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Raising development capital - an introduction

The process of injecting development capital can be a long and complex procedure, not only for target companies but also for venture capitalists. Taking the company management's perspective, Siobhan McElhinney of Kemp Little provides an overview of the legal and commercial issues that arise from a venture capital transaction.

1. INTRODUCTION
 
1.1 
Purpose. The purpose of this guide is to familiarise founder shareholders and management with some of the legal and commercial issues arising out of raising development capital for high growth companies. Of course no two financings that often arise are the same but the issues discussed below are typical of the issues.
 
1.2 
Scope. Partnering with a capital provider such as a venture capitalist (‘VC') can be a challenging experience. There are a number of different types of capital provider, ranging from high net worth individuals to large venture capital companies, and the degree of involvement and control they may require can vary enormously. Knowing what protections your capital provider is likely to require and the potential consequences and pitfalls of different kinds of financing will help with the choice of capital provider and the subsequent negotiations.
 

2. PRE FINANCING
 
2.1 
Due diligence. Any VC serious about its investment will wish to conduct a due diligence exercise on the business which may include site visits, market research, meeting key customers and an examination of the business model. Once a VC has indicated it wishes to invest it will also carry out legal due diligence. It is important to keep track of all the information provided to the VC as this information will need to be considered when reviewing and disclosing against the warranties that the founder shareholders may be asked to give as part of the investment process. 
 
2.2 
Current shareholders. Whilst the management team often finds a new investor, the existing shareholders will need to be fully involved in any negotiations with the potential investor. The existing shareholders will be involved in considering the dilutive effect on existing shareholders of the proposed investment and any further proposed investment that has been identified by the VC or illustrated in the business plan. The consent of such shareholders will need to be obtained to the investment, as they will probably be required to enter into the investment agreement which may include preferential rights given to the new investor. It is advisable to keep all founding and employee shareholders fully informed throughout the investment process.
 
2.3  
The team. Selection of the people to form part of the core business team is fundamental to the ultimate success of the company. How are they going to be kept and incentivised? This issue should be discussed with the VC as soon as possible. It is common for entrepreneurial companies to establish employee share ownership schemes and for a certain percentage of the share capital to be made available to the employees through the share option scheme. The VC may also identify "gaps" in the management team and require the company to recruit new management and future funding may be conditional on this. Share ownership schemes are an attractive incentive for potential new employees and normally expected by executives considering a move to a higher risk company.
 
2.4 
The business plan. The business plan will have played a vital role in attracting the VC. It is important to realise that as part of the investment process the VC will probably seek some comfort that the business plan has been produced on "reasonable" assumptions and that management believe in the future success of the company. The financing of the company may take some time so any material change to any of the assumptions or key factors in the business plan should be notified to the VC.
 
2.5 
Valuing the company. The recent market volatility has lead to a more rigorous analysis in valuing new ventures. This flight to quality is to be welcomed as a return to more sustainable valuation methodologies and positive for properly through business ideas and opportunities.
 
3. NON DISCLOSURE AGREEMENT (NDA)
 
During the course of negotiations and due diligence by the VC confidential information about the company's business will need to be disclosed. Ideally a non-disclosure agreement should be entered into before any information is disclosed, and is often part of the Heads of Agreement. Although the general law does provide some protection for a person's confidential information even where there is no formal contract, a written agreement emphasises that the information being disclosed is confidential and valuable and deters disclosure and unauthorised use. You should be aware that VCs are increasingly reluctant to sign non-disclosure agreements. At the end of the day, the best way to protect confidential information is to restrict who you disclose it to and the nature of the disclosure.
 
4. HEADS OF AGREEMENT (HOA) 
 
4.1
General. Heads of Agreement set out the basic agreement between the parties and vary enormously from one deal to the next. They are normally non-binding other than in relation to confidentiality provisions, any agreement on payment of fees and lock out provisions. Although non binding, it is more difficult in negotiations as a practical matter to back track on something that has already been agreed to in principle in the heads of terms, although of course this is not impossible.
 
4.2 
'Lock-Out' agreements. The company may be asked to agree not to negotiate with any other potential VCs for a specified period of time. Such "lock out" agreements are, in general, enforceable in England provided they are supported by consideration. A lock out for an indefinite period and/or an agreement to continue to negotiate is unlikely to be enforceable
 
5. INVESTMENT STRUCTURE
 
5.1
General. The VC will normally direct the investment structure. The VC may seek a basic percentage of the ordinary share capital but more often than not the VC may look for a form of preference share. Rights attaching to preference shares vary but usually mean a preference for the VCs in a number of circumstances e.g. on a liquidation or sale.
 
5.2
Preference shares. The term "Preference Shares" basically means shares that have preferential rights. Set out below are six basic types of preferential rights a VC might request and the implications to the Company and its existing shareholders of granting these preferences.
 
5.2.1 
Preference on a liquidation, winding up or dissolution of the company. The preference shares have a preferential return on capital in the event of a winding up, dissolution or liquidation of the company. The VC has the right to receive a fixed amount before any capital can be returned to the ordinary shareholders. Normally, the amount will be the original purchase price for the preferential shares plus any accrued but unpaid dividends. In addition, the VC may be entitled to participate in any capital then returned to ordinary shareholders as if the preference share had been converted into an ordinary share immediately prior to liquidation (see Conversion below).
 
5.2.2 
Sale preference. The preference shares have a preferential return on a sale. For example, from the funds raised from the sale of the entire company the preference shareholders first get repaid the original purchase price of the preference shares together with accrued unpaid dividends and then are entitled to share in the remaining proceeds as if their preference shares had been converted into ordinary shares immediately prior to sale. This is called "double dipping" and is a common request when market conditions are tough.
 
5.2.3 
Cumulative preferential dividend. The preference shareholder is entitled to a dividend in preference to the ordinary shareholders e.g. at a rate of 7% on the original issue price, where the right to the dividend, if profits are insufficient in any year, accumulates until profits become sufficient or until a sale or liquidation. The preference shareholder may also be given the additional right to participate in a dividend after payment of the fixed dividend as if it were an ordinary shareholder.
 
5.2.4 
Conversion. Where they are part of venture capital financing, preference shares are often convertible into ordinary shares at the VC's option. Automatic conversion on an initial public offering of the company's shares is standard. The conversion mechanism will usually provide that the preference shares are initially convertible on a one to one ratio. However this conversion ratio will be adjusted to allow for dilutive effects such as new issues (see below).
 
5.2.5 
Anti dilution protection. The VC may ask for the following type of protection: 

Price protection – this usually takes the form of a "weighted average adjustment" to the conversion price by using a weighted average of the various subscription prices and the number of shares issued. 

Ratchet – this drops the conversion price to the most recent lower price at which the shares were sold, regardless of how many shares were sold at that price. 

In both of the above cases issues of shares pursuant to employee share option schemes should be excluded from the circumstances that trigger the above protection.
 
5.2.6 
Voting. Typically, preference shareholders vote as if their preference shares were converted into ordinary shares immediately prior to the holding of the general meeting. They may also be entitled to appoint a certain number of directors to the board.
 
6. INVESTOR PROTECTION
 
6.1
Warranties.  The VC will be investing in the company on the basis of information the company has provided. In the investment agreement, the VC will look for a range of warranties relating to the past and current status of the company and business. The company will usually warrant the information but the VC is also likely to look for warranties from the founder shareholders of the company.
 
6.2
Minimising exposure for breach of warranty. Founder shareholders will want to seek to minimise their exposure as much as possible in the event of a possible breach of warranty. This will include capping maximum liability, restricting liability to matters within knowledge, prohibiting claims for small amount and limiting the time during which claims may be made. In addition there should be 'disclosed' all matters existing prior to completion of the investment which are or may constitute a breach of warranty on the basis that liability will not arise to the extent that a matter has been disclosed. Disclosure is a vital process and should be given sufficient attention by the warrantors.
 
6.3
Warranties about the business plan. Any warranties given in relation to the business plan should be carefully considered. The creation of a business plan and the assumptions used are not an exact science. Warranting the accuracy of the business plan and future performance should be resisted. However, it is likely that the VC will want to know that the business plan has been carefully prepared and the statements of fact contained in it are correct.
 
6.4
Information and directors.  The investment agreement will include an obligation on the company to provide the VCs with information such as management accounts and updates. The VC will normally insist on being represented on the board of directors and may limit the number of non VC directors that may be appointed to the board at any one time.
 
6.5
Restrictions on the business.  The VC will seek commitments in relation to post investment management of the company, such as restrictions on future indebtedness, variations to directors' service agreements, capital commitments etc. It is important to ensure that the management of the business is not unduly fettered by such restrictions and to find a balance between the legitimate protection concerns of the investor and the interests of the company.
 
7. EMPLOYEES
 
7.1
Restrictions. The founders of the business and key employees may be expected to sign up to restrictive covenants. The VC will expect to see restrictions on management's activities both during and after their involvement with the company.
 
7.2
Vesting of shares. In addition, the VC may insist that employee shareholders who leave the company are obliged to sell their shares back to the remaining shareholders. The justification for this is that they should not continue to be entitled to any growth in the company following their departure. Such a rigid obligation may not be appropriate in all cases and variations can be provided for. Graduated "vesting" is one example - from the time of investment if the key employee/shareholder remains with the company 1 year he/she is entitled to retain 25% of their shareholding, 2 years he/she can retain 75% and after 3 years he/she can retain 100%. The vesting right may also depend upon the circumstances in which the employee leaves.
 
7.3
Protecting intellectual property. The VC will expect to see the normal protection for intellectual property rights developed by employees during the course of their employment with the company.
 
7.4
Employee share ownership schemes.  As mentioned previously it is normally a feature of venture capital deals that a specific percentage of the ordinary share capital is set aside for options to be granted to employees. 

7.5
New service contracts. In order to deal with some of the above issues the VC may insist on new service agreements for key employees.
 
8. EXIT ROUTES
 
8.1
Introduction. A crucial part of the negotiations with the VC will be the exit routes available for the VC. The timing of the VC's exit is crucial to all parties concerned. VCs are often looking for a return between three and five years after the original investment (although in reality most VCs accept that it can take longer than this) and management will be concerned to ensure that an exit does not take place at a time which is damaging to the business or which does not adversely affect their own vested interests. 

There is a variety of exit routes available and the importance attached to any particular exit route will depend on the VC partner selected and, of course, the amount of cash invested and the objectives of the business plan. At the time of negotiating the investment it is crucial for all parties to focus on the choice of method of exit taking into account the advantages and disadvantages of each method and how and by whom the decision to exit will be made. It is important to make the right exit route available but of even more importance is to put in place a framework that will allow preparation and planning for exit. The two main exit routes are an initial public offering and a trade sale.
 
8.2
Initial Public Offering (IPO). An IPO is an offering of shares in the company to the public which would normally involve the shares being listed on a stock exchange. IPOs are an attractive exit route for a variety of reasons. It is often thought that IPOs generate a higher price for a company than a trade sale. This is not always the case and much will depend on the market forces at play at the time. An exit through an IPO can allow the original management to stay in place and retain control of the company and also allows management who hold shares to realise their value in the business or retain a share and benefit from the future growth of the company. Going for an IPO will result in higher costs for the company including fees for lawyers, investment bankers and underwriters (and a selling shareholder may be asked to contribute to these costs). In addition, for a VC an IPO may not be a clean exit as the VC may have to retain part ownership to illustrate confidence in the business going forward.
 
8.3
Trade Sales. A trade sale is a sale of the shares or business assets of the company to a third party by way of a private sale agreement. A trade sale may be a more attractive option in times when market conditions are more turbulent. They are often simpler and cheaper for the seller. Of course, for the management of the business it may not be the most popular of routes.
 
8.4
Negotiating the exit route at the time of the investment. It is likely that a VC will require the company and its management to commit to certain obligations in order for the VC to satisfy itself that the company is working towards a profitable exit route and to enable the VC to determine when exit would be most beneficial. 

8.4.1
Exit commitment - it is normal to see in the investment agreement a commitment from the company and its management to use reasonable endeavours to secure a trade sale or IPO before a certain date. 

Such a commitment may go on to say that the company will appoint a merchant bank to advise on the benefits of an IPO and trade sale at the cost of the company after a certain amount of time. There may be more tight control e.g. a party may have the right to force an IPO or there may be a put option or right to redeem preference shares in the event that an IPO or trade sale is not secured. 

8.4.2
Management covenants - in order to monitor the company so that the VC will be aware of the best time to trigger an exit the VC will include in the investment agreement an obligation on the company to produce regular management and financial information.

8.4.3
Ratchets - Ratchets can be positive and negative. A positive ratchet provides that on the occurrence of a specified event e.g. achieving a certain market capitalisation on an IPO, the founder shareholders will receive an "uplift" in their percentage shareholding and thereby benefit further from the success of the company. A negative ratchet will decrease the founder shareholders' holding in the event, for example, the VC fails to achieve its minimum return or targets in the business plan are not met.
 
8.5
Exit concerns. At the time of negotiating the investment agreement a number of concerns relating to exit routes will probably be addressed by the VC: 

8.5.1
Warranties - venture capitalists will not, as a general rule, wish to give warranties in relation to the business on a trade sale and will normally include in the investment agreement an acknowledgement by the management that the VC will not have to give any. The VC will argue it is not involved in the business and therefore is not in a position to warrant any information on the company as they are only aware of information that they have been provided with by the management and will be concerned that it is a "deep pocket" for any potential warranty claims and will be pursued in preference to individual warrantors. 

Therefore the burden of giving warranties at exit often falls on the management shareholders which is unpopular as management take all the risk with no more return. Whether or not you can get the VC to budge from this traditional position will depend on the negotiating position at the time of the investment and what further protection the management team can offer the VC. In addition, particularly in relation to an MBO warranty and indemnity insurance can be purchased if the level of warranty cover needs to be topped up. 

8.5.2
Tag along - this allows the VC to insist that if the management receive an offer for their shares they will have to ensure that the VC is made the same offer. This is extremely common where the VC has a minority stake and is normally an acceptable principle to all. This protection may be strengthened by giving the VC an absolute veto on any sale of shares by any other member thereby enabling the VC to block sales to third parties with whom it does not wish to be a shareholder or whom it does not wish to sell the whole concern to. 

8.5.3
Drag along - these rights allow the VC, on receiving an offer for its shares, to force the other shareholders to sell their shares on the same terms. Obviously if the VC has a minority stake such a right could be abused.
 
8.6
SEC registration rights - SEC registration rights may be seen in investment agreements where the VC considers an IPO through a US exchange a possibility. There are two main types of registration rights: 

8.6.1
Demand rights – the shareholder can demand that the company register its securities if certain conditions are met. 
 
8.6.2
Piggy back rights – the shareholder is given the opportunity to be included in the registration of any securities on a registration statement filed by the company for the sale of the company's securities. 

Copyright © 2002 Kemp Little LLP

Siobhan McElhinney is a partner with Kemp Little LLP.

Kemp Little is a law firm for business and technology. Based in the UK, the firm specialises in commercial, corporate, communications regulation and employment law. For more information please visit www.comlegal.com