Scotland is a great place to start a company. It is also a great place to grow and develop a company. With so many early stage companies growing into strong, ambitious businesses operating on a global scale, it is clear to see what an exciting space we are in at the moment. With these global ambitions comes the need for more companies to raise growth funding, and many of those exhibiting at EIE this year will be looking for VC investment to do that.
With that in mind, it seemed logical that we take time to consider some of the terms often sought by VCs in particular and why these are important to them. Some of these terms may mirror those commonly requested by angel investors (and for a brief recap in relation to those, please take a look at a blog posted previously by my colleague Kenny Mumford) but there will be some important differences too.
To ensure you are able to have a meaningful dialogue with a potential VC investor, you should be aware of the following:-
Liquidation Preference: these provisions set out the way in which investors get paid first on a realisation event (such as a sale) and how much they get paid. Usually a VC will want to get its money out first by way of a liquidation preference.
For example, let’s say a “participating preference” of 1X applies in a deal where a VC has invested £5m in a company for a 50% stake (let’s keep the numbers easy for me). The company is later sold for £30m. The preference operates so that the VC gets their £5m back first, then the remaining £25m is divided between the shareholders. The VC has a 50% stake so it gets £12.5m of that (this is the “participating” element), with the remaining £12.5m split between the other shareholders.
Let’s run those numbers again on a 2.5X preference – so the VC gets back £12.5m first on the preference, leaving £17.5m to be divided amongst the shareholders. The VC also gets half of that by virtue of its 50% stake. Of a £30m sale, the VC receives £21.25, and the other shareholders split the rest.
You can see how different liquidation preferences can have a huge impact on the return delivered to different shareholders and the potential difficulty which is created if a sale could be a success for half of your shareholder base, but a disappointment for the rest.
Liquidation preferences can be tempered by provisions to prevent (or reduce the extent to which) a VC can participate twice in liquidation proceeds i.e. the preference right plus the participation as a shareholder. For example, you might introduce a mechanism in which the liquidation preference operates on a low value liquidation event (so the VC can get their money back first) but not on higher value liquidation events – in the latter, the VC would instead convert their preference shares into ordinary shares as they would do better that way than simply getting their money back.
That’s an overly simplistic scenario, but you can see that in practice you may end up landing on a combination of provisions to fairly balance a VC’s need for a preference and its participation as an equity shareholder, perhaps with specific hurdles attached. If different VCs are competing to invest in a company, these terms will be a key consideration.
Anti-Dilution: these provisions give VCs an element of protection where the value of an investee company goes down and further investment is raised at a lower share price (a “down round”). There are various different forms anti-dilution mechanisms can take but for the sake of keeping things simple, they operate to retrospectively adjust the share price paid by the VC – the VC gets more shares, as if they invested at the lower share price.
By way of example, I invest £1m in a company at a price of £100 per share. I get 10,000 shares. Six months later, further funding is raised, but at a price of £80 per share. The anti-dilution mechanism kicks in so that I am issued a further 2,500 shares, as if I had invested my £1m at the lower share price.
The above example shows the anti-dilution mechanism operating on a full ratchet basis, i.e. I adjusted the share price all the way down to the same price as the down round. This is the most draconian method and any company should try to negotiate a “weighted average” anti-dilution mechanism where the VC’s share price is only partly adjusted and greater account is taken of the total share capital structure that will exist after the down round. There are various different formulae that can be used to do this, to a lesser or greater extent.
The extent to which you are able to narrow an anti-dilution mechanism will depend on how comfortable a VC is with your proposed valuation. This is a constant challenge for early stage companies because with no profits and often little revenue, there’s no scientific way to get to a valuation in the millions – but that overlooks the future growth potential of these companies. So giving a VC an element of protection against anti-dilution can help de-risk what may seem, on the face of it, a hopeful valuation.
Preferred Shares: rights such as those above are granted to VCs by creating a new class of share, often referred to as “preferred” or “senior” shares in VC term sheets. These preferred shares will carry some of the preferential rights referred to above and may also enable dividends to be declared for the preferred shareholders only.
You would not normally expect to find these preferences in most angel term sheets because they would preclude the grant of SEIS or EIS relief to the angel investor.
This is something to factor into your negotiations with VCs – if you have existing angel investors, you may need to find a way to bring in provisions required by VCs without undermining the angels’ economic interests or prejudicing other provisions which are very important to your angels. Creation of a different class of preferred shares for VC investors is usually the way in which you would accommodate different rights for different shareholders, but you should also take tax advice in relation to the structure of any deal at an early stage to ensure that different (and perhaps, conflicting) interests can be managed.
If you have any questions about any of the issues raised in this blog, or generally in relation to any other aspect of raising VC or angel investment, please don’t hesitate to get in touch.
MBM Commercial LLP | Entrepreneurial Lawyers for Entrepreneurial Businesses
Laura Peachey | 0131 226 8234