VC Focus | Warranties and indemnities: the importance of being 'exit ready' in international venture capital transactions
Published on 21st Nov 2022
How can VC funds manage the growing trend in cross-border M&A markets for buyers to ask for problematic exit terms?
Exits are key moments in the life cycle of venture capital (VC) funds and in almost all cases only come after years of hard work, but these moments are not without their stresses.
There has been a growing trend in the cross-border M&A market for overseas buyers, who are perhaps less familiar with the market practice that has emerged to accommodate traditional limited partnership (LP) fund structures, to ask for exit terms that are problematic for most VC funds and therefore unrealistic to expect them to give.
It has been long understood by those in the UK VC market that most funds will only give warranties or indemnification on exit about their own share capital position (that is, that they own their shares and have the power to sell them). Furthermore, most funds will only give indemnification for any unapproved locked box/completion account leakage received by them personally.
The arguments VC funds use to justify this position include lack of day-to-day knowledge of the business (and an unwillingness to be responsible for the knowledge of other shareholders), exit policies in shareholders' agreements and discomfort taking contingent liabilities for unknown risks. This position is also common (although not as rigidly adopted) in most European markets and is followed to some extent in the US by use of general escrow funds.
Why are contingent liabilities challenging for VC funds?
VC funds typically need to return each investor in the fund with the capital that the investor has invested plus a minimum annualised return (the "preferred return") before the general partner is entitled to receive a share of profits (the "carried interest").
There are a variety of approaches to how these economic arrangements are structured, with some VC funds dropping the preferred return in favour of alternative models, but in the majority of cases sponsors are under pressure to distribute returns to their investors quickly after an exit to achieve internal rate of return (IRR) hurdles.
Most VC fund agreements include the right to clawback distributions once returned to investors in the event of warranty claims against the fund (which are known as "LP giveback" or "LP clawback" provisions). However, these provisions are intended to be used as a last resort in the event that a VC fund no longer has sufficient cash reserves or undrawn commitments to meet contingent liabilities.
The ability of a VC fund to clawback distributions will almost always be subject to a cap (which varies significantly but is often 25-35% of LP commitments, and sometimes 25-35% of the lower of commitment/distributions) and time limitations (typically, 24 months from the date of the relevant distribution, sometimes 24 months from the date of termination of the fund – and, occasionally, this can be extended to 36 months for sponsors with a strong negotiating position).
However, VC fund managers are reluctant to utilise these provisions in practice because they are complicated to operate and managers typically do not want to be in the uncomfortable position of asking investors for money back. Doing this is not good for business as any clawback will almost certainly lead to reputational damage, making it harder for the fund to raise new funds in future.
VCs will also be reluctant to distribute carried interest to their investment team if there is a known risk that such amounts may need to be clawed back at a later date. There are numerous practical complications here, but the impact on team morale is obvious. As a result of these challenges, it can be difficult for VCs to distribute sale proceeds that are subject to contingent liabilities, even if these liabilities are remote, which in turn puts pressure on their ability to meet IRR hurdles.
What are buyers doing?
A lot of buyers are now seeking wide title and capacity warranties, including comfort about the accuracy of the share capital table (covering the ownership position of other shareholders and, potentially, option and warranty holders) and company solvency matters.
Some buyers are also asking for wide leakage indemnification on a joint and several basis, in particular for non-cash benefits received by all shareholders. There has been a trend for buyers to ask funds to commit to not investing in competing businesses for a certain time period.
The position has no doubt been coloured by the availability of warranty and indemnity insurance, which is now more widely used in the market, where there is a "warranty gap" (that is, sellers who cannot give warranties) or where the sellers wish to de-risk their position generally.
However, we have also seen buyers in the UK (but less so elsewhere in Europe) ask for wide warranties from funds, despite knowing that the underlying issues are insured. This is often justified on the ground that these are also matters of principle. On one recent UK transaction, the buyer offered to agree, contractually, to pursue insurance first, but still wanted the fund "on the hook" for the accuracy of the entire share capital structure to ensure the transaction appeared to be correct in the eyes of its shareholders.
Osborne Clarke comment
VCs would do well to set expectations clearly at the term-sheet stage, so that problems can be avoided (or at least minimised) once the exit process is under way. Otherwise, the fund could be in a horrible position of disappointing the buyer and the other shareholders in the company being sold.
One common method used to cover this is through a "no warranties on sale" clause in an investment agreement, whereby the shareholders agree that VC investors will only be expected to warrant their own title to shares and authority to sell on an exit.
In the US, such “no warranties on sale” clauses, as well as limitations on restrictive covenants such as non-competes and non-solicits, have become customary conditions to VC investors’ agreements to be “dragged along” into sales by a specified majority voting block. Though contractual drag-along provisions are rarely relied upon in practice to force a sale, the limitations established in the terms of those provisions in early-stage shareholder agreements often set expectations around the liabilities and restrictive covenants that investors are willing to accept upon an exit.
Good investors will seek to set expectations with their management teams, so that there is support and fairness across all shareholders, based on what each shareholder can realistically do. Use of warranty and indemnity insurance can also play a role here; that position will then be communicated to the buyer, with a united front, by all selling shareholders.
Where warranties and indemnities cannot be avoided, another way to manage contingent liabilities is to use a general escrow fund (or holdback/retention) – typically between 10-20% of the selling price – so that all liabilities can be capped at the balance of the escrow fund from time to time. The selling VC fund is then free to distribute its sale proceeds at closing, with the escrowed funds to follow, once released and free from claims. This is a solution commonly used in the US market.
The buyer may also have a right of set-off for any claims against any deferred or contingent consideration in addition to an escrow – VCs can and do also agree to that as a way to meet liabilities before sale proceeds are received.
Any sale proceeds held in an escrow fund will serve as a drag on the fund's preferred return. However, some VC funds do not have a preferred return (more so in the US) which may partly explain the adoption of this approach in the US. Care is still needed to ensure that no warranties and/or indemnities can go round the escrow fund, but that is probably the subject for another note.
Finally, VCs should work closely with their legal counsel to ensure that LP clawback provisions in their fund documents are sufficiently flexible. Care should also be taken when formulating the equivalent provisions for co-investment vehicles established for a single deal, where greater concentration risk means that a cap of 25-35% commitments may not provide sufficient coverage and a higher cap can justified (particularly if co-investors are not paying fees or carried interest).
This is part of our VC Focus series addressing legal, regulatory and tax issues facing the venture capital industry in the UK and internationally.
Osborne Clarke has a market leading venture and growth capital practice across Europe, supporting investors across sectors including financial services, media and communications, life sciences and healthcare and real estate and infrastructure. If you have queries on any of the issues covered in this note please connect with one of our experts.