Following the credit crunch, venture capital activity has held up relatively well. This is not, perhaps, surprising since venture capital investment does not generally depend upon bank finance. There has however been greater caution in evidence. A number of recent developments have emerged in the drafting of investment agreements governed by English Law which reflect the more cautious climate.
Observer Rights
As a result of the perceived risk which directors now face of fraudulent or wrongful trading, there has been an increased tendency for investors to appoint observers rather than directors to the board of investee companies.
Investment agreements should make it clear that observers are entitled to receive notice of each board meeting together with an agenda and all accompanying board papers. Further it should be made clear that observers are entitled to attend and speak at any board meetings of the Company, but not vote. To minimise the risk of being a “de facto” director an observer must ensure that he is not drawn into any discussions with the board during a directors’ meeting and, ideally, that he leaves before any decisions are taken.
Observers do not owe the same fiduciary duties to the Company as directors. There should therefore be a provision requiring the investor to immediately notify the Company if any observer appointed by it has any competing interesting with that of the Company.
Specific provision should also be included to permit observers to recover their reasonable travel expenses in attending board meetings.
Shareholder Information Rights
Shareholders have become more concerned to monitor the Company’s activities closely, whilst the Company wishes to limit the administrative burden of supplying regular information to shareholders.
It has become common to limit information rights to Significant Investors, usually defined as those holding more than 5% of the Company’s share capital.
This development can sometimes work unfairly against “angel” investors. It is worth considering grouping smaller shareholders together for the purpose of receiving regular financial information. It is obviously more important for shareholders who do not have the right to appoint a director or observer to have adequate information rights.
These would normally include monthly management accounts and copies of the audited accounts as a minimum. In addition, it is common to give advance notice to all Significant Investors of each board meeting together with a written agenda specifying the business to be discussed at such meeting and all relevant board papers. After each board meeting Significant Investors may be provided with a set of the minutes. Significant Investors may also have the right to have a meeting with the managing director following each board meeting so that they can fully understand the matters which were discussed and ask any questions which they may have on the monthly management accounts or the proceedings of the board. Significant Investors should be able to request a schedule of all options and warrants and a summary of the fully diluted share capital at the end of each quarter.
In the unlikely event that the Company does not comply with any of its obligations to provide information, there should be a right in the Investment Agreement allowing the Significant Investor to nominate a firm of accountants on their behalf to attend the Company’s premises to examine the books and accounts of the Company.
Management Warranties
Adequate management warranties are now seen as absolutely essential. The key issue here is to ensure that appropriate limitations of liability enable the management to feel comfortable giving the warranties whilst providing real protection to the investors.
The key protection for management is to ensure that there is a cap, often, rather arbitrarily, set at a figure equal to their annual salary, and that there is a relatively high threshold for claims possibly as high as £25,000. This greatly reduces the financial risk to management of a claim whilst providing comfort to investors that the disclosure exercise has been properly carried out.
From management’s perspective it is worth making clear that investors may not assign the benefit of the warranties and may only bring a claim if and to the extent that they still hold shares in the Company on the date the claim is notified. It is usual to release the management from any warranties given in respect of earlier funding rounds.
Investors from outside the United Kingdom will expect a gross-up clause to protect them in the event that any payment of damages is subject to any deduction or withholding.
Co-Investor Confidentiality
There has been a tendency for the size of investor syndicates to increase as existing investors limit their participation in later funding rounds. Large syndicates tend to increase the concerns about confidentiality.
There should be specific provisions permitting each investor to disclose information about the Company to any lender or shareholder in that investor or member of its Group, subject to a confidentiality covenant in the same terms as that contained within the Investment Agreement.
It may also be important to permit shareholders to share confidential information about the Company with other shareholders. This may be particularly relevant to angel investors.
Finally, each of the executive directors should consent to the processing of their personal data under the Data Protection Act.
Business Plan and Information Warranties
The Business Plan is the central document to any investment and investors need to be sure it has been prepared with the highest standard of care and diligence.
Warranties relating to the contents of the Business Plan should be provided as follows:
(a) A warranty in relation to all statements of fact. This should not be qualified by the knowledge of management since all facts contained in the Business Plan should be able to be independently verified. It is usual to include in the warranty a further confirmation that since the date of the issue of the Business Plan, no event has occurred which makes any statement of fact untrue or inaccurate in any respect.
(b) The projections and forecasts contained in the Business Plan are based on reasonable assumptions. This warranty is often qualified by best of knowledge and belief of the management compiling the Business Plan.
(c) Statements of intention and opinion are honestly held by the management team.
(d) The management are not aware of any fact or matter which is likely to prevent the Company from implementing the Business Plan.
It is market practice not to accept any disclosure against the Business Plan. A revised Business Plan should always be prepared reflecting the implications of the disclosure.
If there is additional information which is being relied upon by the investor, this will normally be attached to the Disclosure Letter and separately defined as “The Warranted Information”. This information should be checked at Completion to make sure it is accurate and up to date.
In April 2011, the Court of Appeal held that a whole agreement clause will not generally operate to exclude pre-contractual representations.
It is important to all parties entering into an Investment Agreement to exclude pre-contractual representations and this can only be achieved by a carefully drafted “non-reliance” clause.
Executive Directors
There has been greater due diligence on members of the management team and increasingly a greater focus on warranties relating to the background of members of the management team. These may extend to:
(a) No interest in a competitive business.
(b) No arrangements between the Company and any member of the family of the management team.
(c) No restrictive covenant binding a member of the management team.
(d) No other contractual relations between members of the management team and the Company other than their service agreements.
(e) Confirmation that none of the management team has any interest in any intellectual property or other property used by the Company.
In addition to the above, it is usual for management to be required to fill in a questionnaire regarding their personal financial circumstances and for this to be warranted as true, accurate and complete.
There should be additional warranties confirming that no member of the management team has ever been adjudged bankrupt, convicted of a criminal offence or been a director of a company that has been the subject of a creditors’ winding up.
Bribery Act 2011
Since 1 July 2011, the Bribery Act (the “Act”) has been in force. Section 7 of the Act provides for the corporate offence of failing to prevent a bribe. If an organisation is involved in bribery the only available defence is to demonstrate that adequate procedures have been put in place to prevent bribery.
Investment agreements will already contain the standard warranty requiring the Company to comply with all statutes. This is not really sufficient because an investor will need to be confident that the Company has in place “adequate procedures”. These should include carrying out an appropriate risk assessment and putting in place monitoring, training and management controls including a suitable bribery policy. Warranties should therefore be included to deal with these matters expressly.
Finally
We are advising our venture capital investor clients that now is a good time to review their standard investment agreement with a view to incorporating amendments to reflect the points discussed in this Article. Glovers have also regularly advised the management of companies seeking venture capital on the terms of investment agreements and the associated documents and have experience in both UK based and international transactions.
Please note that this information is provided for general knowledge only and therefore specific advice should be sought for individual cases.
For further information, please contact Paul Gilks at
