2021 Venture Capital Guide - England & Wales

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World Law Group

[co-authors: Neil Hendron, Ross Mackay]*

World Law Group member firms recently collaborated on a Global Venture Capital Guide that covers more than 30 jurisdictions on investment approval processes, typical investment sectors and investment structures on Venture Capital deals (and more!).

The guide does not claim to be comprehensive, and laws in this area are quickly evolving. In particular, it does not replace professional and detailed legal advice, as facts and circumstances vary on a case-by-case basis and country-specific regulations may change.

This chapter covers England & Wales. View the full guide.

ENGLAND & WALES

Gowling WLG

  1. In your jurisdiction, which sectors do venture capital funds typically invest in?

Key sectors for venture capital investors in the UK very broadly include business products and services, ICT (communications, computer and electronics), consumer goods and services, biotech and healthcare (including life sciences), financial and insurance services, and energy.

In 2019, the fastest growing specific sectors for venture capital investment were in the technology sector, more specifically FinTech, AI and deep tech, and energy and cleantech.

  1. Do venture capital funds require any approvals before investing in your jurisdiction?

There is generally limited regulation in respect to the activity of venture capital funds deploying capital by investing into investee entities in the UK. Approvals tend to be at fund level in terms of the regulation of how venture capital funds raise funds and how their investment activities are regulated.

Investments into investee companies operating in certain regulated industries may require regulatory approval from the relevant regulatory body for that industry (particularly if change of control thresholds are triggered as a result of the proposed investment). Specific requirements will vary from industry to industry.

At fund level, venture capital firms themselves (as fund promoters) must generally be authorized by the Financial Conduct Authority (the "FCA") for the purposes of arranging deals in investments in the UK (where this occurs in the UK) and only certain types of investors can be marketed to (e.g., high net worth or sophisticated individuals).

Fund managers must be authorized by the FCA by virtue of the fact that they will be managing an investment fund (and will therefore be covered by the Alternative Investment Fund Managers Directive, or AIFMD) and the principals of the fund manager will also most often need to be approved by the FCA for carrying out controlled functions in respect to the fund.

There are also examples of listed venture capital funds operating in the UK; these will generally require an approved prospectus for their securities to be marketed to the public (subject to various exemptions).

  1. Are there any legal limitations to an offshore venture capital fund acquiring control or influencing the business, operations, or governance of an investee entity?

There are generally no restrictions on foreign venture capital funds investing in and influencing the business and operations of a privately held investee company in the UK, subject to any regulatory approvals that may be granted regarding any change in control in respect to the investee company.

  1. Would an investor be required to undertake an antitrust (competition) analysis prior to investment? When would such a requirement be triggered?

Although venture capital transactions may not typically raise any potential competition concerns, investors should be mindful that they may still be subject to merger control requirements. Currently the UK's relationship with the EU after the end of the transition period (end of 2020) remains subject to negotiation with the EU. Following the end of the transition period, the European Commission’s review of a merger will no longer cover the UK. This will mean that mergers may be subject to review by both the UK Competition and Markets Authority and the European Commission (i.e., a transaction that qualifies under the EU Merger Regulations may also be subject to UK merger control provided the UK jurisdictional thresholds are met).

In the UK, merger control thresholds are triggered where a transaction results in two enterprises ceasing to be distinct (i.e., they are brought under common ownership or control), and either:

  • the aggregate UK turnover of the target business (i.e., the investee company) exceeds GBP 70 million in the preceding business year; or
  • the enterprises ceasing to be distinct supply or acquire goods or services of any description and, after the transaction, will supply or acquire at least 25% of all those particular goods or services supplied in the UK or in a substantial part of it; or
  • if the transaction involves specified activities connected with military or dual-use goods which are subject to export control, computer processing units, and quantum technology:
        •  
        • the investee company's annual UK turnover exceeds GBP 1 million; or
        • the investee company has an existing share of supply of 25% or more of relevant goods or services in a substantial part of the UK.

Where these thresholds are met, the Competition and Markets Authority ("CMA") has jurisdiction to review a completed or anticipated transaction.

It is important to note that even an investor's minority stake in an investee company may give rise to a degree of common control, which may initiate a further review by the CMA. An investor may acquire direct or indirect control of an investee company by virtue of: (i) material influence, where an investor has the ability to influence policy relevant to the behavior of the investee company in the marketplace; (ii) "de facto" control, or the ability by an investor to control the policy of the investee company; and (iii) "de jure" control, where an investor obtains a controlling interest in the investee company. As such, it may be possible for investors to conduct a thorough assessment on the likelihood of potential further review by the CMA, prior to any investments being made. This also allows investors to address any potential competition concerns head on and avoid significant delay and costs which may prove beneficial where a transaction is time-sensitive.

  1. What are the preferred structures for investment in venture capital deals? What are the primary drivers for each of these structures?

The most common structure for venture capital funds is an English Limited Partnership. English Limited Partnerships allow for commercial flexibility and are tax transparent. When making investments an English Limited Partnership will act by its fund manager, which will typically be a limited liability partnership.

Venture capital investors will typically acquire a minority stake in investee companies. Such acquired shares will most likely be a preferred class of share, although convertible loan notes are also a common feature.

Preferred shares are used as they typically have superior rights to capital returns (e.g., sitting at the top of the liquidation preference with a 1x (or higher) preferential return) and income (e.g., dividend rights), as well as other protections such as anti-dilution protection in the event of a down round.

Certain venture capital funds may make enterprise investment scheme ("EIS") and venture capital trust ("VCT") eligible investments. EIS and VCT both offer attractive tax benefits, although both carry specific requirements and will dictate the terms of the transaction documentation and will subject investee companies to specific eligibility criteria.

  1. Is there any restriction on rights available to venture capital investors in public companies?

There are no specific restrictions imposed on venture capital investors in respect to interests in listed companies.

  1. What protections are generally available to venture capital investors in your jurisdiction?

Venture capital investors typically receive significant contractual protection in the transaction documentation (which will most often consist of a shareholders' agreement, articles of association and a subscription agreement) – please see above re: Preference Shares. Often the subscription agreement and shareholders' agreement will be contained within the same document.

A key feature of a shareholders' agreement will be the list of reserved matters in respect to which the investee company requires the venture capital investor's consent. This will provide the venture capital investor a greater degree of control than the voting rights attaching to a minority shareholding would otherwise give.

In common with all other shareholders, statutes grant certain rights to shareholders (i.e., a right of pre-emption for existing shareholders), which can be amended/supplemented by the constitutional documents of the investee company.

Further inalienable remedies available to minority shareholders include:

  • an unfair prejudice petition under the Companies Act 2006, which most likely arises where majority shareholders (who may also be directors) use their powers to promote their own interests to the detriment of a minority shareholder; and
  • bringing a derivative action under the Companies Act 2006, where a shareholder brings a claim on behalf of the investee company against the directors for their negligence, default, or breach of duty or trust. In this respect, the duties of directors are also enshrined in the Companies Act 2006 and accompanying case law.
  1. Is warranty and indemnity insurance common in your jurisdiction? Are there any legal or practical challenges associated with obtaining such insurance?

Warranty and indemnity insurance has become increasingly prevalent on M&A transactions in the UK, with minimum premiums falling to capture smaller transactions. Consideration as to its use may be particularly relevant in transactions where venture capital funds are seeking an exit (given that such investors will, most likely, not give warranties to buyers).

Warranty and Indemnity Insurance will therefore tend to be a feature on exits that involve a venture capital investor selling shareholder (as opposed to being a feature of the initial investment).

The need for the insurer to review due diligence reports for the buying entity and transaction documents (typically the sale and purchase agreement, and the disclosure letter) should be considered in the transaction timetable. As a minimum guideline, a two-week period is generally required in order to put in place such a policy.

It should also be noted that W&I insurance will typically not cover all liability under the sale and purchase agreement – matters disclosed by the warrantors in the disclosure letter and warranties relating to tax and pensions, for example, will most likely not be covered. W&I insurance is therefore not a substitute for a complete due diligence, disclosure exercise, and negotiation with regards to the warranties.

  1. What are common exit mechanisms adopted in venture capital transactions, and what, if any, are the risks or challenges associated with such exits?

With respect to exit mechanisms from successful investee companies, the most commonly utilized in the UK are IPOs or a sale (either by way of a trade sale or a buyout by a private equity firm focused on later stage majority acquisitions).

There are a number of common risks associated with trade sales and buyouts. In particular, there is a risk that management time and external cost is expended trying to complete a transaction which ultimately does not proceed. Further, there is a risk when undertaking a trade sale that during the sale process competitors could access sensitive information which, if the transaction aborts (and notwithstanding that confidentiality arrangements have been entered into), will have been disclosed.

Some of the challenges specific to IPOs are explored below.

  1. Do investors typically opt for a public market exit via an IPO? Are there any specific public market challenges that need to be addressed?

The options available to companies seeking an IPO, if such a listing occurs in the UK, are premium, standard, or high growth segments of the Main Market of the London Stock Exchange (each with their own regulatory regime) or more likely, the Alternative Investment Market (AIM). AIM is London Stock Exchange's market for smaller, growing companies.

Venture capital-backed IPOs are less likely to occur than exit by way of a trade sale or a buyout, but do occur. While an IPO gives credibility to a company and raises the public profile of the investee company, IPOs are a comparatively risky route to exit, being affected by prevailing market conditions and taking significant management time and effort, even in the event that initial marketing of the investee company shares does not result in sufficient interest to proceed to an IPO.

Shareholders of companies which exit through an IPO are often required to enter into lock in agreements, whereupon it is agreed that they shall not sell their shares for a set period of time.

 

*Gowling WLG

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