Negotiating Venture Capital Transactions – Part 1 of 2

This blogpost is the first of a 2-part series that provides foreign and UK-based businesses and investors an overview of the issues and considerations associated with negotiating and structuring venture capital transactions from a UK perspective.

A venture capital transaction is generally structured around three categories of material terms: 1) terms that impact valuation and economics; 2) terms that impact decision making and control rights of the investor; 3) reasonable market investor protection terms. The first category is discussed in more detail below, while the second and third are discussed in Part 2.

Terms Impacting Valuation and Economics

Types of Securities. The HOT will indicate the type of securities contemplated as part of the investment, whether preferred or ordinary shares, warrants, debt securities, partnership interests, membership interests another type of security or some combination of the foregoing. If debt securities are involved the HOT should state whether the debt is to be subordinate to debt from banks, financial institutions, trade creditors or other third parties.

If preferred shares are involved, the HOT should indicate the rights, preferences, restrictions, conversion rights, voting right rights and other special or relative rights of such preferred stock. If a preferred share class already exist, the investment will typically be associated with a new series of preferred shares to distinguish the rights that attach to that series from those that attach to all prior series of preferred shares.

In the UK, it is common practice to distinguish the rights enjoyed by different series because investments made at the time of the creation of each series are usually based on different valuations and market conditions and consequently have different risk profiles.

In some European jurisdictions, there are restrictions on the types of different shares classes permissible. This can be compensated for to an extent by creating special rights for certain shareholders in the transaction documents.

Ordinary shares are defined in s.560 of the Companies Act 2006 (albeit applicable only to Part 5 Chapter 3), as shares which as respects dividend and capital carry a right to participate fully in a distribution.

While in most jurisdictions, the VC investor will normally only subscribe for a preferred class of shares to compensate for the risk they are taking when a large investment is involved, it should be noted that the UK’s generous tax-advantaged investment schemes (EIS/SEIS) require share investments to be on a full-risk basis to be eligible for tax relief i.e. shares cannot be redeemable or carry any special or preferential rights (save for limited preferential rights to dividends). Therefore, preferential share configurations in the main will not be eligible for relief making them unattractive for VC trusts rely on local UK capital pools.

Amount of Investment and Capitalisation The HOT should set forth the total amount the investor (or all investors in a syndicated deal) is/are prepared to invest in the Company in the current round (the “Investment”) as well as the percentage of the Company the investor(s) will own, on a post-closing, fully-diluted basis, after all convertible securities, options, warrants and other rights have been converted or exercised and after the calculation of all anti-dilution adjustments that may be triggered as a result of the transaction. The HOT should specify whether outstanding bridge notes are being converted in the financing.

Price per Share The price per share is the pre-money valuation of the Company divided by the number divided by the number of shares outstanding prior to the Investment. The pre-money valuation is the valuation of the Company prior to the Investment. The number of shares outstanding or “fully-diluted” number is often a subject of negotiation. The term “fully-diluted” generally includes all outstanding ordinary and preferred shares (on an as-converted basis), options, warrants and other convertible securities as if fully exercised or converted.

One often negotiated point is whether “outstanding options” includes only issued options, or unissued options as well. If it is to include unissued options, the parties must further decide whether this includes the additional unissued options resulting from any increase in the option pool resulting from the financing.

The general rule is that the larger the basis (the agreed upon number of outstanding shares), the less the new investors will have to pay per share of stock in connection with the Investment, and the greater the dilution to the existing stockholders. This is a function of the formula: per share price = pre-money valuation / total outstanding shares prior to Investment. The principle behind the negotiation of the definition of “fully-diluted basis” is deciding who will bear the cost of dilution. If the number of the securities in question are included in the fully diluted number, the existing shareholders will assume all the diluting effect of those securities. If those securities are not included in the fully diluted number, the existing ordinary stockholders and the new investors will assume on a pro rata basis the diluting effect of those securities. The venture investor(s) will argue for a larger fully diluted basis (i.e., one including the unissued options) while the Company will argue for a sharing of the diluting effect of the unissued options equally between the existing shareholders and the new investors.

Dividends If the Investment is intended to yield a current return, customarily in the form of a dividend, the amount of this return should be clearly specified. Dividends may be cumulative or non-cumulative. A cumulative dividend is a dividend that accrues regardless of what the Company does. A noncumulative dividend only will accrue, and be payable, if the Company declares the dividend. Noncumulative dividends are more Company friendly than cumulative dividends. Companies should be particularly wary of cumulative dividends that compound given the potentially significant effect on total returns.

A preferential dividend is one paid to the shareholders of preferred stock to the exclusion of ordinary shareholders. In the UK this a dividend preference is the only one that preferred stock can enjoy and still remain eligible for EIS tax relief, although this distinction is not important for the non-UK tax resident investor as the EIS scheme applies to UK taxpayers only.

In most cases venture investors are not looking for cash dividend payments but rather a means to boost the underlying equity investment. Upon conversion of the preferred stock, the cumulative dividends convert into additional ordinary shares, which increase the investor’s percentage ownership interest in the Company. Cumulative dividends will also typically be paid upon payment of the liquidation preference and any redemption.

Companies should be cognizant of the fact that accumulating dividends are liabilities that generally appear on the Company’s balance sheet, which may impair the Company’s ability to borrow. To provide some flexibility in the event cumulative dividends pose an impediment to an important prospective transaction, the parties should agree to some method by which the board of directors or the preferred shareholder may waive cumulative dividends. Another alternative is to give the Company the option to pay accrued and unpaid dividends in cash or in ordinary shares valued at fair market value.

In addition to a dividend preference, venture investors typically require that the preferred shares be entitled to participate in any distributions on the ordinary shares, i.e. to receive a pro rata share of any dividends paid to the ordinary shareholders on top of any dividend preference paid only to the preferred shares. This ensures that a company cannot declare a small preferential dividend to the preferred shareholder followed by a much larger dividend to the ordinary shareholders. For more details on participating preferred shares, see below.

Escalation dividend provisions can be used to encourage the Company to work towards an exit and help its investors recover some of their investment if the Company not meeting its objectives within the expected timeframe e.g. if it has not achieved a successful exit with a certain period of time it will be required to declare and pay cumulative dividends to the new investor(s) at rates that increase each year.

Liquidation Preference & Deemed Liquidation. Liquidation preferences typically apply to distributions in connection with a liquidation and dissolution of the Company, as well as “deemed liquidations” i.e. distributions in connection with the merger, acquisition, change in control, or consolidation of the Company or a sale of all or most of its assets. Sometimes (but not typically) deemed liquidations include an initial public offering (IPO) or qualified exit.

If the venture proves to be unsuccessful, the investor who provided the most recent funds to the Company often will get first opportunity to recover its investment. Typically, an investor in the preferred shares will be entitled to receive, upon liquidation, an amount equal to its investment, or some multiple thereof, prior to distribution of proceeds to the holders of securities which rank junior to such series of preferred shares, for purposes of liquidation.

The HOT should specify such entitlement and whether the preferred shareholders will be entitled to participate in the distribution of additional proceeds among ordinary shareholders, on an as-converted basis (“participating preferred”) or if the investor must convert to participate in proceeds distributed to ordinary shareholders (“straight preferred” or “non-participating preferred”). With “non-participating” preferred stock, upon a sale or liquidation of the Company, the preferred shareholders are entitled to receive only the amount of their preference (typically the amount paid for their investment), plus any accrued and unpaid dividends. Any remaining proceeds are distributed exclusively to the ordinary shareholders. If the ordinary shareholders would receive more per share than the preferred shareholder upon a sale or liquidation, typically when the Company is sold at a high valuation, the preferred shareholder can convert their shares into ordinary shares and give up their preference in exchange for the right to share pro rata in the full liquidation proceeds.

Management and other ordinary shareholders generally favour non-participating preferred stock because it requires that the preferred shareholder to convert and stand on equal footing with the ordinary shareholders to receive a gain on their investment beyond the negotiated preference amount. With “participating” preferred stock, preferred shareholders are entitled to receive their preference amount first in a liquidation event, plus accrued and unpaid dividends, and then any remaining proceeds are divided among ordinary shareholders and preferred shares on an as converted basis.

Participating preferred stock provides a significant benefit to the investors, at the expense of the founders, whose right to any residual amount after payment of the preference is cut by investors’ participation in the distribution of the remaining amounts. A participation feature may be more justified when the risk associated with the investment, or in a later stage Investment, the possibility of a sale shortly after the investment, justify a premium. One alternative is to provide the new investors with a participation feature but cap the amount of participation at some multiple of the purchase price. This alternative can be used in situations when the risk of investment in the business, or closeness of a sale, justify it, but do not justify the investors getting the benefit of the participation feature in a true exit. If the capital return is exceeded, the investor would convert to ordinary share to receive the full upside if the exit was sufficiently lucrative. Despite the common use of this feature, it is a term of great contention, as it is the one feature that can have the greatest impact on the exit returns of everyone from the founders to the preferred stock investors.

Investors should exercise discretion when negotiating liquidation preferences, particularly those that provide for multiple returns or participation rights, which may result in skewing management incentives toward an IPO when an acquisition may be a more realistic or strategically desirable outcome. Therefore, all parties to a preferred stock financing must pay particular attention to the size and participation of the liquidation rights.

Redemption or Repurchase Rights. The right of redemption is the right to demand under certain conditions that the Company buys back its own shares from its investors at a fixed price.

A redemption can be used to ensure that the venture capital investors recover some of their investment if a company has not been able to achieve a successful exit within a certain period of time. In the UK there are legal requirements that must be satisfied before a company can redeem any of its shares. A right of redemption can also be used by an investor where it needs to strongly discourage a company from breaching certain obligations, by providing a way for the investor to dispose quickly of its shareholding. Prudent investors will negotiate provisions to gain improved rights, such as enhanced voting rights, in the event the Company fails to redeem shares when requested.

A right of redemption is not appropriate for every investment and is not allowed or is limited (e.g. to a certain percentage of the issued and outstanding shares) in some jurisdictions in Continental Europe. In the UK shares of companies that are certified under the EIS/SEIS scheme are not permitted to have redemption features.

Vesting of Founder Shares. HOTs often include a discussion of the investors’ expectations regarding the vesting of founders’ shares. Vesting of founders’ shares can be a contentious issue, particularly if the founders’ shares are not presently subject to vesting or are subject to a different vesting schedule than contemplated by the investors.

Investors will want founders’ shares to be subject to vesting, even when shares have been purchased for value or have previously vested, to create an incentive for the founders to remain committed to the Company, particularly when a significant portion of the value of the enterprise lies in the “human capital” of the founders. Vesting also helps to mitigate the potential dilutive effect associated with filling a management position vacated by a departing founder (i.e., any invested shares may be allocated to the new hire).

Founders may object to vesting requirements, particularly with respect to stock purchased for value or when vesting does not appropriately account for the time and effort already contributed by the founder. The HOT should set forth any conditions regarding founder share vesting or “re-vesting.”

Employee Incentive Schemes. In the UK employee incentive schemes are available in various forms broadly categorised as “tax advantaged” and “non-tax advantaged”. Tax advantaged schemes included CSOPs, EMIs, SAYEs and SIPs. A company share option plan (CSOP) is a plan that reserves and allocates a percentage of the shares of the Company for share option grants to current and future employees of the Company (and certain other individuals) at the discretion of a management committee. The intention is to provide an incentive for the employees by allowing them to share in the financial rewards resulting from the success of the Company. Investors typically want 10%-20% of the share capital of the Company to be reserved in a CSOP creating an option pool. The Company will then be able to issue the shares under the plan without requiring further approval from the investors. Founders and other management with significant shareholdings may be excluded from participating in the CSOP.

When key employees are hired, they often are given shares or options to buy shares of the Company as part of their compensation. If such options are promised, they usually are earned over time. Step vesting often occurs in annual, quarterly, or monthly increments, usually over periods of two to four years. Cliff vesting occurs all at one time. It is common to see cliff vesting of a percentage of the shares or options after one year, with monthly step vesting for the remainder of the vesting term. The HOT should set forth vesting provisions applicable to employee share schemes or restricted stock.

Share Option Pool Increase. The HOT should set forth the size of the equity “pool” immediately prior to the closing of the financing. The size of the pool is often a point of negotiation in an investment round. This pool of shares often is factored into the pre-investment capitalization when arriving at the price per share of preferred stock to be paid by the investors. When calculated this way, investors are not diluted by grants under the plan, only the pre-existing stockholders and the founders are diluted.

While the size of the pool is important, it can vary significantly from one transaction to the next. The more complete the Company’s management team is at the time of funding, arguably, the lower the pool needs to be to attract and retain key hires. Investors generally take the position that there should be sufficient equity in reserve to cover the Company’s hiring plan up to the time of the next round of institutional financing.

George Marques   

Head of Corporate


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