Earlier this year the UK’s British Private Equity & Venture Capital Association (BVCA) issued revised versions of its standardised documents for early stage investment (the BVCA Model Documents), which can be viewed here. As exit timelines are being pushed out and venture capital investors are holding their investments for longer, there will be a greater number of funding rounds by privately funded companies. Therefore, investors and companies should focus on the key provisions of the BVCA model documents that impact the successful closing of future funding rounds.
The BVCA Model Documents are now split out into three principal documents:
- Subscription agreement,
- Shareholders agreement, and
- Articles of association (and, where necessary, a registration rights agreement if an offer of shares in the US is going to be reasonably likely).
Helpfully, the subscription agreement and shareholders agreement now comprise two separate documents. This means that multiple subscription agreements can be used for current and future investment rounds without impacting (unless where necessary) the continuation of the shareholders agreement that governs the overall control of the company. The subscription agreement deals with the funding and share allocations, closing of the round, and risk management and disclosure via warranties. The changes made reflect this:
- It has been updated to take account of pre-Series A funding by a company, such as under convertible notes, SAFEs or advanced subscription agreements (ASAs),
- The warranties are still extensive, but it is important to note that the warranties being given are from the company only. As the number and the size of the rounds increase, investors will need to consider whether the founders or management should be giving the warranties directly as well (subject to appropriate caps on their liability), and
- A form of disclosure letter has also been inserted as an appendix, which should establish a more standard approach to the general disclosures and the "front end "of the disclosure letter.
Specific advice will need to be sought in relation to execution and closing conditions to funding, as well as what regulatory and tax conditions may be needed. In particular, investors will need to consider whether the UK’s National Security and Investment Act will apply and whether a mandatory (if it is an investment into a sensitive sector that meets the conditions) or voluntary notification to the UK Government will be required or, in relation to any EIS or VCT investors, the appropriate level of assurance that the company will qualify (and continue to qualify) for the relevant tax reliefs.
- Acknowledging that there will have been pre-Series A funding rounds, the shareholders agreement provides for both founders and existing shareholders (whether as a result of prior seed rounds or the exercise of convertible loans, SAFEs or ASAs) being parties. Careful thought will need to be given to the rights and obligations of founders, existing shareholders and investors to ensure voting thresholds, consents and the ability to vary the shareholders agreement and articles are set at levels that do not give small minority shareholders a veto on future funding rounds and decision making.
- The shareholders agreement also provides that it can be amended and reinstated on subsequent funding rounds. Specific consideration will need to be given in determining what terms and rights of shareholders continue (and how) from prior funding rounds. In relation to the continuation of warranties from previous rounds, this should be made easier to track by having the separate and standalone subscription agreements for each funding round.
- As before, the shareholders agreement deals with the control, oversight and governance of the company and its group (including information rights, board appointments and undertakings from founders). Considerations to be aware of are:
- If founders or other management are subscribing for shares in this or any previous round entry into appropriate elections under section 431 of the Income Tax (Earnings and Pensions) Act 2003 and relevant undertakings to pay any tax should be considered, and
- Where there are multiple investors coming into the round who are both institutional and non-institutional, the lead investor on the round will need to consider the appropriate thresholds for the investor consent requirements. A decision will need to be made on whether that is simply by reference to a percentage of the series of shares being issued, or to a majority of a defined set of named investors. If it is the latter, consideration should be given on whether those investors will still have the ability to fund in subsequent funding rounds (for example because their fund concentration restrictions will have been reached or they are coming to the end of fund’s investment period) so will they be long term aligned investors or could their control become disproportionate to their overall investment when aggregated over all rounds. Please also see our article, here, on the recently reported DnaNudge Limited v Ventura Capital GP Limited  decision and the importance of considering the drafting of the rights of an “Investor Majority” alongside share class rights in a company’s articles of association.
- We also welcome the addition of specific ESG and sustainability undertakings within the undertakings being given by the Company under the shareholders agreement. Each investment and investor will have different considerations as to what will be appropriate ESG policies to adopt and these should be considered between the lead investor and the board at the outset of the investment round’s negotiations and regularly reviewed by the board moving forward.
The Articles of Association
Pre-emption on future funding rounds
- Clearly the terms around pre-emption rights on new share issues will be critical when it comes to meeting the further funding needs of the company. As the BVCA Articles clearly state, both the terms of the pre-emption rights and setting the disapplication of the rights need to be considered so that they are not unduly restrictive which opens up the risk of smaller investors (who do not have the liquidity to conduct a follow on investment) with a veto over future funding. In particular:
- The exclusions to pre-emption rights need to be thought through and, as a minimum, excluding shares issued under (board and investor approved) (i) share incentive plans, and (ii) consideration on future acquisitions should be considered.
- The new BVCA Articles do, however, include a form of “anti-embarrassment” protection for all investors, which means that if the pre-emption rights are waived by an investor who subsequently participates in the new funding round, then the other investors will be also entitled to participate in the funding round pro rata to their existing shareholding. The inclusion of this provision and the class of investors who have the benefit of this protection needs careful thought by the lead investor and company.
Permitted transfers for investors
- As investment periods become longer, focus should be given on the permitted transfer provisions under the articles. Under the BVCA srticles, for venture capital and other fund-based investors, share transfers are allowed to other members of the same fund group. If, following a transfer of shares amongst a same fund group, the original shareholder and the permitted transferee of shares ceases to be in the same fund group, the shares need to be transferred back to the original shareholder or there is a risk that a mandatory offer of the shares to other shareholders is triggered. These provisions need to be carefully reviewed to ensure transfers to continuation / run-off funds or out to LPs of the funds are permitted.
- Change of control provisions are also included in the articles which also potentially trigger a mandatory offer of shares on a change of control. It should be made clear that these provisions do not apply to investors.
Departing founders or employee shareholders
Depending on the circumstances in which a founder or employee who holds shares leaves (and whether they leave as a “good leaver” or “bad leaver”), the articles provide that a proportion of a good leaver’s shares (being the “unvested” element) are converted into deferred shares, and the balance retained. Investors will have their own views on this, particularly on (i) the length of the vesting period for these founder’s shares, and (ii) whether it would be more appropriate to have a fair market determination to value the shares and require the founders to sell some or all of their vested shares when they leave. That will be a decision for the lead investor on the combination of treatment of a leaver’s shares.
Drag along provisions
There are sensitivities on the extent to which obligations can be imposed on a shareholder who is being dragged (forced to sell their shares) on an exit. The BVCA articles seek to adopt a more balanced approach, so that rather than limiting the dragged shareholder to giving title and authority warranties only, the articles seek to apply a proportionate approach on what are termed "common liabilities" on a sale. Common liabilities include any (pro rata) contribution to price adjustments (such as an earn out or completion accounts adjustment) and any liabilities under any general warranties being given on a dragged sale. However, these provisions make clear that a dragged shareholder’s liabilities are limited to the extent of any unpaid or held back consideration and that the shareholder is not required to repay consideration that has previously been paid. Specific advice should be taken on whether these are appropriate extensions to drag along provisions and whether, in the specific circumstances of the investment, they strike the balance between the enforceability of the drag along and the extent of the shareholders’ collective liabilities to achieve a successful and non-contentious sale.
Management of conflicts of interest for investor directors
This is an important element to ensure that the articles provide for the continuing approval of a director’s conflicts where those directors have been appointed by an investor. The conflict provisions within the articles should be carefully reviewed to ensure they have covered the potential conflicts that may arise as a result of the individual being a partner or employee of the investor and being appointed to the board of the company.
Although not expressly covered by the BVCA Model Documents, we would also recommend that, as part of the closing conditions, a deed of indemnity is entered into by the company and any new director being appointed by an investor. Under this deed the company will, in addition to any directors and officers insurance available, agree to indemnify the director for any decisions or acts taken in that capacity (to the extent allowed under the UK Companies Act).
The introduction of the updated BVCA Model Documents is a constructive step by the BVCA to provide a standardised market approach to early stage venture investment and, although it is relatively early days, we have seen a positive adoption of the documents amongst investors and advisers.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, October 2023