Venture Capital & High Growth Companies

A Term Sheet is the roadmap for the investment transaction. It sets out the key terms and conditions on which an investor proposes to invest in a company.

While a Term Sheet will typically be non-binding, it sets the direction of the deal — and it’ll be very difficult to row back from positions that are signed-up to at the Term Sheet stage. It’s therefore vital for founders to seek advice and understand all the terms before committing to a Term Sheet.

The level of due diligence will depend on the nature of the investor and size of the investment. Due diligence can be a time-intensive process for even small deals and it pays to be prepared in advance.

This term often causes confusion, as it provides investors with a preference on both a liquidation and a sale of the Company.

The preference gives investors a priority right to receive their investment back ahead of distributions to other shareholders. 

There are two common types of preference:

• Participating Preference (or double dip preference) — this gives investors both a priority right to receive their investment back and a share of any proceeds remaining once the initial preference has been paid. 
• Non-Participating Preference — this is a downside-only protection for investors, entitling them to either receive their money back or receive a pro-rata share of the proceeds on a distribution.

Anti-dilution rights protect investors in the event of a ‘down round’ — a subsequent round carried out at a lower valuation than the investor originally invested at. 

An anti-dilution mechanism seeks to deliver the investor with additional free shares to put them into the position they would have been in had their original investment been priced at the down round valuation.

Leaver-type provisions require founders to give up some or all of their equity if they leave their business. They’re designed to protect investors from the business being devalued as a result of a key team member leaving and free up equity for the company to incentivise a replacement.

Typically, leaver provisions are split into ‘Good Leaver’ and ‘Bad Leaver’ categories. A Good Leaver may be entitled to keep either all (or a vested proportion) of their shares, whereas a Bad Leaver may be required to forfeit all their shares.

The scope of the Good Leaver and Bad Leaver categories — and the number of shares to be forfeit in each case — differ from deal to deal. They’re often one of the most negotiated provisions in a venture capital investment.

Vesting (or reverse vesting) is a process by which a founder becomes entitled to keep an increasing number of ‘vested’ shares, depending on how long they’ve remained with the business. 

For example, an investor may require that a founder’s shares will vest over three years so that they become entitled to retain an increasing number of shares over a three-year period.

'Drag and Tag' provisions are common in most equity investments. A Drag Along right allows a majority of shareholders to force a minority to sell to a third-party purchaser on the same terms as agreed between the third party and majority. Some investors will require a right to force a drag unilaterally after a certain period of time. 

A Tag Along right provides minority shareholders with the right to 'tag along' in any sale, which would give a third-party control of the company. Any investor with a minority stake is likely to insist on a tag along provision so that they can participate in any sale agreed by the majority shareholders.

Investors will typically seek to agree a list of matters requiring investor consent and generally expect rights to receive regular information.

Many investors will require some form of Board participation right. This may include a non-voting observer, a right to appoint a nominated Investor Director or the right to require the appointment of a Chair of the board.

Warranties are an investor’s primary contractual protection in relation to the business they invest in. They provide a level of assurance to the incoming investor that the business is in good order and all material information has been formally disclosed.

It’s important for founders to review the warranties in detail and disclose to the investor — via a formal disclosure letter — any inaccuracies or inconsistencies with the warranties sought. 

Convertible loans and advanced subscription agreements are mechanisms that allow investors to invest at an early stage in a company, prior to the company closing its full funding round. An investor advances funding to the company, which will convert into shares on the next funding round, typically at a pre-agreed discount on the pricing for that round to reflect the greater risk that the investor has taken in investing early.

With a convertible loan or convertible loan note, an investor’s investment will either convert into shares on a future funding round or become repayable if a funding round hasn’t occurred by a certain date (or if the company is sold). An advanced subscription agreement works in a similar way, save that it carries no right to repayment. Investments made via advanced subscription agreements can qualify for EIS relief, provided that the funds advanced convert into shares within six months of the date on which they’re paid.

The Seed Enterprise Investment Scheme (SEIS), Enterprise Investment Scheme (EIS) and Venture Capital Trust (VCT) scheme are a series of schemes established by the Government to encourage investment into higher risk earlier stage businesses.

The schemes provide a number of attractive tax reliefs to investors. The EIS and VCT schemes provide an income tax relief of 30% of the amount invested. Under SEIS, investors can qualify for 50% income tax relief on investments up to £200,000.

Gains realised on the sale of SEIS, EIS or VCT qualifying shares are exempt from capital gains tax, provided that the investment has been held for a minimum qualifying period.

Subject to limited exceptions, for EIS and VCT relief, the investee company must have been trading for no longer than seven years from the date of first commercial sale, increasing to ten years for knowledge-intensive companies.

These reliefs are lucrative for investors and there are a number of private investors and funds that will only invest in SEIS, EIS or VCT qualifying companies. It’s therefore important for founders to understand whether their company qualifies for these schemes before going out to seek investment.