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Top 5 series October 29, 2019
VC investments – top 5 issues for investors

VC investments – top 5 issues for investors

What are the top 5 (legal) issues for investors on VC deals…?

Venture capital fund managers, corporate venture capital teams and angel investors ask us that question all the time.

The supply of capital, leverage between management and investors, market conditions and deal structures generally change all the time – but, right now in the continuing tech bull market, here is what we are seeing throughout the cap table…

1 – Cap table is king

You can’t close a deal without a cap table.  No, you really can’t – no matter how many drafts of documents pass between lawyers, how many all parties calls are organised and how much noise is made in the background.  The cap table wireframes the deal and is the structure on which the investment documentation is built.  Drafting and circulating your investment agreement, subscription agreement, shareholders’ agreement and articles of association before the structure is locked down in Excel (or on a cap table platform online) is like building a house without instructions.  It’s also a sure-fire way of massively increasing legal costs and exponentially increasing the amount of time and energy needed to be invested into the deal by all concerned.  That said – even as we approach the third decade in this century – it is amazing how many deals we see where agreeing what the cap table looks like is shifted well down the list of priorities in favour of going round in circles on other issues.  Typically you’d want to see a new class of shares being issued to investors on each round/series and the share classes should be written into the cap table.  So too should the cap table prescribe the size of the (granted and ungranted) option pool, and make clear whether that goes in pre- or post-money.

2 – Ask for warranties – buyer beware

Ask for warranties from management and the Company.  Base them on something close to the BVCA standard wording, but also think about the specifics of the investee business and additional risks and circumstances that should be covered off.  That’s not because you want to be suing anyone, primarily in a VC context the warranties will flush out disclosures against them which will give you a detailed look at the risks, issues and potential liabilities lurking under that surface of the glossy investment deck first presented to you.  You definitely want a warranty that the cap table is 100% accurate, but you also want warranties as regards the assumptions in the business plan, the accuracy of the management accounts, IP, key commercial contracts, employees, (no?!) litigation, grant funding (if an EIS/VCT investor – goes to tax qualification), real estate, etc.  And you want management giving those warranties personally so that they have their ‘feet to the fire’ when running through that disclosure process (albeit with their liability capped at 1x-3x salary).

3 – Leavers

Imagine investing into the Company, and the next day management leave to work for a larger corporate or they win the lottery and move to Hawaii or there is some fraud or criminality in play or it turns out they are just grossly incompetent.  Well… guess what… they probably don’t have to give their shares back at that stage.  If your valuation of the Company was predicated on where the business will go in the future and what might happen at exit then management just ate your lunch.  What every investor wants is a set of leaver provisions hard-wired into the articles of association – but what they get will depend on the leverage they have in negotiations.  One key point that is often missed is that even a perfectly drafted set of leaver mechanics housed in the articles of association may well fall down if there is no or if there is a defective management service agreement with which they inter-relate.  Ask to see management service agreements and look at – if nothing else – the termination and notice periods and how they feed into the leaver provisions in the articles of association.  We took a deep dive into the subject in July this year.

4 – Consent rights

Next on the list of doomsday scenarios is the one where you invest into the Company and the next day management go spend the money on a Ferrari each.  As a minority investor, you aren’t controlling the Company or the board – but what you should be asking for is a list of consent matters to include re-arranging the share capital, winding the Company up, taking key recruiting decisions, entering into non-arm’s length agreements, not buying Ferraris, and so on.  You would usually ask for new share issuances to be included in the list, but suit-up for discussion on that as this gives you a de facto veto on the next round.  There is a standard list of consents in the BVCA model shareholders’ agreement, or ask us for one.  If you are co-investing alongside other funds or angels then expect to see arrangements where only the lead investor holds the reins on those consents (so that the business doesn’t grind to a halt waiting for consents to be given…) – but think about how much you trust the person holding the reins and where there are any specific carve outs where your consent is needed.

5 – Board seat and information rights

If you are investing a substantial sum or are the lead investor, or both, then you want a seat at the board.  The directors manage the Company and you want to be sat at the table for the key discussions, even if you can’t ultimately force anything through (although you may be wielding those consent rights referred to above).  You also want to see monthly management accounts – the rise of cloud accounting software has meant that you rarely see push back on this point any more, if there is push back then that may be a red flag in itself.  You may want to be prescriptive about the format of those management accounts.  You also want details of material litigation passed to you, so also details of any offer made to buy out the Company.  If management are pushing back on any of that, well, why…? And how can you help the business if you are not involved in the decision making and given access to management information?  Think also about insisting that a directors’ and officers’ insurance policy is put in place for the benefit of those on the board.

There are many other issues that could have been included in this list – restrictive covenants could well have been on the list above, so too tax status for EIS/VCT investor purposes – but the above are points we are advising investors to focus on in just about every tech and media deal right now.  When the supply of capital retracts and there are fewer cheques to go around then one or two down-side protections might make it onto this list, liquidation preferences and anti-dilution ratchets for instance.

This piece was prepared by Henry Humphreys.  All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice.  None of the above should be relied upon.  Always seek your own independent professional advice.

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