Road Map to Europe III - Why Europe is an Increasingly Exciting Place to Fund and Grow Companies
It's a common issue: a US venture capitalist and a European company agree on the commercial terms of an investment transaction and think that the hard work is done but quickly find themselves at an impasse over the way the transaction will be documented. With the increase in cross-border venture capital transactions, particularly US investors taking stakes in European companies, this is an issue that companies and investors are dealing with more regularly than ever before.
From a commercial perspective, a venture capital transaction (where an investor or a group of investors privately acquires shares in a company) should essentially be the same transaction, regardless of jurisdiction. In practice however, documentation styles vary considerably outside of the US, which can be seen to be frustrating by many venture capitalists, the majority of which are US based.
This article focuses on two of the principal forms of venture capital documentation – US (NVCA) and UK (BVCA) – that are often looked to as international standard form investment documentation. This article seeks to identify several of the more salient aspects in which these two forms of documentation diverge from each other and should act as a guide for US based investors who are looking to invest into European companies and for European based investors looking to invest into the US.
A typical venture capital transaction, whether it is an investment into a US or a UK company, involves the following key elements:
The investor or investors subscribe for (referred to as "primary") or purchase equity (referred to as "secondary") in a private company in return for cash.
Investors typically receive a class of preferred stock which provides a priority right to receive payments in the event the company is sold, liquidated or wound-up.
The company and, in some cases, its key executives or founders provide investment related protections (representations, warranties or indemnities) to the investors about the company and its business.
The investors are given various rights by the company, including rights to receive financial and other information relating to the company.
The investors are given board membership, granted board observer or other representation rights.
The rights of the parties on an "exit", particularly an initial public offering or sale of the company, are defined.
When comparing documentation used in typical US and UK venture capital transactions, a number of key differences emerge, including, in particular:
form and style of documentation (inclusive of terminology used);
representations and warranties; and
scope and style of investor protections.
Form & Style of Documentation (inclusive of terminology used)
Almost exclusively, a US venture capital transaction involves use of industry standard documentation (based on the NVCA form) which involves the following key documents:
The Stock Purchase Agreement. This agreement includes the mechanism for the purchase (subscription) of shares by the investors, the representations and warranties and the arrangements for the closing of the transaction. Typically this agreement also includes terms requiring the company to provide the investors with information on, and access to, its business.
Schedule of Exceptions. This is a schedule to the Stock Purchase Agreement that sets out disclosures against, or exceptions from, the representations and warranties given to the investor.
The Investor Rights Agreement. This agreement typically includes registration rights (provisions relating to an eventual public offering and registration in the US), information and board rights as well as pre-emption rights over future stock issuances.
The Right of First Refusal and Co-Sale Agreement. This agreement typically includes rights of first refusal, co-sale rights, as well as stock transfer provisions.
The Voting Agreement. This agreement typically includes board composition arrangements and drag-along rights.
The Certificate of Incorporation. This is the constitutional document of the company. When an investor is to purchase preferred stock with special rights such as anti-dilution protection and liquidation preferences, the company's Certificate of Incorporation must be modified (or, in some cases, a Certificate of Designation may be used) to grant such rights.
By-Laws. The by-laws, together with the Certificate of Incorporation, regulate the internal governance of the company. An investor will sometimes require that these be modified if they contain corporate governance procedures deemed unsuitable for the company; often, however, the by-laws can be left as they are.
In a typical UK venture capital transaction, the following documents are typically involved:
"Investment Agreement", or "Subscription and Shareholders' Agreement" (SSA). This agreement, regardless of the name used, is a combination of a Stock Purchase Agreement and the Shareholders' Agreement. As such, it includes the mechanism for the subscription of shares and sets out certain of the investor's rights. As an alternative, some investors prefer to have a separate "subscription agreement" and a stand-alone "Shareholders Agreement" which eliminates the redundancy of the subscription section of the SSA post-closing.
Articles of Association. This document is the UK equivalent of the Certificate of Incorporation and By-laws combined. It typically includes share class rights, pre-emption rights on the issue and transfer of shares and provisions dealing with the mechanics of holding board and shareholder meetings.
Disclosure Letter. This is a letter from the company to the investor that sets out disclosures against, or exceptions from, the warranties given to the investor. This letter is the equivalent of the schedule of exceptions at the back of the US-style Stock Purchase Agreement. The disclosure letter, and warranties and indemnities generally, are discussed further below.
Employment Contracts. Investors in UK-style transactions frequently require key executives of the company to enter into new employment contracts (sometimes referred to as “service” contracts) in a form approved by the investors. These will typically set out in detail the terms and conditions of employment of the executive and will impose restrictive covenants after his or her departure from the company. These restrictive covenants are discussed further below.
The constitutional documents of a company must, of course, comply with the requirements of the jurisdiction in which the company is organized; however, there is nothing inherent in either the US or the UK system that dictates the use of one style of documentation (or even governing law) over another. Generally, parties to a venture capital transaction choose the form of documentation traditionally associated with the organisational jurisdiction of the company (and if it is a European based target, often use English law documents as the default).
In addition to the differences in approach in terms of the style of documentation, the terminology used in US and UK venture capital transactions also differs. For example, venture capital investors in a US company "purchase stock" or have a "co-sale right", while investors in a UK company "subscribe for shares" or have a “tag-along right”. The choice of terminology is largely dictated by the jurisdiction in which the company is organised and is generally inconsequential at a commercial level. The appropriate terminology can be used with either style of documentation.
US companies are most commonly incorporated in Delaware because of the state’s business-friendly reputation, which includes flexible business formation statutes (allowing for flexibility in structuring business entities and allocating rights and duties), a specialized, highly experienced court dedicated to hearing corporation cases which brings with it the additional benefit of well-established case precedent (which provides greater guidance reducing the need for litigation) and an efficient Secretary of State (which reduces administrative burdens and hold-ups). Most US investors also tend to prefer Delaware because of the ease with which capital stock can be transferred (including the ability to go public). Furthermore, the corporation law of Delaware enjoys the advantage of being widely familiar to legal practitioners across the United States.
UK companies are incorporated under the Companies Act 2006 (as amended) (the "Companies Act"), which regulates the incorporation and operation of companies incorporated in England and Wales. It is equally quick and easy to establish a company in the UK as compared to Delaware and similarly inexpensive. The English courts are also highly regarded and seen as sophisticated and impartial.
Representations and Warranties
UK companies will usually only give "warranties" while US companies will give both representations and warranties. The difference is more than terminology. Under English law, a misrepresentation can allow an investor to rescind the contract. Further, a claim for misrepresentation is a claim in tort instead of contract, and the level and type of damages that can be claimed may be higher (depending on the circumstances of the claim).
Another significant difference in the treatment of warranties in typical US and UK venture capital transactions is in the manner in which disclosures (or exceptions) to the warranties are given. While the form of delivery of "specific" disclosures differs (between a schedule of exceptions (US) to a disclosure letter (UK)) it is the additional inclusion of “general” disclosures in the UK that is the material difference. General disclosures are typically disclosures of those matters of which the investors are deemed to have public knowledge, such as matters on public record and frequently the entire data room (or at least a large bundle of specific documents) being deemed disclosed. General disclosures, however, are not a usual feature in the US transactional landscape and as such, by and large, met with resistance by US investors.
In both the US and UK, a number of limitations are given on the liability of the warrantors, such as time limits within which warranty claims must be made, caps on liability of the warrantors and minimum financial levels for claims before they can be made. These limitations are frequently the subject of detailed negotiation between the parties.
Finally, in the US, founders do not typically make representations or give warranties. Business warranties are, however, often given by founders in the UK, typically capped as a multiple of salary.
One area of common ground between representations and warranties given in typical US and UK venture capital transactions is that it is extremely unusual for actual claims to be made. The threat of litigation is nonetheless seen as a valuable way of ensuring thorough disclosure and of driving an investor's due diligence investigation of a company.
Scope and Style of Investor protections
It is in the area of investor rights that the biggest differences lie between typical US and UK venture capital transactions. The differences are particularly acute in relation to:
founder and executive share retention rights;
registration rights; and
pre-emption rights on issues and sales of shares.
Anti-dilution protection has long been a standard feature of both US and UK venture capital transactions, with almost all transactions using a weighted average basis for calculating anti-dilution. The main difference is not the way in which it is calculated but rather the manner in which any anti-dilution benefit is provided to the existing shareholders. In the UK, upon the occurrence of an anti-dilution event, usual practice is to grant the existing shareholders such number of shares as to compensate for the requisite dilution. In the US, due to the potential impact of deemed dividend rules (i.e. the granting of additional shares being seen by the IRS as deemed dividends), shares are not granted in lieu of imposing an adjustment to the conversion rate of the preferred shares held by the investor as well as voting being done on an as converted basis.
Typical US and UK venture capital documentation contain lists of certain operational or corporate actions which require the prior consent of the investors. Such actions include matters such as issuing new shares or changing the constitutional documents of the company. In the US, this list is normally limited to a number of key protections of shareholder rights, and the investors rely otherwise upon their board representation to protect their interests. In the UK, the list is likely to be longer and can include matters often regarded as pertaining to the normal business of the board of directors, such as changing key employee terms and conditions. US investors generally will not request an extensive list of consent matters (even of a UK company) unless prior investors have already received such protections.
Non-compete provisions or restrictive covenants on the activities of a company's founders or executives are commonly found in UK venture capital documents (in favour of the investors) as well as employment contracts (in favour of the target company). The objective of these provisions is to ensure that, having invested money in a company, the founders or executives do not leave and set-up a competing business or poach employees or customers. To ensure that the restrictions are enforceable under English law, the restrictions must be limited in scope and duration.
In the US, by contrast, non-compete provisions in venture capital documents are rare, principally because they are difficult or impossible to enforce. Further, in the US, employees are commonly employed at will, without any written contractual terms of employment, although employment agreements (rare) or offer letters (more common) may be required for a founder or a particularly key employee. Even where such agreements are in place, they will rarely contain non-compete provisions because of the difficulty in enforcing them.
Founder and Executive Share Retention Rights
Because a company's management team is often a key component of its value, investors in both US and UK venture capital transactions usually seek to provide incentives for founders and key executives to remain with the company. Vesting and reverse vesting provisions will often be instituted upon founders and key executives and there may be punitive actions taken (including forfeiture) in the event that founders and key executives leave the company under certain circumstances, usually linked to bad or criminal behaviour, although this is more usual in the context of a UK transaction than a US one.
While both the US and the UK usually feature time based vesting (rather than performance based) that allows for increasing levels of share retention the longer the individual remains with the company, UK-style transactions additionally provide for differing levels of share retention depending on the circumstances under which the individual leaves the company. There are often categories and even sub-categories for departing individuals, generally referred to as "good leavers" and "bad leavers", the determination of which impacts the treatment (economic or otherwise) of the departing individual’s equity ownership stake in the business.
A common feature of UK venture capital transactions is the requirement for a mandatory takeover offer to be made by any 3rd party purchaser once they acquire 30% or more of the share capital of the Company. This is a replication of the same right that applies in the public markets in the UK as well as across the EU and certain markets in Asia. The obligation is such that when a 3rd party acquires a defined level of shares, they must make an offer to purchase all of the shares in the company from each of the other shareholders at a price per share not less than the last price paid for shares in the company. This obligation does not typically feature in a US transaction.
A standard feature of US venture capital transactions is the right of the investors to compel the company to register shares. This is due to a double hurdle for shares to become publicly traded in the US – the class of shares must be admitted to trade AND the specifically held shares must also be registered. By contrast, in any listing of a company's shares on the London Stock Exchange or another European market, the entire issued share capital of the company is included. Consequently, registration rights are not relevant when seeking a listing outside of the US.
There are two basic types of registration rights: demand rights and piggy-back rights. Demand rights entitle an investor to compel a company to file a registration statement with the US Securities and Exchange Commission (SEC) covering the shares held by an investor. Piggy-back rights are available where a company is already in the process of filing a registration statement; with these rights, an investor can oblige the company to extend the registration statement to cover the investor's shares. These rights are particularly important because unregistered shares can only be sold to a relatively small universe of potential purchasers.
Where a venture capital transaction has a nexus with the US, it is usual to have a registration rights agreement in place where requested by investors. Even where there is no nexus with the US, there is a growing trend for investors in technology companies to seek registration rights in anticipation of a possible future US listing.
Pre-emption rights on issues and sales of shares
In the UK, the Companies Act requires new issues of shares to first be offered pro-rata to existing shareholders unless otherwise disapplied by shareholders in relation to a specific issue of shares or generally. Modified pre-emption rights are therefore commonly included in the Articles of Association of a company. These may require that any shares not taken up by existing shareholders be offered again to other existing shareholders before being sold to a non-shareholder.
As the laws of Delaware and most other US jurisdictions do not grant shareholders pre-emption rights automatically, US transactions generally will provide for such rights. The pre-emption rights granted by these provisions in US-style agreements do not differ markedly from typical pre-emption rights in a UK-style transaction.
US and UK venture capital transactions are also alike in typically including rights of first refusal on proposed transfers of shares. Rights of first refusal require a selling shareholder to first offer the shares to the company and/or the other shareholders. Only if the company and/or the other shareholders decline to purchase the shares can the shares be sold to non-shareholders (and even then, they may only be sold for the same price and on the same terms that the shares were offered to the existing shareholders).
There are a range of differences between the documentation of, and rights granted in, venture capital transactions in individual international jurisdictions. Some of these differences are rooted in local law, but many are simply a product of common practice. We have chosen to highlight several of the more salient differences between US and UK style documentation. While there are more commonalities between the two styles than there are differences, a better understanding of the differences makes for a smoother execution process and leads to less friction during the lifecycle of the investment.