Following the lead of the US, the past few years have seen a significant increase in venture capital (VC) activity in the UK and Europe. Although the recent rate of growth is not expected to continue in 2001/2002 in line with expectations of a slowdown in the general economy, nevertheless it remains an exciting time for the VC industry for the reasons identified below. This article examines some of the trends that have emerged in VC deal structure, often in response to the high risk nature of many of the investments made in the TMT (Technology, Media and Telecoms) sector.
Recent growth: can it continue?
The past few years have seen rapid growth in the levels of investment made by VCs in the TMT sector, in both the US and Western Europe. During that time, almost half of all private equity investment in Western Europe occurred in the UK with over $12 billion being invested in 1999 (as compared to $3.5 billion being invested in Germany, which ranked second in Western Europe). The first half of 2000 continued the impressive rates of investment with $11.4 billion invested in Western Europe alone, a significant proportion of which was invested in the TMT sector.
Given the recent falls in the share valuations of many companies in the TMT sector it appears inevitable that VCs will become more discerning with respect to the companies in which they choose to invest. However, there is no reason to believe VCs will not continue to support companies in the TMT sector that can exhibit a good underlying concept and a well thought out business plan. Areas such as TMT infrastructure, selected B2B opportunities and niche technologies can remain optimistic about the future. It will not be surprising though, in a more depressed market, to see a greater emphasis placed on protection of a VC’s investment through one or more of the mechanisms considered below.
Protecting the VC TMT investment
The VC’s role in the operations of the business
In addition to being granted the right to appoint a director to the board of a company in which a VC invests (or, alternatively, to have an observer present at board meetings), VCs are requiring the company to specifically seek VC approval in respect of important operational decisions. Decisions that often require the VC’s approval include: any amendments to the Articles of Association of the company; the sale of all or a significant part of the business of the company; share transfers resulting in a change in control; the issue of new shares and the approval of business plans and budgets.
Control over share transfers
A major consideration in a VC’s decision to invest in a TMT company is the identity of the current shareholders who, in many cases, also form the management team of the company. VCs will want to restrict the ability of such manager/shareholders to transfer their shares as a way of trying to ensure that they stay with the company and have a vested interest in its future success. Key employee shareholders are therefore “locked in” and prevented from selling shares, although transfers to family members or other related parties are often allowed on the basis that such transfers may be required as part of a shareholder’s tax planning. Conversely, mechanisms are often included requiring members who leave the employment of a company to sell their shares. The degree to which VCs want to tiein existing manager/shareholders can be reflected in the price per share agreed to be paid to such shareholder when leaving.
VCs also often require the ability to be able to drag i.e. force the other members along in the event that the VC and other major shareholders receive an offer for all the shares in a company. In addition, VCs may also want the ability to tag along, i.e. join in with any proposed sale of shares by existing members. There are many combinations to these basic concepts and each is a matter for negotiation e.g. “partial tag along” allowing a VC to exit at the same rate and time as a founding shareholder sells. The underlying aim is for the VC to maximise satisfactory exit opportunities.
Following the lead of the US, many European VC transactions in the TMT sector are incorporating “antidilution” provisions. The concept behind such antidilution provisions is that a VC does not want to be penalised by investing in a company when its valuation (and hence the price paid per share) is high as compared to a subsequent investor investing at a time when the company’s valuation (and hence the price paid per share) is lower (thereby allowing the subsequent investor to be issued more shares per pound invested).
Antidilution protection may be given on either a “full ratchet” or a “weighted average” basis. Simply put, “full ratchet” protection requires that at the time of any subsequent investment which is made at a lower per share price, the VC receives additional shares to ensure the number of shares held by the VC equals the number of shares that the VC’s initial investment would have purchased at such lower per share price. “Weighted average” protection (the less aggressive approach) applies antidilution protection with reference to the actual proportion of shares in a company which may be issued to a new investor at a reduced per share price; full ratchet applies irrespective of how many new shares are issued at the reduced valuation.
A liquidation preference ensures that upon the return of capital of a company to its shareholders (or an event which is treated as if it was as a return of capital, e.g. a sale, as discussed below), the VC gets “first bite at the cherry”. The size of the bite, and the circumstances in which a bite can be taken, is a matter of negotiation.
The size of the preference
The amount of capital to be returned to the VC as a priority may range from the amount of the VC’s investment (conservative) to a multiple of such investment (more aggressive) upon a liquidation or “deemed” liquidation (e.g. sale, see below), with any remaining capital to be split pro rata among the remaining shareholders (including the VC). It is not unusual to see VCs require multiples, e.g. up to three times, of such initial investment to be returned before any pro rata distribution is made.
Timing of the preference (“Deemed liquidation”)
A liquidation preference may be deemed to apply not only in cases of the actual (solvent) liquidation of a company, but also upon the sale of all (or sometimes a part) of either the shares or assets of the company. Any proceeds of such a sale are then returned to shareholders in accordance with the prescribed liquidation preference sequence.
A variation of such arrangement is to have any liquidation preference (whether or not deemed) apply only below a threshold figure (which often relates to valuation of the company at the time of the VC’s investment). The notion behind this latter structure is that if a liquidation or deemed liquidation brings in a sufficient amount of funds, a liquidation preference is not required for the VC to realise a sufficient return on its investment.
There is an increasing trend for companies in the TMT sector to turn to existing investors for shortterm finance until they can arrange for a subsequent round of funding. It is likely that instances of bridge finance will continue to increase as the market for VC funding tightens. VCs often insist that any such short term funding be convertible into equity at a rate favourable to the VC (for instance, at a rate discounted by reference to the price paid by the VC when it initially invested in the company or, alternatively, by reference to the price paid by any incoming investor). Conversion of the debt would typically occur if the loan had not been paid by an agreed date.
Many of the rights set out above (particularly liquidation preference, antidilution and convertible loan rights) have the effect of increasing a VC’s percentage shareholding over time as compared to that of the original members. However VCs appreciate the need to ensure that founders, managers, and employees (upon whom the success of the company and therefore the return on the VC’s investment is dependent) are sufficiently incentivised. VCs are beginning to again think about ratchets and other mechanisms which increase the original shareholders’ shareholdings on the basis of the future performance of the company. There are many ways of incorporating this concept. Relative shareholdings may be adjusted on a sale of the company or an IPO in the event that a certain threshold valuation is achieved (e.g. a multiple of the post money valuation of the company immediately following the VC’s investment). Alternatively, shareholdings may be adjusted on a more regular basis if the company attains certain financial or other relevant targets at defined periods, e.g. customers, sales or profit levels.
There has been a noticeable trend in TMT VC transactions of VCs seeking syndication of a new round of funding in a company. This is designed to diversify and mitigate the VC’s risk, particularly in uncertain times.
Another trend is for TMT corporates e.g. Intel, Nokia, Marconi, i.e. businesses that have a commercial interest (rather than a purely financial one, as in the case of VCs) to invest in an emerging company (often alongside VCs) as a method of gaining strategic benefits through their relationship with that company.
The recent dampening of activity in the TMT sector has seen VCs take a more cautious approach to their investments and has been accompanied by the increased use of some, if not all, of the protections outlined in this article. While most commentators believe the venture capital market is likely to remain subdued relative to 1999/2000 levels there remain opportunities for VCs to make wellinformed investments. Continued development and refinement of the concepts outlined in this article can be expected, as VCs strive to minimise their risk in a manner that is acceptable to the companies in which they wish to invest.