This blogpost is the second 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 is covered in Part 1 while the second and third categories are discussed below.
Terms that Impact Decision Making and Control
Voting Rights. The venture investor commonly receives the number of votes equal to the number of ordinary shares into which its securities may convert at such point in time, including conversion of dividends, if applicable.
The HoT should describe whether the investor’s preferred shares have “class” or “protective” voting rights (i.e., the preferred shareholders, or certain classes of preferred stock, voting separately from ordinary shareholders must consent to certain fundamental transactions), or whether the investor has special rights to take control of the Company upon the occurrence of certain events of default.
The investor will often have the right to elect one or more members to the Board of the Company. The HoT should set forth the means for effectuating these provisions. One approach is to file an amendment to the articles of association that provides for election (or appointment by the Company’s members) to the Board of Directors of a representative of the class of securities being purchased by the investor. Such an amendment should be filed prior to, or contemporaneously with, the execution and consummation of the final agreements. Alternatively, a majority or preferably all the existing stockholders of the Company should execute an agreement, either as a part of the subscription agreement or as a separate document, wherein they agree to vote their shares to elect a member of the Board of Directors appointed by the investor.
Class rights. VC investors normally require that certain actions cannot be taken by the Company without the consent of the holders of a majority (or other specific percentage) of their class or series of shares (known as the “investor majority”). Sometimes these consent rights are split between consent of an investor majority, consent of the investor director(s) or consent of the Board. Alternatively, each of the largest investors may have specific consent rights. The purpose of these rights is to protect the investors from the Company taking actions which may adversely affect the value of their investment.
Typically, what requires investor majority consent and what requires investor director consent would relate to major changes in the Company whereas operational matters that need more urgent consideration would be left for the Board. The types of actions requiring investor consent include (among many others): changes to share classes and share rights, changes to the Company’s capital structure, issuance of new shares, mergers and acquisitions, the sale of major assets, winding up or liquidating the Company, declaring dividends, incurring debts above a certain amount, appointing key members of the management team and materially changing the Company’s business plan.
Care should be exercised to ensure that each class right is reasonable and appropriate in light of the expected benefit to the Investors and the administrative burden on the Company associated with having to regularly obtain stockholder approval. Class rights, particularly those with high vote thresholds, have the potential to expose the Company and the Investors to opportunistic behaviour by other Investors.
It is prudent to provide that the protective provisions will terminate if the number of outstanding shares of preferred stock falls below a de minimis amount. In the unlikely event that a small number of preferred remain outstanding, the Company and the other Investors, including any preferred holders that have converted to common, will want to avoid a situation where the remaining preferred stockholders are able to exercise influence disproportionate to their holdings. The threshold should be determined based on the capitalization of the Company.
Board Representation. There are 3 key areas of concern to a VC investor in relation to the operation and activities of the board of directors:
- Board Composition: It is typical for the HoT to provide that the majority of the board must at all times be non-executive directors. This ensures that the executive directors on their own cannot come to control the board process but also provides a broader range of views and experience to be brought to bear in decision making.
- Board Nomination: VCs will insist on the ability to appoint and replace their nominees to the board as a means of protecting against downside risk and developing the business opportunity. The number of nominees will depend on the size of the investment, the stage of development of the business and size of the syndicate if there is one. At the very least, a significant minority will be requested (at least one director for the lead VC fund at least one further director for the rest of the investment syndicate. It is important here to be c0gnizant of the inherent potential for conflicts of interest and consequent liability arising for directors when the interests of the Company diverge from those of the appointing investor shareholder. One solution is the appointment of board “observer” rather than director to act in a ex-officio (non-voting) capacity. To avoid the potential for the VC firm to appoint observers who are in learning mode and will bring little to conversation, founders will need to work through their concerns with the VC.
- Board Process: the VC will want to ensure meetings are held regularly to ensure it is able to exercise its monitoring powers; monthly or bi-monthly meetings are typical. In addition, VCs will insist that board meetings not be quorate without its nominee director(s) present. Founders will want to insist on adjournment powers to ensure a VC cannot deliberately hold up important business decisions by not showing up for meetings. It is also common for the HoT to provide for the setup of committees with full delegated authority to i) establish remuneration of directors, ii) supervise the financial planning and audit functions; iii) nominate members of the board and iv) in the event an exit opportunity is identified, approve, and supervise its execution.
Founders should negotiate their own right to appoint a nominee to the board. This is often missing from HoTs because executives take for granted that their position on the board is secure, which is not the case.
Shareholder and Director Level Veto: It is very common for VCs to require the Board to cede certain decisions to the VC investor directly or by requiring the VCs nominee director(s) to be part of the majority. The former is known as a shareholder veto and the latter a board level veto. Both forms of veto power are reasonable asks from the VCs perspective. It is in the interests of the founders to have as many vetoes as possible operate at the board level since the nominee director(s) is subject to an over-riding obligation to act in the best interests of the Company whereas shareholder vetoes can be exercised selfishly.
Non-compete/non-solicitation Agreements. The HoT should specify whether and which key employees are required to execute non-complete/non-solicitation agreements. VC investors may request these to protect their investment in the Company. Another view is that it should be up to the Board to decide on a case-by-case basis. Equally for founders, non-solicitation covenants from the VC firm are important as often the highest valued assets for a high growth company are its employees. This is an often-missed area by founders notwithstanding the obvious fact that the Company’s know-how/show-how and innovative edge in the marketplace are often to be found in the minds of its employees.
Reasonable Market Protections for the VC Investor
Anti-Dilution Rights. Anti-dilution provisions are commonly demanded by the VC investor as downside protection on its investment, a sort of insurance policy underwritten by the founders and other share constituencies. Functionally, the protection works by applying a mathematical formula to calculate the number of new shares which the VC investor will receive at no cost to offset the dilutive effect of the issue of shares at a lower price than that paid by the VC investor, which is often called a “down round”. There are several variations on the formula. In the “full-rachet” protection scenario, the investors’ full percentage ownership is maintained at the same level or at the same value in down rounds. The “weighted average” approach examines the relative dilutive impact of the down round on the share capital with the protective rights, in the context of the overall share capital. It is a more realistic approach and ensures that smaller share issues will not give rise to disproportionate anti-dilution protection.
There are different mechanisms used in European jurisdictions to create this protection. In the UK, one approach is to adjust the preference/ordinary share conversion ratio. Another involves the issue of “bonus” shares through the granting of options (or warrants as they are sometimes called) exercisable if the anti-dilution provision is triggered. Founders should be aware that certain European jurisdictions may limit the use of certain warrant structures for anti-dilution purposes, as is the case in France.
Anti-dilution provisions are also common to provide adjustments for mechanical changes resulting from stock splits and capital restructurings that do not affect the underlying investor economics. Unlike with down-rounds, these adjustments are not generally controversial.
Founders/management would do well to negotiate exclusions to anti-dilution. To begin with, anti-dilution protections should not be used by VC investors to claw back value from an over-priced investment. Where exceptions are carved out, the VC investor should require that approval for the new issue at the Board level require majority consent that includes the investor director. This protects the VC investor while also avoiding some of the “hold up” risk associated with a unanimous approval requirement, where one director can effectively paralyse the Board’s decision-making process.
Mandatory Conversion. It is typical for investors to be required to convert all their shares into ordinary shares prior to the Company going public in an IPO or other exit. VC investors will often require an automatic conversion mechanism to take effect immediately prior to the “exit” event. The investors will only want the conversion mechanism to kick in if there is a sufficient opportunity for them to dispose of their shares (after the expiry of any lock-up period) and for this reason the exit needs to meet sufficient liquidity and valuation thresholds. Examples include identifying the listing exchange, having a recognised national underwriter, and raising at least a minimum amount of gross proceeds. This avoids the risk that preferred shareholders will have to convert their shares and lose all preferential rights if the Company lists or exists at a low value.
A new VC investor in a later-stage financing should exercise care in negotiating the automatic conversion provisions particularly if it has a larger preference or has priority relative to other series holders of the same class to ensure that the other investors in the same class do not effectively eliminate any preferences or priority by effecting an automatic conversion through a class vote of the preferred holders as a whole. To protect its liquidation preference, the new investor may want to request a higher vote threshold or a separate series vote.
Pay to Play. This is a non-standard provision designed to encourage the participation of the VC investor in subsequent financing rounds. It is included here for completeness as it is not necessarily a protective provision for the VC investor. For founders and management, it is a good “come back” provision to balance the effects of anti-dilution protections on them and the other share constituencies. The basis for arguing for its inclusion is that the VC investor should not gain access to the “insurance policy” provided by anti-dilution unless it is also prepared to support the Company in its time of need by participating in a down round, otherwise it will be getting a “free ride” at the expense of the other investors and shareholders. The mechanism works by removing certain rights of preferred holders who do not participate to their full pro-rata percentage of the financing.
Representations & Warranties. VC investors expect appropriate representations and warranties to be provided as part of the transaction to provide a complete and accurate understanding of the current condition of the Company and its history so that investment risk can be evaluated, and a partial clawback of the investment can be realised in the event of a breach. The reps & warranties typically relate to the legal status and condition of the Company, the financial statements, the assets, particularly IP rights, liabilities, material contracts, employees, and litigation. In the UK it is typical for a disclosure letter to be prepared setting out on a line-by-line basis any shortcomings relative to the warranties as a way to provide notice to the investor which then prevents a claim being made with respect to the matter in question. There are usually limits to the exposure of the Company, such as caps and time limits which need careful negotiation. The disclosure threshold is also extremely important to negotiate depending for both parties as this will act as a filter as to which disclosures meet the threshold (relative to clarity, completeness, fullness etc..) for deemed notification.
It is always a good idea for the VC investor to ensure that the HoT contains language to cover the breadth and scope of warranties that will appear in the deal documents by including therein a provision to the effect that the “standard and customary representations and warranties” will be requested.
Drag Along rights. VC investors will usually require a right to compel other shareholder constituencies to sell their shares provided a certain percentage (or specific class) of the shareholders vote to sell. Drag along provisions are most often triggered in connection with a sale of the business or its assets to a purchaser or an IPO, but generally any opportunity to “exit” the business requires the founders, employees (who participate in the employee share schemes), other shareholders and warrant holders to collectively submit to the exit so that no constituency is able to block the transaction through the exercise of class voting rights or otherwise. Although the UK has a statutory procedure (known as a “squeeze out”) for compulsory acquisition that may assist, it is only triggered when the purchaser has acquired 90% (of each class) of the target’s shares, is cumbersome, expensive, does not deal with option and warrant holders, and in the end may not function if a large majority of shareholders in a single class become “hold outs”. For this reason, it is preferable for the VC investor to have a contractual right that compels all stakeholders regardless of the nature of their holdings to act in unison when an exit opportunity presents itself.
Tag Along/Co-Sale/First Refusal rights. A tag along right is the opposite of a drag along right in the sense that it applies in the event that someone else is able to sell shares i.e. by having been through both the threshold approval process for sale and the transfer pre-emption process and emerged with a parcel of shares to sell to a third party (or to an existing shareholder outside the pre-emption process). In such circumstances, the VC investor will have the right to participate in the sale transaction alongside, or partly in place of the selling shareholder on a pro rata basis. VC investors often require tag along rights on any sale of shares by the founders or key managers as a way to protect their investment in the event existing management wishes to exit the business since it was likely their experience and expertise that drove the original investment decision.
VC investors often require a right of first refusal with respect to shares held by founders so that a founder who wishes to sell must first offer them to the Company and/or the other shareholders as a way of keeping the Company’s capital stock with the existing ownership group. If founders or other major shareholders wish to exit, the VC investor will want the ability to purchase their shares either to obtain greater control over the Company or prevent the transfer of control to non-strategic or hostile parties.
Logically, founders and other shareholder constituencies may request tag along rights for the same reason, which would be difficult for the reasonable VC investor to refuse. This then opens a discussion around priorities with respect to tag along rights, which can add additional complexity to the negotiation.
In practice, the concept of tag along rights tends to become unworkable when a company’s capital structure contains multiple classes of shareholders. This is because in a tag-along scenario, the non-selling shareholders of one class will inevitably end up in a different position than the selling shareholders of that class from the perspective of distributions that the selling shareholders received in the sale. To preserve the underlying economic rights of each class, the non-selling shareholders would need to be equalised by way of a re-allocation of subsequent distributions vis-à-vis the selling shareholders of the same class. This becomes an impossible exercise unless the tag-along concept is applied exclusively on a class-by-class basis. In practice, this means that VC investors will only be able to tag along on sales of other investors in its share class, and founders and management on sales among their class, making tag along rights of less value relative to the difficulty of negotiating them.
Information Rights. It is common for VC investors to require and a company to agree to provide regular updates concerning its financial condition and budgets, the right to examine its books and records and even the right to periodic site visits. As noted, VC investors may have access to this information via their investor director or appointees to committees such as the audit committee, but the VC investor would do well to make these as contractual obligations because of the potential liability that can otherwise arise for their investor directors in relation to their duties to the Company.
For founders and the Company, the main issue is to be aware that the burden of providing information does not outweigh their capacity to collect and disseminate that information having regard to their need to focus on operations.
Conditions Precedent. One of the most common features of the HoT are the conditions for closing. These are usually grouped in four or five categories: due diligence, VC firm approval, technical conditions, sweeper up “no material adverse change”, and specific deal conditions. Due diligence conditions usually covers the legal, financial, commercial, product/IP/technical areas examined by the VC and its advisors and consultants. Technical conditions can include share/corporate restructurings, tax clearances, shareholder consents and the like. Approval and final signoff by the investment committee of each of the VC investors is the “sin qua non” of completion. Deal specific conditions are usually commercially oriented and can include final signoff on budget, conclusion of a specific supplier or customer agreement, recruitment of a key member of senior management etc…Sweeper clauses give the VC an overarching right to walk away should circumstances change materially for any reason during the final phase of the investment.
Both VC investors as well as founders and senior management would do well to negotiate these provisions heavily as the wording of conditions precedent can contain traps for the unwary.
Execution and Post-C0mpletion Issues. Execution of the HOT is the last and sometimes overlooked part given that most of its provisions are non-binding. Yet an executed HoT can be very valuable to both parties in relation to confidentiality, exclusivity and other terms that may be binding, but most importantly is evidence of the forth coming investment for the Company in dealing with existing creditors, customers, suppliers and strategic partners.
The parties may also wish to specify whether the Company will allow additional investors to join after the initial closing within a reasonable period, usually 60 to 90 days. This allows the Company to give investors flexibility in transferring the capital and allows the Company to raise funds from smaller investors that have not committed prior to the initial closing.
VC investing is a complex and multi-faceted endeavour. While VC investments have the potential to be transformative for a company’s growth and expansion, they are also replete with pitfalls for the unwary that can have lasting consequences for founders and other key contributors. It is important to seek knowledgeable and experienced advisors to help navigate the process to your benefit.
George Marques firstname.lastname@example.org
Head of Corporate
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