Venture capital deal terms trends in the UK

The current economic conditions including rising inflation and bank borrowing rates, due to ongoing wider global crises, have led to a worldwide reduction in venture capital (VC) investment over the last few months. The lack of certainty as to how the economy will play out this year and in 2024 has made investors wary of striking a bad deal and cautious of forecasted positive investment returns.

General UK picture

GlobalData and Pitchbook both report that in the first half of 2023, there have been in the region of 1000 venture capital deals raising approximately £6.5 billion in funds for UK-based start-ups. This represents a staggering 245% decline in total deal value and 60% drop in the number of funding rounds. 

However, those statistics must be taken in context. The UK remains the most attractive market in Europe for early stage and growth investment, not least in the tech start-up space, and globally the UK ranks in the top five markets for both deal volume and value. It ranks third globally for VC investments made and it raised over double its closest European rival, France, in 2022.

The UK may have been harder hit than other European peers due to its higher proportion of later-stage companies. There has been a specific fall in larger deals and the making of new unicorns, but the reduction in deal volumes should also be viewed as a correction in the market after unusually high levels of innovation and investment resulting from the pandemic, with levels returning to a more normal base level; and that level is still high compared to historic norms.

London and the South East continue to make up the lion's share of investment, but there is considerable growth in investment into businesses in the UK's regions. Businesses connected to or located within the geographic areas of lead research environments such as Cambridge and Oxford universities still attract substantial investment.

Despite conditions remaining more challenging than in recent times, the outlook for investment in the UK is increasingly positive in the coming months with more economic stability and predictability forecast, thanks to the UK's solid history of successful start-ups and availability of capital.

We explore below how the prevailing economic conditions have affected key aspects of venture deals in the UK, including the impact on specific deal terms and deliverability, and any changes we expect to see as we head into 2024.

We have sought to summarise the general themes for venture investments, but, naturally, differences in deal terms trends will occur depending on the level of maturity of the target business and the nature of the investor.

Sectors

Fintech (including insurtech), software, energy, renewables, cybersecurity, business-to-business (B2B) services and biotech healthcare and digital health are the sectors attracting the most investment in the UK and we are seeing this reflected in our client mandates.

As the cost of living crisis bites, popularity of investments into real estate, retail and consumer focused start-ups has slowed.

We anticipate that investment in start-ups focusing on generative artificial intelligence (AI) will continue to grow over the next 12 months.  The sector has certainly come into sharp focus with investors over the past year and, with our pipeline of deals, this does not appear to be changing at all.

Government-backed initiatives encouraging innovation and deal flow

The UK government has recently announced several projects and incentives to encourage a start-up culture.

These included £3.5bn to the UK's tech sector, of which £1bn has been pledged to develop the next generation of supercomputing and AI. During 2022, the UK’s tech sector was the largest and fastest-growing in Europe, growing by £24bn. The UK is home to the most quantum technology start-ups in Europe, attracting the most investment, having become a leader in the sector for more than a decade. We have certainly seen our clients in this sector attract investment from some of the most active VCs in the early stage investment market.

The government has also released a white paper entitled "A pro-innovation approach to AI regulation"; this project includes the launch of an AI sandbox and an annual £1m prize for AI research.

The £3.5bn funding announcement followed the publication of the government’s Science and Technology Framework. The framework’s targets include nurturing innovative science and technology start-ups, increasing research and development, and establishing a "pro-innovation culture" in the UK’s public sector.

The government has been critical of how London-centric VC funding has tended to be and wants to encourage investment to level up the regions, and through the Innovation Accelerators programme, the government plans to invest £100m into 26 research and development (R&D) projects in Glasgow, Greater Manchester and West Midlands to boost the country’s science and technology capabilities.

The government has targeted an increase in investment in research and development to 2.4% of UK GDP by 2027. Accordingly, the R&D expenditure credit (RDEC) scheme credit rates have improved, giving a boost to companies claiming under the scheme. There have also been changes to simplify the process to grant share options under the Enterprise Management Incentives (EMI) scheme, which are widely used by start-ups and to expand the availability and generosity of company share option plans (CSOP); this will allow companies that have grown beyond the scope of the Enterprise Management Incentives (EMI) scheme to better incentivise employees.  

Access to the Seed Enterprise Investment Scheme has been widened and the funding limits increased, encouraging additional investment and so further supporting the growth of early-stage companies.

New BVCA terms encourage move towards standardisation of market terms

In February, the British Private Equity & Venture Capital Association (BVCA) published a revised version of its Subscription Agreement, Shareholders’ Agreement and Articles of Association. A new model term sheet and ancillary documents will be provided in due course.

We have seen a keen uptake in use of these model documents, which is leading to a standardisation of market terms across VC deals.

One area that investors are tending not to accept the BVCA standard terms is where the model documents require investment warranties only from the company, not from the founders. In the majority of cases, we are still seeing investors require the founders to stand behind the warranties. But, there are undoubtedly investors in the market who are willing to accept the new BVCA position. Perhaps it is a case of investors becoming more used to the concept of "company only" warranties.

Historically, leaver provisions were the cause of some debate. In recent times, and certainly since the publication of the BVCA model documents, the market has settled on the position set out in them: where all shares are at risk if the founder is a bad leaver (that is, fault-based scenarios such as summary dismissal and breach of restrictive covenants) and a proportion of shares (based on a three to four year vesting schedule) are at risk otherwise.

This is a positive change and helps to ensure a smooth dealmaking process, and manage expectations.

More investor-friendly deal terms

Reflective of the current market, where investors are more cautious, we have noticed some elements of the term sheet becoming more investor friendly. Most noticeably, we have observed an increased number of participating liquidation preferences and also a marginal increase in the multiple used for the preference. These are being deployed by the more risk-averse investors or on the slightly riskier deals, including down or rescue rounds where existing investors have run out of appetite to fund further and are essentially giving the company an agreed runway to achieve an exit/similar transaction. That said, the majority of deals retain a 1x non-participating preference arrangement.

There has been a slight uptick in the use of full anti-dilution ratchets to better protect an investor on a down-round, but weighted average ratchets remain the standard.

There is anecdotal evidence that more investors are structuring their investments by only taking a preferred class of share; there is less investment in a mix of ordinary and preferred shares.

A longer timetable to completion

Deals are generally taking longer to reach completion. This may simply reflect the new norm in terms of deal process, as this is a trend that we have observed over the last few years with more complexity attached to deals, their structuring and due diligence. It is also possible that, given the economic uncertainty, deals are taking longer as investors weigh up the potential benefit in making the investment, undertake thorough due diligence to support an investment decision, and react to the fast  and changing economic landscape.

It is likely there is a higher abort rate, given the riskier investment climate, but as lawyers we will not tend to see an instruction until it is given the complete green light to go ahead, and have therefore not seen first-hand many deal aborts.  

More rescue rounds; tranching

Unsurprisingly, there has been an increase in down rounds and rescue rounds. These can lead to some challenging structuring, insolvency law, unfair prejudice, variation of class rights and conflicts of interest considerations.

There is little use of tranching on new rounds, but we are seeing it deployed as a structuring device on follow-ons or where the company is not perhaps performing as well as hoped and an existing investor wants to hedge their bets when making any further investment.

Cost conscious companies

With tight budgets and increased overheads, companies are sensitive to increased costs and balance sheet impacts; this can influence the company's approach to a funding round.

Founder protections more settled

The position regarding founder rights and vetoes tends now to be linked to a service and minimum shareholding requirement, which reflects the drafting in the new BVCA model documents.

Simpler ESG clauses

As part of the drive to ensure funds and investee companies are ESG-focused, recent years have seen an increase in lengthy clauses setting out ESG requirements and expectations.

In some cases, these have tended to be unworkable and overly-detailed, and consequently, it is uncertain these will have been effectively implemented post-completion. However, the BVCA model documents contain succinct and more workable clauses, and we expect these to be increasingly adopted in investment documents in place of fund-specific drafting.

Osborne Clarke comment

It is anticipated that venture capital investment in the UK will remain relatively subdued this year and through the first half of 2024. It is likely that rescue rounds and down rounds will continue to feature with the complexities these bring, and that deals will continue to be closed with more investor-friendly terms, not least to protect the economics of the deal through the sale and liquidation preference and anti-dilution ratchets.

We expect the trend of standardisation of terms through ever-increased adoption of the BVCA model documents to stay.

Despite borrowing rates remaining high, as a firm we are already seeing improved deal flows as we head into Q4 of 2023 and 2024. Venture funds have dry powder and need to invest; having taken a "wait and see" approach while the economy was more volatile towards the end of last year and through the first half of this year, investors are more optimistic.

Some uncertainty may return with a potential change of government in 2024. The Labour Party, which is currently leading in the opinion polls, has already put forward its own proposals to grow the economy and encourage venture capital investment in its policy paper entitled "Start-up, Scale-up". Some of these continue or enhance the proposals brought in by the current government and include:

• unlocking investment by building engagement and understanding between institutional investors and VCs, reviewing the opportunities for institutional and ISA investors and pension funds to invest in high-growth firms;
• transforming the British Business Bank;
• reforming the approach for university spin-outs;
• making public procurement work for start-ups; and
• incentivising investment and entrepreneurship, including reviewing incentives, such as SEIS, EIS and the R&D tax credit system.

The Labour Party also focuses strongly on investment in the green transition, the digital economy and its new industrial strategy to encourage innovation and investment. As a result, we predict that the sectors that are currently attracting the most investment will remain those most appealing to investors in the coming months and years.  

It is certain that any government will need to foster an innovative environment to grow the economy which has slowed since the pandemic, and this will support a flourishing venture capital investment market in the UK.

OC Ventures is Osborne Clarke’s international resource centre for market disruptors and drivers of innovation. OC Ventures currently supports some of the most exciting emerging technologies today, advising from start-up through venture financing and the growth journey beyond, whether continuing to sale, IPO or international expansion. We work across the full ventures ecosystem, advising on spin-outs, technology transfer, commercialisation and investment transactions involving world-leading universities and research institutions.