Entrepreneurs and investors should think deeply about which reserved matters are good for a startup business and which would be unnecessary and slow down a company’s ability to act swiftly.

On the other hand, businesses with strong, stable cash flows that have been around for a long time may benefit differently from a longer list of reserved matters. 

Every business will have unique characteristics that call for varying consideration of its reserved matters.

The goal is for an entrepreneur and investor to come to an agreement that optimizes governance hygiene while empowering the business to operate in the best way possible. 

Deciding on which set of governance decisions should be identified as reserved matters can be confusing. It’s always advised to speak to your legal team when drafting transaction documents. 

How Zest can help

Zest is digitizing private market transactions, building tools to streamline how entrepreneurs, funds and investors transact. Our platform is designed to save you time and reduce administrative costs, simplifying the end-to-end investment process.