Below we explore the implications of excluding stock sale transactions from the definition of a Deemed Liquidation Event (DLE) in a company’s charter. While this exclusion follows the National Venture Capital Association (NVCA) model, it may leave gaps in protection for VCs, especially for European VCs.

What is a Deemed Liquidation Event (DLE)?

A DLE refers to events, other than a liquidation, dissolution, or winding up, that trigger distribution of cash or other consideration to stockholders. The company’s charter uses this definition to ensure distributions from such events follow the liquidation preferences of preferred stockholders. Typical DLEs in the NVCA model charter capture 2 main categories of transactions: (a) merger, consolidation, statutory conversion, transfer, domestication, or continuance on the one hand, subject to exceptions listed in the Charter (which we would categorize as “Mergers/Statutory Transactions”); and (b) sale, lease, transfer, etc. of all or substantially all of the company or a major subsidiary’s assets (“Asset Sales”). It is important to note that the requisite holders — typically an agreed majority of preferred stockholders — can elect to waive treatment of either of these events as a DLE by giving written notice to the company but cannot expand the definition unless the charter is amended.

When a DLE occurs, preferred stockholders are entitled to receive their liquidation preference (often 1x their investment) before any payments to common stockholders or get to participate in the DLE on an as-converted basis if this yields higher returns. Accordingly, if a Merger/Statutory Transaction or Asset Sale occurs, the liquidation preference protection kicks in and ensures downside protection or upside benefits for the investors.

The requisite holders also have an explicit right in the charter to approve the occurrence of a DLE under the preferred stock protective provisions.

Why the Exclusion of Stock Sale Transactions?

A stock sale transaction is the sale of more than 50% of a company’s capital stock or voting power to a third party. As noted above, unlike Asset Sales or Mergers/Statutory Transactions, stock sales are not included as a DLE in the NVCA model. The NVCA explains the exclusion of stock sales from the DLE definition, which we excerpt in summary below:

“It is generally inadvisable to insert language that includes a transfer of shares by stockholders as a Deemed Liquidation Event, as such transactions may not be within the control of the Corporation and, in any event, could be inadvertently triggered with unintended consequences… A better practice is to protect against such events through other measures.” (Emphasis ours)

The explanatory note advises against including stock sale transactions as DLE for the reasons stated above and note that a better approach is to protect against such events through a combination of other measures which we discuss in the next paragraph.

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Protections Available Without DLE Treatment of Stock Sales

If stock sales are excluded from the DLE definition, investors may still rely on:

· ROFR and Co-sale rights: The investors have rights of first refusal (ROFR) and co-sale rights which allow them to purchase the shares sought to be sold in the stock sale transaction and/or co-sell their shares together with the common stockholders. If they exercise their co-sale rights, the consideration from the stock sale is required to be distributed as though the stock sale was a DLE. These terms are included in the NVCA model ROFR and Co-sale Agreement (ROFRA).

· Restrictions in the Voting Agreement: The NVCA model voting agreement includes a provision prohibiting sales of control unless all preferred stockholders participate in the transaction on a DLE-equivalent basis and the consideration is distributed in the same manner as a DLE (or unless the requisite holders waive this treatment).

· Protective provisions: The NVCA commentary mentions protecting against such events through protective provisions in the charter regarding ‘issuance’ of stock. However, the sale of stock from shareholder(s) to a third parties is not an issuance of stock and so it is unclear how this protection applies.

When These Protections May Be Inadequate

Despite these protections, gaps can arise depending on ownership structure and class dynamics:

· Common stock majority (early-stage) — At the Seed or Series A stage, founders and common holders often own the majority. ROFR and co-sale rights may protect investors if common holders try to sell control. However, these rights may fall short if the sale terms favor founders, for example, through earnouts or special management compensation, or if investors believe they could secure a better exit with another buyer. In such cases, investors may want stock sales included in the DLE definition, so they have a direct say before the deal proceeds.

· Preferred stock majority (later-stage) — In later stage companies, earlier stage investors in one or more classes of preferred stock (for instance Seed + Series A) may collectively hold the majority over other later stage, senior investors (for instance Series B) and the common stockholders. Given that ROFR and co-sale rights usually apply to common stockholders and not investors, a majority block of earlier stage investors could sell control without involving senior but minority investors. To prevent this, those senior investors may push to treat stock sales as DLEs, ensuring liquidation preferences are still respected in such circumstances.

· Challenges with restriction on sale of control in voting agreement — The voting agreement restricts stock sale transactions by requiring sellers to include investors in such transactions on DLE-equivalent terms, but this protection has limits. If investors dislike the overall deal economics, inclusion alone may not help. Additionally, requisite holders can waive the restriction. That means if one investor class both controls the company and constitutes the requisite holders, they could sell control and waive DLE treatment, thereby leaving minority but senior investors at a disadvantage. Including stock sale in the DLE definition while ensuring minority but senior investors votes are counted as a separate class for the purpose of waiving such treatment, could balance out the parties’ respective concerns.