This blogpost provides foreign and UK-based businesses as well as their investors with an introduction to the general legal process associated with venture capital fundraising transactions from a UK perspective.
Is Venture Capital the Right Option?
A preliminary consideration is whether the business is ready to take on a venture investor as shareholder and “partner” of sorts. VC investors are typically interested in businesses with proven businesses models in need of new investment to scale the business (i.e. grow revenues but not necessarily profits). The industry term for this is the “series” stage which is broadly characterised by the size of the investment and of being preceded by fundraisings during the “seed” stage. There is no hard and fast rule but reaching this stage of readiness can take from several months to a few years. At this juncture in their business journey, founders would do well to pause and reflect on where they want to take their business having regard to their respective personal situations. Can the business match those ambitions? Do they want to retain control of the business for a long time? What kind of life do they want to lead? Are they comfortable with an exit? How much capital is required, and will it be negotiated in a one-off “round” or through milestone financing?
If the timing is right and the objectives are clear, then the next step is to find a venture investor/partner that is a good fit for the business. This involves several factors such as the firm’s length of relevant experience in the sector, whether it has powerful networks of ecosystem partners, co-investors, advisors and alumni, a community built around its portfolio companies, international reach, a successful reputation and above all, personal chemistry with the founders.
Some key preliminary considerations to work through prior to engaging the venture investor is determining a valuation and grooming the business for the investment.
Valuation Valuing high growth VC stage companies is a notoriously difficult exercise. The Company will usually look to its tax advisors and accountants for this advice. Most often a combination of approaches is used to establish a valuation “range” that will serve as the guiding rails for negotiating the equity participation in the Company that will traded for the capital infusion. The amount invested should be justified by the business plan and the capital requirements to scale the business. Companies should resist asking for more money than required to achieve the business plan objectives/milestones to foster healthy investor relations for future rounds.
Grooming Once the valuation range and equity stake are established for the purposes of negotiation, the Company should start preparing for the next steps by taking measures to ensure its governance and financial house are in order in accordance with the advice given by the Company’s tax advisors and accountants. These include record keeping, revising value assumptions, preparing for site visits, and management stability.
Management stability refers to assessing the capacity of management to contend with the demands of the capital raising process in light of its other priorities including running and growing the business. The capital raising process can be time consuming and it’s important to ensure that the management team is prepared in advance s to ensure the team does not become overburdened or distracted from its main objective of executing the business plan.
Due diligence is an investigation that any reasonable investor would normally undertake about the proposed business opportunity before making the decision whether to invest. Prior to committing to the investment, the investor will want to be sure that he knows business he is investing in. The due diligence consists of 3 parts, financial due diligence, legal due diligence and commercial due diligence. A company seeking to raise funds should never allow any due diligence without having a signed confidentiality agreement in place first.
As part of the legal due diligence venture investors (or their legal/financial/tax advisors) would commonly review the Company’s constitutional, finance, property, employment, customer and supplier, intellectual property, environmental and regulatory, and tax documents/agreements/arrangements, amongst others. VC legal counsel will typically prepare a legal due diligence report setting out matters that the VC investor will need to consider carefully before determining the final valuation and deciding to move forward.
The principle of caveat emptor (“buyer beware”) is generally held to apply to transactions between businesses so that the onus is on the investor to find out as much as he can it about the business before exchange of contracts. The law will afford very limited protection unless the wording of the contract provides the investor with appropriate contractual protection. Moreover, the UK, unlike other jurisdictions, has imposes no legal duty of good faith in commercial transactions, meaning parties can effectively do whatever they wish subject to any bind obligations they may have agreed (e.g. confidentiality, exclusivity etc…).
The VC term sheet
A key initial document for both the Company and venture investor is what is variously known as the Term Sheet or Letter of Intent in most jurisdictions or, especially in the UK, the Heads of Terms (hereinafter the HOT). The choice of designation is one of personal preference with no substantive difference. The primary purpose of the HOT is to focus the attention of the Company and investor on the major business and structural issues involved in the proposed investment so that relatively quickly the parties can assess whether there are irreconcilable differences or fundamental issues that are likely to make the investment infeasible.
It is always a good idea to have a confidentiality agreement in place at the outset of the engagement to protect both parties but primarily the Company. Alternatively, binding confidentiality provisions can be included in the HOT.
The investor will often require the Company to agree an exclusivity period. Given that the investor will have expended significant time and effort in conducting due diligence and negotiating deal terms, the investor will not want the Company to use the HOT to leverage better deal terms from other investors. However, companies should exercise caution in agreeing non-solicitation/exclusivity provisions because doing so too early can foreclose better opportunities. More importantly however, exclusivity terms can become increasingly coercive when the Company is close to running out of money as the investor has no obligation to proceed with the investment (as already mentioned, UK law imposes no legal duty on parties to negotiate in good faith). Without certainty of a deal, the Company may be left with no or bad options at the end of an exclusivity period. Whether to ultimately agree an exclusivity period depends on several factors including, among others, the Company’s financial condition, market conditions and finally the other financing options available to it.
Despite the non-binding nature of HOTs, it is not uncommon for the Company upon receipt of the first draft of definitive agreements to exclaim “but this outside the scope of the HOT!”. Accordingly, it is important for the venture investor to include all key provisions while explicitly noting that the final agreement will contain “such other usual and customary provisions as may be appropriate”.
The VC term sheet is explored in detail in our forthcoming 2-part information series entitled “Negotiating VC Transactions”.
George Marques Head of Corporate