As U.S.-based venture capital funds have become an increasingly significant source of capital for UK start-up and scale-up companies, the negotiation of terms often give rise to gaps in expectations and market norms between the two jurisdictions.
Many of the differences are often a function of the investment styles in the respective markets. Generally speaking, U.S. venture and growth investors tend to invest with a more aggressive high risk/high return approach, whereas UK-based funds often take a more targeted approach with less potential for upside but similarly less risk of downside. While neither approach is right or wrong, it is important for the parties to enter into any deal with full awareness as to the differences in expectations among investors. Without alignment, founders, management, and investors often find themselves at odds soon after investment leading to painful changes that often limit value for all parties or even complete failure of the business and loss of investment.
In addition, while the U.S. and UK share a common legal tradition, there are systemic differences in deal structure as well driven by both differences between various elements, both substantive and structural, of UK and U.S. law and regulatory processes.
While there still remain more similarities than differences in the style of deals in both jurisdictions, this article highlights the top differences in structure, process and terms between a U.S. and UK-style venture/growth capital deal.
1. Typical Transaction Documents and Timing
The most obvious difference between UK and U.S. VC financings is the structure of the transaction documents. A U.S. deal appears to have more documents than a UK deal, which will frequently confuse each party. The U.S. investor will think the UK documents are not fulsome enough, while the UK investor will be concerned that the parties are spending too much detail on the documents.
First, it is helpful to explore some history. The U.S. uses a widely accepted sets of model documents as a framework for transactions. The U.S.-based National Venture Capital Association (NVCA) model documents are used in 80 percent-plus of venture financings as a baseline. That is not to say that NVCA-styled deals are not negotiated, but the NVCA forms have been in use for decades and are updated annually with input from a number of market sources, so the exercise is much less custom-built. Additionally, the U.S. forms were designed from inception for the venture capital lifecycle: modular to allow raising multiple rounds of capital and designed to facilitate a sale or IPO. By contrast, the UK has a younger corollary to the NVCA: the British Venture Capital Association’s (BVCA) model documents. Historically, the BVCA model forms were based on private equity-styled documents that were less functional for layering in multiple rounds of financing and emphasized control by certain named parties. As a result, until recent modifications to the BVCA forms, they were less widely adopted in practice as compared to their American counterparts. However, with changes in recent years, they are increasingly aligning with principles in the NVCA models to make them more user-friendly and an increasingly preferred starting point for drafting.
Second, in terms of difference in structure, the NVCA includes five main transaction documents, whereas the BVCA only has three main transaction documents. Overall, however, the suite of rights is fairly similar except as further explored herein. The difference in document sequencing is largely driven by three major factors: i) the public availability of documents, ii) enforceability considerations under Delaware law, and iii) U.S. IPO disclosure requirements. In the U.S., the only governing document for venture-stage companies that can be accessed publicly in most cases is the company’s Certificate of Incorporation; there is no public stock ledger or list of directors or shareholder resolutions. As a result, the parties treat the certificate of incorporation, which is generally the most superior document, as written for all holders of the securities, and then layer in specific rights into the supporting documents. In addition, the Right of First Refusal and Co-Sale Agreement and Voting Agreement are designed to fall away upon an IPO and thus never need to be filed publicly in a public offering.
Third, in terms of deal efficiency, despite having more pages, the NVCA forms tend to be a more well-trodden path for parties and are built for greater speed to execute and fewer points of drafting failure. By contrast, the BVCA forms have only recently become more streamlined and also tend to include more detail to populate. As a result, the average NVCA-styled deal will tend to move from term sheet to completion faster than a BVCA-styled deal largely due to efficiency of the form.
Fourth, the litigation environment of the jurisdiction will inform the level of detail. The U.S. generally does not have the “loser pays” rule common in the UK and many other countries; in many non-U.S. countries, the loser in litigation bears a significant part of the winner’s legal fees. While the NVCA has an optional provision for the parties to agree that loser pays, the more typical environment in the U.S. is that even a relatively weak claim in the U.S. has value because the party bringing the claim knows the defendant’s cost to settle the claim likely is less than the cost of defending it. Thus, U.S. investors tend to seek greater clarity in the documents on the front end, making them more detailed than a non-U.S. deal, with an eye towards avoiding a potential for dispute completely since the prospect of a dispute may be higher.
2. The Effects of Tax Considerations for Early-Stage Investors
In the UK, certain qualifying investors can gain preferential tax treatment on income and capital gains relating to an investment through the UK’s Enterprise Investment Scheme (EIS) and Seed Enterprise Investment Scheme (SEIS) depending on the type of shares purchased by the investor and duration of holding in qualifying companies. Venture capital trusts (VCTs) also offer investment vehicles that give individuals income tax relief on VCT investments.
SEIS/EIS investment plays an important role in the UK pre-seed (and seed) VC tech ecosystem, and to qualify for tax relief, in addition to the Company meeting certain substantive criteria, the SEIS/EIS/VCT shares must be equivalent to full risk ordinary shares (i.e., they cannot be redeemable or carry any special or preferential rights save for limited preferential rights to dividends). Additionally, the liquidation preference language will be bifurcated for situations where SEIS/EIS/VCT shares can gain a preference and where it cannot by law. The result of these structural risk limitations is the SEIS/EIS/VCT shares look and are meaningfully different when compared to more classic venture/growth capital investment terms. In early-stage UK financings, it is not unusual for SEIS/EIS/VCT shares to be issued without dividend or full liquidation preferences and/or anti-dilution protection.
In the U.S., U.S. taxpaying investors can take advantage of a similar investors purchasing qualified small business stock, or QSBS, in a financing to exclude a certain amount of the gains on a sale of such stock made at least five years after the initial purchase if the entity is a U.S.-organized corporation. Unlike SEIS/EIS/VCT, the requirements for QSBS generally relate to the stage and nature of the underlying business and not to the investment features of the shares purchased except with respect to later buybacks by the Company. As a result, outside of a few sentences in the documents that express the desire of the investors to qualify for QSBS treatment, there is little difference in the substance or look of QSBS-eligible shares.
As a result, there is structural tension between some UK and U.S. investors around this issue. SEIS/EIS/VCT investors often insist that if they cannot have anti-dilution or liquidation preferences, no investor should get it. By contrast, U.S. investors in UK companies cannot avail themselves of SEIS/EIS/VCT or QSBS tax breaks, and they expect to have the typical protections they are used to having. Most deals result in having parallel series of shares that may be SEIS/EIS/VCT-eligible but lack the same preferences and protections as the other investors as a compromise, but this can be a major flash point between parties. UK SEIS/EIS/VCT investors feel aggrieved because they are taking lesser rights, while U.S. investors are not getting the same tax benefits and expect to get the full suite of investor protections as a result.
3. Warranties and Recourse
Both the NVCA Stock Purchase Agreement and BVCA Subscription Agreement include a series of warranties (or statements of fact) relating to the issuing company and its business. While the NVCA warranties tend to be much more detailed and specific than the BVCA set, the NVCA is largely silent on procedures for breaches of warranties (except a time limit for claims). In addition, U.S. investors generally eschew founder warranties as not meaningful and off market. A later article in this series will dive deeper into the warranty practices in the U.S. and UK and how they shape an underlying deal.
4. Diligence and Disclosure
In the UK, the company will generally prepare a separate disclosure letter, which will contain both general and specific disclosures that modify warranties. While typical U.S.-styled venture deals include specific disclosures it is not customary to permit general disclosures. As a result, U.S. investors often resist general disclosures in UK disclosure letters and typically expect more extensive warranties. Stay tuned for a future article in this series, which will provide more context on the similarities and differences between disclosure standards.
5. Founder Vesting and Leaver Provisions
The management team is typically the key component of an early-stage company’s business value. As a result, investors in both U.S. and UK companies use contractual provisions to incentivize founders and key executives to remain with the company after the financing beyond merely the opportunity for appreciation of their shares. An upcoming article in this series will provide a more detailed discussion of the differences between the NVCA-style vesting schedules and the BVCA-style vesting and leaver provisions that each jurisdiction typically uses to provide those incentives.
6. Employment, Non-Competition and Non-Solicitation Provisions
In the UK, investors often seek to protect their investment by including restrictive covenants on founders and key executives in both the Shareholders’ Agreement and in separate service agreements. These include engaging in completion or soliciting employees or customers. Many UK employees also have statutory protection over termination service and guaranteed notice periods such that they are not easily terminated. As such, there is a certain degree of balance between the position of the founder, who is entitled to some protection before termination, and the position of the company, who will seek non-competition protection.
By contrast, restrictive covenants are less commonly requested by U.S. investors due to issues surrounding enforceability which vary by U.S. state. However, major tech centers including California and Massachusetts generally prohibit non-competition provisions except directly in connection with a sale of a business. In many jurisdictions, not only are the provisions unenforceable, but they may result in penalties against employers. Accordingly, U.S. investments nearly universally do not include non-competition provisions. However, founders also bear greater risk of termination under U.S. employment law, which generally favors at-will employment arrangements with no statutory notice and severance periods in most cases. We explore these restrictions and their enforceability on both sides of the Atlantic in greater depth in an upcoming article in this series.
7. Investor Protective Provisions (a.k.a., “Veto Rights”)
Both the BVCA and the NVCA model documents typically include minority investor consent rights over certain key shareholder decisions involving the company. While the NVCA tends to limit these rights to shorter list of fundamental matters that go to the heart of the investment (e.g., liquidation of the company, exit decisions, issuing shares pari passu or senior to the preferred class and transactions or arrangements involving founders, among others), the BVCA list of investor veto matters is far more extensive and includes operational matters as well. In addition, where an investor or group of investors has a right to appoint a director to the board, a BVCA deal will also typically include a list of investor director veto rights over certain board decisions. By contrast, although the NVCA model form includes a more limited list of investor director veto matters as an optional provision, they are less commonly included in U.S. deal documents.
8. Anti-Dilution Provisions
Both U.S.- and UK-styled deals often include anti-dilution rights that provide enhanced economic protection for investors from the full dilutive effect of a down-round, which are typically based on a broad-based weighted average mechanism. As noted earlier, a fundamental difference on inclusion of these provisions is influenced by SEIS/EIS/VCT status of UK investors, who cannot avail themselves of such protection.
9. Share Issuances and Transfers
The NVCA and BVCA model documents both include restrictions on the transfer of shares of the company. These restrictions come in the form of pro rata rights (referred to in the UK as preemptive rights) on new share issuances and rights of first refusal over transfers.
UK company law requires new issuances of shares for cash to first be offered on a pro rata basis to existing shareholders. Such rights can be disapplied by a 75 percent majority of voting shareholders either generally or in respect of specific issuances. Modified preemption rights on new issuances are typically included in BVCA financing articles of association and are often made more broadly available to shareholders. By contrast, the most U.S. jurisdictions do not have mandatory preemption rights. However, the NVCA financing documents typically include contractual pro rata rights in respect of new issuances of shares, although this is often limited to large “major” investors and not to all stockholders.
Both the NVCA and BVCA model documents grant a contractual right of first refusal to investors (typically restricted to major investors in the U.S.) over transfers by founders and certain other ordinary/common shareholders. In addition to these rights, U.S. and UK deals usually include investor co-sale participation rights, minority tag-along and majority drag-along rights (typically exercisable in each case on a change of control or exit sale) on broadly similar terms.
The most fundamental difference however between the U.S. and the UK is who is restricted on transfers. In UK deals, it is much more typical for all shareholders to be subject to restrictions on transfer while the company is private. By contrast, U.S. venture investors are generally never subject to restrictions on transfer, although they expect the common stockholders (including the founders) to be limited. This is likely due to certain structural differences in U.S. securities laws regarding resales but also the nature of the U.S. venture community, which has a much greater volume of repeat players that rely on the reputational effect of dissuading transfers before all parties exit.
10. Registration Rights
U.S. investors typically expect to include provisions relating to registration rights, which allow them to compel the company to register its shares with the SEC at a later date to facilitate a resale when the company has gone public. These are generally of limited concern to companies and largely serve to protect larger investors from being treated differently from smaller stockholders that can sell without restriction in a public market.
In UK financings, registration rights are rarely requested as the UK securities laws do not impose the same restrictions on larger shareholders. However, the BVCA model documents in recent years have included registration rights in less detail along with an optional form registration rights agreement to help accommodate U.S. investors.
One other key difference outside the term sheets is also how quickly parties “lawyer up” in each jurisdiction. U.S. parties tend to involve their counsel earlier in the process, often at a term sheet stage. By contrast, UK investors do not tend to engage counsel quite as early for cost concerns. However, UK founders are often at a disadvantage if they do not lever experienced counsel at the term sheet stage. The most valuable bargaining chip a company has in a process if the competitive tension it can create among investors, but that bargaining power can be lost if the company signs an incomplete or one-sided term sheet that also results in weeks of exclusivity for an investor. Accordingly, in addition to appreciating the major differences in terms, we would also urge founders to plan ahead at the term sheet stage on all these issues.
