knowledge | 12 March 2021 |
Start-Ups – A Guide to Venture Capital Fundraisings
For many start-ups, completing a venture capital fundraising is an important milestone in its lifecycle as they try to scale the business with a view to an exit. The prospect of engaging with a venture capital firm (a “VC”) can be a daunting prospect for founders and we are often asked what they can expect if they seek VC funding. This briefing contains a short description of what venture capital means and a summary of some key rights and protections that often form the basis of negotiation in a minority investment by a VC in an Irish private company.
1. What is Venture Capital?
Venture capital is a subset of private equity and its essential characteristic is the provision of long term capital to unquoted companies that are at an early-stage of development but are judged to have a high-potential for growth. A VC seeks to make money by owning equity in the companies it invests in, which usually have a novel idea or business model in high technology industries, such as biotechnology, information technology or software – essentially, only a company that appears poised for significant growth will be an attractive proposition for a VC investor.
Venture Capital is capital provided by full-time, professional firms who invest with management in ambitious, fast-growing companies with the potential to develop into significant businesses.
The typical initial venture capital investment (sometimes referred to as the Series A Round) occurs after smaller initial funding has occurred (e.g. with family and friends and/or angel investors) and the investee company is in a phase of research and development or is moving from the research and development phase toward commercialisation and exploitation. Making investments at the early stages of a company’s development, often before the company’s product or service is much more than just an idea, involves significant entrepreneurial risk, which in turn severely limits the range of capital sources that are available for such companies. VCs are willing to assume this risk alongside the company founders by providing capital in exchange for an equity stake in the company. An investment at this stage of a company’s life cycle can allow it to grow and expand at a point in time where its business is immature or its revenues are insufficient to support development.
The VC’s goal is to grow the investee company to a point where it achieves an exit, most typically through a sale of the company to a trade or financial buyer or an IPO at a price that far exceeds the amount of capital invested. Approximately one-third of investee companies fail, so those that do succeed must do so in a big way in order for the venture capital fund to make an acceptable return.
Venture capital is very different from debt finance as a venture capital investment is usually in return for an equity stake in the investee company, with no security granted to the venture capital investor. In addition, there is usually no defined time-line for repayment of the investment. Although VCs generally seek to exit three to five years after investing in a portfolio company, this may not always be achievable, as the exit opportunities will be driven by whether the investee is ready for a trade sale or an IPO and the state of the M&A and IPO markets.
2. Common Rights and Protections in a VC Negotiation
Preferential Returns on Investment
Most VCs will require a preferential return on their investment in the event of a sale, liquidation, winding up or dissolution of the company. Often the VC’s shares will contain special rights which shall entitle the VC to receive (before any return to holders of any other shares) a fixed amount of any net proceeds to be distributed amongst the shareholders. Depending on the nature of these preferential rights, the VC’s shares may entitle to investor to receive this fixed amount but also then participate pro-rata in the remaining proceeds to be distributed to the other shareholders.
In addition, sometimes a VC will seek to have a fixed preferential dividend right in priority to the other shareholders. This ensures that the VC’s shares are continually accruing value during the lifecycle of its investment. However, it would be more typical for a VC to participate in any dividends on the same basis as the ordinary shares in the investee company.
Lock-Up/Restriction on share transfers by Founders
Often a VC will totally preclude founders/key individuals in the business from selling any shares, unless the investor consents otherwise. The rationale is to ensure that the key drivers of the business remain fully focussed on the job of running the company. There would often be carve outs from these restrictions for transfers between permitted transferees such as such as family members, trusts or to related corporate entities. Founders will typically seek to include a “sun-set provision”, so that these restrictions cease to apply after a certain period of time.
Restricted Transactions/Veto Rights
One of the primary sources of protection a VC will seek is so-called “negative control”, which is a list of matters which cannot be undertaken without the prior consent of the VC. The primary purpose of these veto rights are to ensure the company does not take any actions that would impair the value of the VC’s investment.
Depending on the relative bargaining positions, the list could be relatively short, dealing with matters relating only to the rights attaching to shares and the issue of new shares in the company. However, often the veto list can be significantly longer and deal with many key matters relating to the company’s business (e.g. hiring and dismissing employees, borrowing/lending and making material decisions in relation to the business).
Director appointment rights & Observer rights
Generally, an investor will look for a contractual right to appoint a director (or a set number of directors) to the board of directors of the company. Where any shareholders are to have an entrenched director appointment right, it is often agreed that this right to appoint a director would be linked to their continued holding of a certain percentage of the issued shares (e.g. if their shareholding fell below 10%, they would no longer be entitled to appoint a director to the board).
It is often the case that an investor will not intend to exercise their director appointment right in the first instance, and in such circumstances it would not be uncommon to have a supplementary right to appoint an observer to attend any board meetings (but not to vote) in lieu of the appointment of an investor-nominated director.
VC investments will be accompanied by some level of protection in the form of warranties (often to be given by each of the founder shareholders and/or the company) in relation to the company and its business. The scope of the warranties may vary significantly depending on the nature of the business, the age of the business and the relative bargaining positions of the parties.
The warranties will generally be subject to market standard limitations including caps on the maximum liability of the warrantors. Often founders can negotiate much lower financial caps than the company in terms of their exposure under the warranties, given that generally individuals will have fewer resources at their disposal than a corporate vehicle.
The idea of making the founders give warranties is as much about focussing their minds on the warranties as it is about the investor actually recovering from them in the event of a claim.
Protection of Goodwill
To protect the value of a shareholders’ holding in a company, it is usual for a VC to include a non-compete restriction in the shareholders’ agreement, that prevents all of the shareholders (or possibly just the management/founder shareholders) from competing with the company for as long as they remain shareholders (and often for a stated period afterwards). Areas typically covered include: non-competition with the business and non-solicitation of staff, customers and suppliers of the company.
Most VCs will seek some form of anti-dilution protection in relation to any additional issue of shares, warrants, convertible loan notes or options for shares at a price below the price the VC paid for its shares. This protection often operates by the issue of further shares at nominal value to the investor either through a bonus issue or by subscription by the investor for the shares at par.
Compulsory Transfers/Leaver Provisions
It is often provided that if an employee shareholder ceases to be an employee he must transfer some or all of his shares in the company to the company or to the other shareholders. The terms for the transfer of these shares would usually be dependent on the circumstances in which the employment ceased. In general these provisions can provide comfort to the VC that the key employees in the business are incentivised to remain with the business. Obviously this can be a sensitive topic for the incumbent shareholders who are also employees of the company and it can be a heavily negotiated term of the VC transaction.
Drag-Along & Tag-Along
Tag-Along describes an arrangement whereby if shareholder/group of shareholders (e.g. 50%+) wishes to sell to a third party he/they must first procure an offer for the other shareholders on the same terms. This often applies only where a majority of the issued shares in the company have agreed to sell their shares. This affords the minority shareholders (including the VC) protection against being left behind.
Drag-Along describes an arrangement whereby if one or more shareholders wish to sell their shares they can compel the other shareholders to sell their shares on the same terms. Typically, this will only apply when a certain percentage majority of the shareholders wish to sell their shares (e.g. 75%+). Although not a minority protection per se, a VC will typically require to be including in the formulation of the drag majority to prevent the VC investor from being forced to sell against its will.
How can we help?
McCann FitzGerald is a premier Irish law firm. With over 650 staff located in our principal office in Dublin and our international offices in London, New York and Brussels, our specialists are ready to help your business thrive. Our Corporate practice combines with our Company Secretarial and Compliance Services group to offer your start-up enterprise the market-leading advice that you need to grow, from corporate advice on fundraising and governance, to day-to-day advice on compliance matters – leaving you free to focus on developing your business. Please contact any member of the McCann FitzGerald Start Strong team for assistance.
This briefing is for general guidance only and should not be regarded as a substitute for professional advice. Such advice should always be taken before acting on any of the matters discussed.