The British Venture Capital Association has published its long awaited update to its model documents for early stage venture capital investment. With a stated aim of promoting “industry-standard legal documentation in the UK”, the expectation is that many parties will look to use these documents as a base for their transaction documents.
We note that the BVCA state they have consciously followed US precedent and, in many ways, the new documents do move the needle in favour of the company and its founders. This will certainly provide more flexibility for emerging companies. However, institutional investors will need to be conscious of these changes and consider whether the revised documents are the correct starting point, particularly if the market moves to a more investor friendly environment.
With the above in mind, we set out below some of the key changes to the previous set of model documents published by the BVCA.
What used to be a combined Subscription and Shareholders’ Agreement, is now two separate documents. This is a welcome update, reflective of the common distinction between the mechanics of subscription and the terms applicable to the ongoing relationship between the shareholders more generally.
The new Subscription Agreement provides more flexibility for closing investment rounds with multiple investors, such as a rolling close option. This is more reflective of the reality and range of transactions we now see utilising the BVCA model documents, although tailoring will still be required for each given structure and agreed commercial terms.
Investors may also wish to see more detail on the closing (and funding) mechanics and timing and (if applicable) repetition of warranties.
Warranty liability has been refocused on the company as sole warrantor, with the company and founder warranties no longer the default option. While this can be a more contentious negotiation point, founder warranties are often a key area of protection for many investors, particularly on earlier stage investments. Ensuring that the founding team has ‘skin in the game’ is seen as important to encourage fulsome disclosure during the course of diligence and the specific disclosure process, and provides investors with reassurance as to founder commitment.
We welcome the broadening of the warranty scope to include ESG, sanctions and a warranty covering the applicability of the National Security and Investment Act. The revisions to some warranties, such as real estate, also more accurately reflect the position of many early stage businesses.
We envisage that many institutional investors will have concerns about the addition of knowledge qualifiers in warranties on key areas of risk, particularly FinCrime and AML warranties, where they will expect the risk-allocation to continue to sit more firmly with the company and, in many cases, the founders too.
The limitations have also been modified, which, in most cases, reflects the (limited) frequency of investor warranty claims in practice; for example, the de minimis and bucket thresholds for claims have been removed.
A requirement for investors to commence proceedings on a claim within a certain period of initial notice remains missing, and could result in claims hanging over the company, particularly since claims can be notified in respect of a contingent liability.
The disclosure process has been modified with a lower disclosure threshold but on the basis that there will be no general disclosure of the data room or diligence documents. A pro forma disclosure letter has also been included which should help ease that process.
We welcome the amendment to the liquidation preference mechanics to enable investors to receive the greater of their liquidation preference amount and the amount available for distribution to the ordinary shareholders, removing the administration for all parties of a conversion of preferred shares prior to a return of capital.
The definition of “Arrears” has been narrowed so that only arrears of declared and accrued (but unpaid) dividends are counted. This means interest and “other amounts payable” are no longer counted, which has knock on effects on the Preference Amount which investors can receive.
The threshold required in order to disapply pre-emption rights has been reduced from a special resolution to a matter requiring “Investor Majority Consent”. The drafting note flags this has been done to prevent smaller investors from having a veto right on a future financing in a manner that is not consistent with the consent thresholds in the Shareholders’ Agreement. Whilst understood, minority shareholders may have concerns about the removal of this protection.
The ability of the Board (with Investor Director consent) to waive anti-dilution rights in the event of a Qualifying Issue is in line with common practice for many transactions but will need to be considered by minority investors and founders who do not have a board presence. Similarly, the anti-dilution formula now takes into account the “weighted average” equivalent price per share, rather than the lowest price, providing a more accurate calculation of the issue price (particularly where there are multiple rounds of shares being issued at different prices). The current drafting does not define the “weighted average” so this will need to be clarified between the parties.
Exits and Share transfers
The board has been granted further control over share transfers and exits. This will provide the board with a greater ability to manage its cap table; however, we may see resistance to this shift in control from some investors.
In some cases, this greater control provides a soft veto to the board on transfers, for example, the removal of rights to disclose information to potential purchasers without consent, and the removal of the Investor Directors’ veto over disenfranchisement of a transferor’s shares for failure to provide the board with requested information. In many cases, these are highly contested areas in negotiations and we do not anticipate that this will change as a result of this amendment.
The mechanics of exit have been tightened in a number of places which should make for an easier process for all parties. There are also more express obligations on shareholders on an exit; for example, in respect of “Common Liabilities” on a drag and the inclusion of a lock-up (not to exceed 180 days) for all shareholders on an IPO. This may cause concern for institutional investors who face regulatory or policy constraints on assuming such obligations and so this may still be an area of negotiation.
As with the governance rights (see below) a number of the transfer-related rights are now granted to Major Investors only, such as on a co-sale with resulting implications for minor shareholders.
The general restriction on a founder not transferring its shares without Investor Majority Consent has now been removed. There are other protections but investors will need to be comfortable that the documents ensure founders remain involved in, and are committed to, the relevant company.
The application of leaver provisions has both broadened and narrowed in some respects:
- the definition of “Bad Leaver” has been restricted, for example, a person who ceases to be a Service Provider as a result of wrongful/unfair dismissal, lawful termination and/or fair dismissal will no longer be considered a Bad Leaver; and
- however, where a Service Provider is a Bad Leaver, all of their Service Provider Shares are to be automatically converted into Deferred Shares (rather than providing an option for the Board to decide whether to purchase / reallocate them), which may make for an easier process.
We anticipate these provisions will remain a continued point of negotiation.
The articles have helpfully included a note to remind parties that the date of the commencement of a Good Leaver’s vesting period should not be tied to a date which can be reset (e.g. the “Date of Adoption”).
Governance and conduct of business
As a general theme, the board has assumed greater control over certain matters, which will provide greater flexibility for earlier stage companies. However, it will be interesting to see how this plays out with investors in future transaction negotiations.
There has also been a shift towards approval rights falling to the “Major Investors” only with the aim of preventing smaller shareholders from blocking transactions. For companies with large cap tables this will be a welcome move, similarly the lowering of some of the thresholds for variations or similar should ease corporate process.
One of the other key structural changes is that an investor director’s ability to approve investor reserved matters has also been excluded. As many investors prefer to delegate these matters to their appointed director nominees, and as it can be easier to achieve responses at the investor director level, this may have practical implications.
The founder now has a default right to appoint themselves to the board for so long as they are employed by or provide consultancy services to the company and hold not less than 10% of the shares. There is also an undertaking from the other shareholders not to vote to remove the founder directors from office but this should not override statutory shareholder rights of removal. We suspect that this entrenched right will remain a point for negotiation.
The articles are now silent on whether the chairperson has a casting vote at Board meetings. We would anticipate that the majority of transactions will still prohibit the chairperson from having a casting vote.
Other notable points to consider
The documents helpfully include EIS and VCT specific provisions and a degree of standardisation in this area is welcome. However, these provisions will need to be carefully considered by the parties in the context of the deal being negotiated.
Similarly, the articles have been modernised to allow for DocuSign and electronic formats for Company documents.
The removal of the default position that the company will be responsible for the legal fees of the investors up to a capped amount will be welcomed by companies. However, market practice both in the UK and in the US suggests that this will continue to be an expectation of many investors.