Venture capital documentation

Author: | Published: 4 Jan 2001
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It's a recurring problem: a venture capitalist and a company reach an agreement in principle for an investment in the company and, before the deal even gets underway, the parties hit a stumbling block over the way the transaction will be documented. With the increase in cross-border venture capital transactions, particularly US investors taking stakes in European companies, this issue is one that companies and investors are facing ever more regularly.

At its core, a venture capital transaction, where an investor or a group of investors privately acquires shares in a company, is essentially the same transaction in any country. Nevertheless, the US style of documentation is substantially different from its European counterparts. This may be because the US documentation has moved further beyond the leveraged buy-out precedents that many view as the origin of venture capital documentation, or it may be because US and European investors simply have differing attitudes towards risk. Whatever the reason, the US and European approaches to documenting a venture capital transaction differ markedly in a number of significant respects, and, in at least some respects, many observers have expressed a view that US documentation affords venture capitalists less contractual control over the operations of the company in which they are investing.

This article focuses on two of the principal forms of venture capital documentation – US and UK – that are often looked to as international standards. The article seeks to identify several of the more salient aspects in which these two forms of documentation diverge from each other. These variations present the parties to a transaction with the opportunity to craft hybrid documentation best suited to their particular deal. And as an increasing number of parties engage in this process of borrowing terms more common in other jurisdictions, we can expect the gradual emergence of a global cross-border standard in venture capital documentation. While a truly unified approach will take a long time to come into its own, we are already seeing signs that the process is underway.

Venture capital transactions can take a number of different forms depending on the type of investor, whether the investor is acquiring debt or equity (or a combination of both) and the stage of development of the company. In this article, we will address venture capital transactions involving equity investments.

A typical venture capital transaction, whether it be an investment into a US or a UK company, involves the following key elements:

  • The investor or investors subscribe for or purchase equity in a private company in return for cash.
  • Investors typically receive a class of preferred or preference share giving a priority right to receive payments in the event the company is sold, liquidated or wound-up.
  • The company and, in some cases, its key executives or founders give representations, warranties or indemnities to the investors about the company and its business.
  • The investors are given various rights by the company, including rights to receive financial and other information relating to the company.
  • The investors are given board membership or representation rights.
  • The rights of the parties on an "exit", particularly an initial public offering or sale of the company, are defined.

A number of key differences are apparent between the form of a typical US and UK venture capital transaction, including, in particular:

  • style of documentation and terminology used;
  • corporate differences;
  • representations and warranties; and
  • investor protections.

We will examine each of these differences in more detail.

Style of documentation and terminology used

A typical US venture capital transaction involves the following key documents:

  • The Stock Purchase Agreement. This agreement includes the mechanism for the purchase of shares by the investors and includes the arrangements for the closing of the transaction. Typically this agreement also includes terms requiring the company to provide the investors with information on and access to its business. At the back of the agreement is usually a schedule of exceptions to the representation and warranties made by the parties.
  • The Stockholders' Agreement. This agreement typically includes pre-emption rights, rights of first refusal, co-sale and drag-along rights, and often a vesting schedule by which the founders would forfeit shares in the event of their departure from the company.
  • The Certificate of Incorporation. This is the constitutional document of the company. When an investor is to purchase preferred stock with special rights such as anti-dilution protection and liquidation preferences, the company's Certificate of Incorporation must be modified (or, in some cases, a Certificate of Designation may be used) to grant such rights.
  • By-Laws. The by-laws, together with the Certificate of Incorporation, regulate the internal governance of the company. An investor will sometimes require that these be modified if they contain corporate governance procedures deemed unsuitable for the company; often, however, the by-laws can be left as they are.

In a typical UK venture capital transaction, the following documents are typically involved:

  • "Investment Agreement" or "Subscription and Shareholders' Agreement". This agreement, regardless of the name used, is a combination of the Stock Purchase Agreement and the Stockholders' Agreement. As such, it includes the mechanism for the subscription of shares and sets out the investor's rights.
  • Articles of Association. This document combines the Certificate of Incorporation and the By-laws. It typically includes share class rights, pre-emption rights on the issue and transfer of shares and provisions dealing with the mechanics of holding board and shareholder meetings.
  • Disclosure Letter. This is a letter from the company (or its lawyers) to the investor (or its lawyers) that sets out disclosures against, or exceptions from, the warranties given to the investor. This letter is the equivalent of the schedule of exceptions at the back of the US-style Stock Purchase Agreement. The disclosure letter, and warranties and indemnities generally, are discussed further below.
  • Service Contracts. Investors in UK-style transactions frequently require key executives of the company to enter into new service or employment contracts in a form approved by the investors. These will typically set out in detail the terms and conditions of employment of the executive and will impose restrictive covenants after his or her departure from the company. These restrictive covenants are discussed further below.

The constitutional documents of a company must, of course, comply with the requirements of the jurisdiction in which the company is organized; however, there is nothing inherent in either the US or the UK system that dictates the use of, for example, a combined Subscription and Shareholders' Agreement instead of separate agreements. The choice of investment documentation is often dictated largely by the prejudices of the parties. Some individuals involved in a transaction may be quite flexible about which form of documentation is chosen as long as the substance complies with applicable law and reflects an agreed term sheet, while others may be unwilling to look beyond the form to the substance of the documents. Generally, parties to a venture capital transaction choose the form of documentation traditionally associated with the organizational jurisdiction of the company, but a good drafter should be able to adapt any form of documentation to suit the particular requirements of the transaction.

In addition to the contrasts in the style of documentation, the terminology used in US and UK venture capital transactions also differs. For example, venture capital investors in a US company "purchase stock", while investors in a UK company "subscribe for shares". The choice of terminology is largely dictated by the jurisdiction in which the company is organized and is generally inconsequential on a commercial level. The appropriate terminology can be used with either style of documentation.

Corporate differences

US companies are most commonly incorporated in Delaware, which is widely regarded as offering a form of corporation that is flexible in both initial organization and continuing compliance with corporate governance rules. Delaware corporation law has the benefit of a state government focused on amending and clarifying the law as events warrant. The state also offers a specialized, highly experienced court dedicated to hearing corporation cases, as well as an unusually well-developed body of case law on corporate matters. Furthermore, the corporation law of Delaware enjoys the advantage of being widely familiar to legal practitioners across the country.

UK companies are most commonly incorporated under the Companies Act 1985 (as amended) (the "Companies Act"), which regulates the incorporation and operation of companies incorporated in England and Wales. Although it is relatively quick and easy to establish such a company, the Companies Act includes a number of restrictions that can affect a venture capital transaction, some of which may be a surprise for a non-UK investor in a company incorporated in England and Wales. For example, the Companies Act includes restrictions on the giving of "financial assistance" by a company incorporated under that Act in the purchase of its own shares. Venture capital investors frequently require the company into which they make an investment to pay their legal and other fees in relation to the investment. It has not been definitively resolved whether the company can pay these fees without this constituting financial assistance, and leading barristers have given conflicting opinions on this point.

Representations and warranties

UK companies will usually only give warranties while US companies will give both representations and warranties. The difference is more than one of terminology. Under English law, a misrepresentation could allow an investor to rescind the contract. Further, a claim for misrepresentation is a claim in tort instead of contract, and the level and type of damages that can be claimed may be higher (depending on the circumstances of the claim).

Another significant difference in the treatment of warranties in typical US and UK venture capital transactions is in the manner in which warranties are given. In a typical UK venture capital transaction, warranties are qualified by information provided in a separate disclosure letter, while the equivalent carve-outs in the US-style transactions are provided in schedules at the back of the purchase agreement. The idea is the same: these disclosures are to carve out exceptions from the warranties.

The UK-style disclosure letter includes both general and specific disclosures against the warranties. General disclosures are typically disclosures of those matters of which the investors are deemed to have public knowledge, such as matters on public record at Companies House. Specific disclosures are matched to individual warranties, although it is normally agreed that disclosure against one individual warranty is also effective against other warranties to which the disclosure is relevant. The Subscription and Shareholders' Agreement commonly provides that the warrantors will not be liable for any matter which is "fairly" disclosed in the disclosure letter. In a typical US venture capital transaction, specific disclosures against representations and warranties are listed in schedules at the end of the share purchase agreement. General disclosures, however, are by and large not acceptable to US investors, and thus companies usually cannot avoid liability under a representation or warranty because a key fact was publicly available through some other source.

In typical UK venture capital transactions, a bundle of disclosure documents is also delivered to the investors or their lawyers. These documents are referenced by the specific disclosures in the disclosure letter. Once again, all matters that are fairly disclosed in these documents are typically deemed to be effectively carved out of the warranties. Although equivalent documents are delivered to investors in a typical US venture capital transaction as part of the due diligence process, this is not generally effective to protect the company from liability under the representations and warranties.

In the UK, a number of limitations are given on the liability of the warrantors, such as time limits within which warranty claims must be made, caps on liability of the warrantors and minimum financial levels for claims before they can be made. These limitations are frequently the subject of detailed negotiation between the parties. Equivalent limitations are unusual in a typical US venture capital transaction.

Finally, in US-style transactions, the founders of the company do not typically make representations or give warranties. Representations by founders are more commonplace in UK deals.

The trend in cross-border transactions with respect to representations and warranties has been towards warranties (or representations and warranties) covering less detail than is common in purely UK transactions.

One area of common ground between representations and warranties given in typical US and UK venture capital transactions is that it is extremely unusual for actual claims to be made. The threat of litigation is nonetheless seen as a valuable way of ensuring thorough disclosure and of driving an investor's due diligence investigation of a company.

Investor protections

It is in the area of investor rights that the biggest differences lie between typical US and UK venture capital transactions. The differences are particularly acute in relation to:

  • anti-dilution protection;
  • consent rights;
  • restrictive covenants;
  • board representation;
  • founder and executive share retention rights;
  • registration rights; and
  • pre-emption rights on issues and sales of shares.

Anti-dilution protection

Anti-dilution protection has long been a standard feature of US venture capital transactions. Increasingly, however, investors in non-US companies are incorporating anti-dilution protection into their deals even in cases where the investors are not from the US.

Any new issuance of shares by a company will dilute existing shareholders' holdings in the company, but an issuance of shares at a price below that paid by the existing shareholders will reduce the value of the shareholders' investments even further. Typical US venture capital transactions incorporate provisions protecting investors against the company issuing new shares at a lower price than that paid by the investors.

There are two main types of anti-dilution protection:

  • Weighted average. Weighted average anti-dilution protection ensures that an investor will not be diluted any further than the investor would have been had the new issuance of shares been made at the same price as the investor had paid. This form of protection is sensitive to the number of shares involved in the subsequent issuance, meaning that an issuance of a relatively small number of shares at a lower price will result in the investor receiving a relatively small number of additional shares in compensation.
  • Full ratchet. Full ratchet protection provides the investor with the additional number of shares its investment would have purchased at the lower price set in the subsequent issuance. Full ratchet protection is considered punitive in nature because it takes no account of the number of shares being issued at the lower price. If even a single share is issued at a lower price, the investor's holdings will be adjusted so that, in effect, its price per share will be reduced to the lower price. Consequently, full ratchet protection could actually result in an increase in an investor's percentage ownership of a company.

For administrative simplicity and to allow for the possibility of multiple issuances at a lower price, the mechanism for increasing an investor's holdings is generally an adjustment to the conversion rate of the preferred shares held by the investor. An exception to these anti-dilution protections is usually made for shares issued pursuant to the exercise of employee options and as consideration for an acquisition.

Consent Rights

Typical US and UK venture capital documentation contains a list of various actions of the company which require the prior consent of the investors. Such actions include matters such as issuing new shares or changing the constitutional documents of the company. In US transactions, this list is normally limited to a number of key protections of shareholder rights, and the investors rely otherwise upon their board representation to protect their interests. In UK transactions, the list is likely to be longer and can include matters often regarded as pertaining to the normal business of the board of directors, such as changing key employee terms and conditions. US investors generally will not request the extensive list of consent matters (even of a UK company) unless prior investors have already received such protections.

This disparity may have its roots in a tendency by US investors to be more proactive as directors of a company and to use their board positions to affirmatively guide and control the direction of the company, while UK investors may traditionally have been more reactive (providing and denying consent) in their role as directors. The disparities in the roles of US and UK investors on the board of directors may have diminished in recent times, but the vestiges remain in the differences in the list of items on which the consent of investors is expressly required.

Restrictive Covenants

Non-competition provisions or restrictive covenants on the activities of a company's founders or executives are commonly found in UK venture capital documents. In the US, by contrast, non-competition provisions are rare, principally because they are difficult or impossible to enforce.

UK investors wish to ensure that, having invested money in a company, the founders or executives do not leave and set-up a competing business or poach employees or customers. The investors often insist on including non-competition provisions and restrictive covenants in the Investment Agreement or Subscription and Shareholders' Agreement. To ensure that the restrictions are enforceable under UK law, the restrictions must be limited in scope and duration.

In UK transactions, investors commonly introduce new employment or service contracts for the founders or key executives that also include restrictive covenants on the activities of these individuals. In contrast with the provisions in the Investment Agreement or the Subscription and Shareholders' Agreement, the covenants in the employment or service contracts run in favour of the company rather than the investors. Separate provisions may be included in the Subscription and Shareholders' Agreement allowing the investors to require the company to enforce these restrictions. Restrictive covenants in employment contracts are typically shorter in duration than those given to the investors in the Investment Agreement or Subscription and Shareholders' Agreement because they are considered more difficult to enforce in an employment contract.

In the US, employees are commonly employed at will, without any written contractual terms of employment, although such agreements may be required for a founder or a particularly key officer such as a president or CEO. Even where such agreements are in place, they will rarely contain non-competition provisions, and, unlike in the UK, the enforceability of such provisions in the US does not generally vary depending on the agreement in which they are contained.

Board Representation

Investors in both UK and US venture capital transactions typically seek representation on the company's board of directors or observer rights at board meetings. The extent of these rights will usually depend upon the size of the investment, but it may also depend upon the value that the company believes the investor can add through its board participation and other areas (such as introductions to new customers). US investors will generally rely largely upon their board representation to protect their interests, while UK investors will often require, in addition to their board seat, detailed consent rights relating to board matters. US investors may seek a greater number of board seats than UK investors would in the same circumstances (perhaps because UK investors can rely upon their more extensive list of consent rights).

Founder and executive share retention rights

Because a company's management team is often a key component of its value, investors in both US and UK venture capital transactions usually seek to provide incentives for founders and key executives to remain with the company. Often the investors will require that the founders and key executives relinquish a portion of their share ownership if they leave the company. In UK transactions, often the individuals will be forced to relinquish all of their shares under certain circumstances, although this would be surprising in a US deal. Striking a balance between the interests of the company and fairness to the individuals often results in these forfeiture provisions becoming the subject of detailed negotiation by the parties.

The ultimate contours of this balance will depend upon the relative bargaining positions of the parties. The framework within which the balance is struck has traditionally been quite distinct between the US and the UK. US-style transactions have imposed a vesting schedule that specifies increasing levels of share retention the longer the individual remains with the company. UK-style transactions provide for differing levels of share retention depending on the circumstances under which the individual leaves the company. UK documentation distinguishes between two broad categories of departing individuals: "good leavers" and "bad leavers". Then, within each of these categories, a further distinction is made so that, for example, an employee who resigns voluntarily is treated differently from one who is constructively dismissed, and one who is dismissed without cause is treated more favourably than one dismissed for cause.

In international transactions in the UK, the venture capital market is seeing a hybrid of these two concepts emerging. A growing number of transactions distinguish among a variety of situations in which the individual might leave the company, but within each of those categories, a sliding schedule, based on length of service, is imposed to determine the percentage of shares that the individual may retain and the price at which the remainder of the shares may be repurchased by the company. This sort of schedule is not a vesting schedule per se because the shares belong at all times to the individual in question. Its effect, however, resembles that of a vesting schedule in that during certain periods (and in certain events) the price at which the shares may be repurchased by the company will be negligible.

Registration Rights

A standard feature of US venture capital transactions is the right of the investors to compel the company to register shares. By creating liquidity, this right provides the investors with an exit from their investment if they desire. There are two basic types of registration rights: demand rights and piggy-back rights. Demand rights entitle an investor to compel a company to file a registration statement with the US Securities and Exchange Commission (SEC) covering the shares held by an investor. Piggy-back rights are available where a company is already in the process of filing a registration statement; with these rights, an investor can oblige the company to extend the registration statement to cover the investor's shares. These rights are particularly relevant to US investors because not only can unregistered shares only be sold to a relatively small universe of potential purchasers but also a registration statement filed with the SEC is effective only as to the shares specifically identified; it does not serve to register all the shares of the company.

By contrast, in any listing of a company's shares on the London Stock Exchange's markets for listed securities (as part of a listing on the official list of the UK Listing Authority), the entire issued share capital of the company is included. Consequently, registration rights are not relevant in the same way for a company seeking to list its shares in London.

Where a venture capital transaction has a nexus with the US, the trend appears to be that registration rights will be requested by investors – including in transactions where the investors are not from the US. Even where there is no nexus with the US, there is a growing trend for investors in technology companies to seek registration rights in anticipation of a possible future listing in the US on Nasdaq. In international transactions, registration rights sometimes fall away if the company has listed its shares on a recognized European exchange.

Pre-emption rights on issues and sales of shares

In the UK, the Companies Act requires new issues of shares to be first offered pro-rata to existing shareholders. These provisions can be disapplied by shareholders in relation to a specific issue of shares or generally. Modified pre-emption rights are commonly included in the Articles of Association of a company. These may require that any shares not taken up by existing shareholders be offered again to other existing shareholders before being sold to a non-shareholder.

Because the laws of Delaware and most other US jurisdictions do not grant shareholders pre-emption rights automatically, US transactions generally will provide for such rights. The pre-emption rights granted by these provisions in US-style agreements do not differ markedly from typical pre-emption rights in a UK-style transaction.

US and UK venture capital transactions are also alike in typically including rights of first refusal on proposed transfers of shares. Rights of first refusal require a selling shareholder to first offer the shares to the company and/or the other shareholders. Only if the company and/or the other shareholders decline to purchase the shares can the shares be sold to non-shareholders (and even then, they may only be sold for the same price and on the same terms that the shares were offered to the existing shareholders).

Conclusion

There are a range of differences between the documentation of, and rights granted in, venture capital transactions in individual international jurisdictions. Some of these differences are rooted in local law, but many are simply a product of tradition and culture. We have chosen to highlight several of the more salient differences between US and UK styles. Some differences between these two styles (such as non-competition provisions) look as if they may forever remain distinct, while in other areas (such as anti-dilution protection), the two forms are rapidly converging. In some cases (such as provisions on executive share retention), the market is seeing hybrid provisions develop, while in others (such as consent rights), a choice is simply being made to accept provisions substantially in the form considered standard in one or the other jurisdiction.

No "typical" approach to a venture capital transaction will perfectly suit any particular transaction, but a solid understanding of the various national approaches to these types of deals will enable an investor and a company to assemble the deal best suited to their transaction. The parties to a cross-border deal have an excellent opportunity to harness this diversity and incorporate concepts and approaches that may be unusual in their respective domestic markets but particularly well suited to the dynamic of their transaction. By broadening the range of options available on any given point and synthesizing these into the proposed venture capital transaction, the investors and the company are more likely to finish with a deal more beneficial to all parties.

Over time, this process of borrowing concepts and approaches from across borders (a process already well underway) will surely result in an even greater number of provisions becoming commonplace across jurisdictions and, with a bit of flexibility on the part of investors and companies alike, may eventually lead to a more unified approach to documenting venture capital transactions.




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