Key documentation for venture capital investments

As referred to above, the VC will wish to carry out some level of investigation into the company. The extent of investigation will vary depending on the position of the company (i.e. its stage of development, whether it has ever traded, etc) and the amount of the investment. It is fair to say that VCs take significantly differing views as to the level of due diligence required. 

Typical subjects of investigation will be: 

Legal

Normally as a minimum this would cover:

• The company's constitution – ensuring that it is properly incorporated and understanding the ownership of its share capital.
• Share option schemes – in order to understand the equity ownership.
• Employment contracts – to ensure that staff are employed on proper terms.
• Intellectual property ("IP") – to ensure that the company's IP is properly protected.

Financial

To ensure that the VC is comfortable with the basis on which the business plan and projections have been based (if the company has traded).

Commercial

Looking at the company's products, competitors and potential for growth, possibly by obtaining a report from an industry specialist or simply by talking to relevant parties. 

It is wise to pre-empt a due diligence investigation and to take advice as to how to deal with any issues which are identified.

The Investment Agreement and articles of association (see below) are the principal documents relating to any venture capital investment. These documents reflect the commercial terms agreed in the term sheet, but at a level of legal detail intended to make the rights and obligations of the parties absolutely clear. 

The Investment Agreement, also sometimes referred to as a subscription agreement or a subscription and shareholders' agreement, will document what the VC gets for its money and the ongoing relationship between all of the parties (i.e. the VC, company and management). 

These latter terms are sometimes contained in a separate agreement referred to as an 'Investor Rights Agreement', but it is more usual for all terms to be covered in the same document. 

The key issues, which will generally be covered, are set out below: 

Form of investment

• A venture capital investment will normally take the form of some kind of 'preferred equity' (shares with preferential rights). This means that the VC will take a share in the company (entitling it to a share of income, capital and to vote with other shareholders) but subject to preferred terms. More detail on the nature of the preferred terms is set out below.
• Sometimes the investment may be made via 'preference shares' or 'loan stock', both of which generally provide a fixed income and capital return.

Warranties

• Warranties are a set of statements provided by management and the company itself as to the status of the company and its business. They are intended to supplement the VC's due diligence, by attaching a liability to the accuracy of the information supplied.
• Typically, warranties will cover matters such as the business plan (to ensure assumptions and projections are reasonable and achievable) and due diligence reports (to ensure that the factual information, on which the VC is basing its investment case is correct) as well as other general trading matters.
• The warranties are normally supported by personal liability on the part of the directors up to a set amount (usually based on a salary multiple). The company's liability is usually capped at the full amount of the investment. They will also be qualified by the contents of the disclosure letter (see below). Due to the nature of the relationship between the VC and management, claims under Investment Agreement warranties are very rare in practice, other than in the case of fraud.

Restrictions

These will take the form of a list of matters which the company will be prevented from carrying out without the prior consent of the VC (such as issuing new shares, selling its business, incurring debt, employing senior staff, etc.). These vetoes should cover matters outside the ordinary course of the company's business, so as not to be overly restrictive, whilst still protecting the VC's position so that extraordinary decisions cannot be taken without its consent.

Undertakings

The VC will expect the business to be properly run, for board meetings to be held regularly and possibly for the creation of remuneration and audit committees. The company and management will be required to undertake to the VC that this is the case. In addition, the VC will normally require the right to appoint a director to attend (and to be paid an annual fee for the attendance at) board meetings, and to monitor its investment.

Provision of information

Typically, the VC will require copies of accounts, management accounts, business plans and board papers to be provided promptly, and will expect the right to appoint investigating accountants if these are not forthcoming.

Restrictive covenants

The value of the VC's investment would be significantly threatened if the company's management team were to leave and set up a competing business. The Investment Agreement will therefore contain restrictions on the managers (which are enforceable by the VC) for the duration of their employment (or sometimes for such time as they hold shares in the company) and a period after that. These restrictions will normally prevent the managers from competing with the company or hiring its senior staff.

Negotiation fee

The VC will often charge a fee on completion of the investment, normally equal to between 1% and 2% of the total value of the investment. This is particularly common for VCTs and EIS Funds.

Other

• The Investment Agreement may contain other provisions depending on the nature of the VC investing. If the VC is a VCT or EIS Fund, it will need additional provisions to ensure that the company qualifies for the special tax treatment afforded to these types of investment.
• VCs from non-UK jurisdictions may also require specific provisions to ensure compliance with their domestic securities laws.

As referred to above, a VC's investment will usually be made via the issue of preferred equity. The company, therefore, will need to adopt articles of association which reflect the preferential terms applying to these new shares. 

The rights attaching to these shares will normally be more favourable than those applying to ordinary shareholders' shares, and the main points will be contained in the term sheet agreed at the outset of the deal. 

The key issues are generally as follows:

Dividends

VCs in early stage companies will rarely require the payment of a dividend in the early years. This is because they will not expect the company to be making profits, but also that they would expect any profits made to be reinvested in the company's research and development and growth.

Return of capital

The VC's investment will normally benefit from a liquidation preference, which means that when the company is sold, or capital otherwise returned to shareholders, it will be entitled to a sum equal to the value of its investments (or sometimes a multiple of such sum) before any other money is paid to other shareholders. After payment of the liquidation preference, the remaining proceeds are typically split pro rata among all shareholders or just the ordinary shareholders.

Voting

The VC's shares will generally carry votes on the same basis as the ordinary equity shares in the company. However, such voting rights are sometimes enhanced, e.g. if the company fails to perform to plan.

Leaver provisions

• A VC will generally require the founders/managers to lose all or a portion of their shares on ceasing to be employed by the company. This is because it is important to maintain a pool of shares sufficient to motivate the managers to deliver value to shareholders, and it is often not helpful to have non-active shareholders as investors in private companies. Sometimes shares will convert into worthless "deferred" shares or be required to be offered for transfer; the proportions of and price at which such shares are to be transferred will generally depend on conduct (e.g. whether a 'good leaver' or a 'bad leaver') or time (where the value of shares increases over time – a 'vesting schedule'), or often a combination of the two.
• In venture capital deals it is often possible to distinguish between directors who are founders and those who are managers. In the case of the former, it is often the case that the company will outgrow the original founders, and a management team with additional skills is brought in to manage the business going forward. This does not mean that the founders should be left with no part of the future growth of the company, and so leaving founders may be entitled to retain shares, although any shares retained would generally be disenfranchised so that leaving founders no longer have a say in any voting matters.

Board appointment rights

Typically, a VC will want the right to appoint a non-executive director to the board of the company, and may also require the right to appoint additional observers to attend board meetings.

Anti-dilution

• One of the most difficult aspects in making investments into private companies is valuation. In order to mitigate against over-valuation, the VC will often include a provision in the company's articles of association which will state that if the company issues more shares at a lower price than that paid by the VC (therefore implying that the VC overpaid), it will issue free or cheap shares to the VC so that the average price paid for all shares held by the VC is reduced.
• There are a number of methods of calculating how many new shares would be issued under these provisions, and the effect of them can be dramatic on ordinary shareholders. Proper advice, therefore, should always be taken in respect of such provisions.

To ensure that the management team devote its full time and attention to developing the company's business (and therefore increasing the value of the VC's investment), the VC will want to ensure that managers are employed on contracts which contain proper protection for the company. 

This will normally mean including provisions such as restrictive covenants, intellectual property assignment provisions, notice periods of six months or less, pay in lieu of notice clauses (allowing the employee to be dismissed immediately in return for payment of his salary during the notice period) and garden leave clauses (allowing the company not to require the employee to attend work during the notice period), as well as making sure that the contract properly reflects the executives' remuneration package (including any bonus arrangements).