Member Article

Back in February 2023, The British Private Equity and Venture Capital Association (BVCA) revised and relaunched its model documents for early-stage investments.

The model documents are widely used throughout the growth company ecosystem in the UK and provide a basis for the constitutional arrangements of most privately held businesses backed by institutional growth capital at all stages - from seed to pre-IPO.

Their update was designed to promote industry-standard legal documentation, so investors and entrepreneurs can focus on deal-specific matters – with most dealmakers choosing to refer to the standard proposed BVCA Model documents for early-stage investments.

Between 2020 and 2022 the venture capital market experienced an explosive increase in the value of investments being made. The bubble lasted about 18 months delivering 100% growth for this sustained period before falling dramatically to pre-boom levels in Q1 of 2023. Macro-economic headwinds, including the impact of the war in Ukraine, global supply-chain issues, rising interest rates and inflation all fuelled a challenging fundraising environment.

It was during this period of decline the new BVCA model documents were re-launched with some more preferable deal terms for founders and a greater streamlining of investor approved decisions.

For close to two years, investors had been fighting for stakes in hot sector markets, particularly within the tech industry – meaning terms naturally leaned towards the side of founders. Valuations were high but by the end of Q1 2023, the taps were turned off for ‘risky’ start ups and founders were suddenly left with an environment where it was much harder to raise venture capital financing. Investors were now looking to later stage private equity investments for a safer return and deal activity slowed by a third. From thriving in an environment with multiple investors fighting over businesses, thus inflating valuations, founders have had to significantly lower their expectations and accept less favourable terms.

The below article examines noteworthy deal term changes since the revisions were introduced.

Warranties and disclosures

The new BVCA documents have moved away from founders giving warranties. Whilst this has been accepted by some venture capital investors (particularly on larger and later stage VC deals or deals with an American investor where the practice is market standard), some investors still require warranties to be given by founders on seed/Series A stage investments, particularly if no institutional money has previously been invested.

Shoosmiths’ own data from the last 12 months shows that there has been a 11% decrease in the volume of deals in which both the company and founders are giving warranties – this highlights the impact on the approach put forward in the new BVCA documents. However, the vast majority of earlier stage deals still require the founders to give warranties and there is sound reasoning for this. With founders having ‘skin in the game’ it is anticipated that they will be more engaged in the disclosure process resulting in more accurate and fuller disclosures, providing investors with greater comfort in the information provided.

A point to note, however, that warranty claims following venture capital deals remain a very rare occurrence.

Leaver provisions and vesting

There has been notable reduction in the number of categories of ‘leaver’. In the 12 month period prior to the new BVCA documents being published, 33% of deals contained three categories (good, intermediate and bad) reducing to 16% of deals in the 12 months after.

There are two reasons to consider for this. Whilst the new BVCA documents retained two categories of leaver (good and bad only) from the previous documents the leaver provisions overall were simplified. In particular, they provided a much clearer definition of ‘bad leaver’ by being more specific in what types of conduct are ‘bad’. Many investors are adopting this new approach, even where they were typically using three categories in their own precedent documentation previously. Also, as the market switched to being more investor friendly in the period after publication, founders will have found in more difficult to negotiate the flexibility afforded by ‘intermediate leaver’ status, although as explained below, flexibility materialised in other areas.

Linked to this is the percentages of shares that a founder risks if they were to become a ‘leaver’ on day one after the investment. Indicative data (particularly from Q4 of 2023) indicates that the most common level of shareholding at risk was 75%, whereas at the start of 2022, 100% of shares were at risk on the vast majority of deals. This suggests that flexibility has moved away from how leaver is categorised with a focus (presumably driven by founders) on what the founder actually risks as a result of becoming a leaver.

Liquidation preferences

A further key change evidenced by Shoosmiths’ data is the increased use of participating liquidation preferences. This is where investors get their money back before any other shareholders but then also participate pro rata in the excess proceeds on an exit – this is opposed to a non-participating preference where investors get the greater of their money back or a pro rata share of the exit proceeds. Participating preferences were used in c50% of deals throughout 2023, up from c33% in the previous 12 months.

This change had more to do with prevailing market conditions than the new BVCA documents which contain non-participating preference drafting as standard. As mentioned above, the hefty reduction in venture capital investment in 2023 meant that (i) investors had greater bargaining power to request better terms and (ii) founders were finding it harder to raise and this resulted in many getting to the point were investors were making ‘rescue investments’, with increased use of participating preferences reflecting the greater risk being taken.

 

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