Venture Capital 2024 Comparisons

Financings

Of the publicly disclosed transactions, the largest UK venture financing over the past 12 months occurred in May 2023, in which London-based wellness testing company YgEia3 secured an enormous GBP602.7 million investment from undisclosed investors. Two companies followed suit shortly afterwards.

• Conigital, a Birmingham-based driverless vehicle start-up, which raised GBP500 million in September 2023 in a series A+ financing, an outcome which was the result of a strategic partnership with a private equity infrastructure firm. Conigital asserts that it is now the highest-funded driverless vehicle start-up in the United Kingdom and Europe.
• Abound, a London-based fintech lending service, which raised GBP500 million in March 2023 in a mixture of equity and debt finance. Equity investors included K3 Ventures, GSR Ventures and Hambro Perks, and debt financing was provided by US bank Citi and clients of Waterfall Asset Management.

Exits

In September 2023, Eutelsat Communications SA completed its USD3.5 billion acquisition of OneWeb, the global low Earth orbit satellite communications network to form the world’s first integrated GEO-LEO integrated satellite communications operator. OneWeb’s shareholders were the UK government, Bharti Enterprises, Softbank, Hughes, Hanwha Systems as well as Eutelsat. The combined group was admitted to trading on the London Stock Exchange as part of the transaction. This transaction represented one of the largest growth capital exits in 2023. Herbert Smith Freehills acted for OneWeb.

In January 2023, InstaDeep Ltd, a Tunisia-founded, London-headquartered artificial intelligence start-up was acquired by BioNTech SE for GBP562 million. BioNTech, a German company which had invested in InstaDeep’s series B financing round the previous year, stated that the acquisition was in support of its strategy to accelerate AI-driven drug discovery and strengthen its pioneering position in the biotech field. InstaDeep’s venture capital investors included Endeavor Catalyst, Alpha Intelligence Capital, CDIB Capital, Google and Synergie. InstaDeep now operates as a UK-based global subsidiary of BioNTech.

Much like in the US, the UK’s current economic climate has forced the venture capital (VC) market to shift from a strategy of “growth at all costs” to one where companies need to show strong positive unit economics and a pathway to profitability if they are to remain attractive for funding. Company valuations have started to align more with their public market comparables but, broadly, there remains a delta in the “bid/ask” in relation to valuations, with investors not necessarily willing to subscribe at valuations that founders and management are proposing.

More mature companies with robust business plans and management teams that forecast long-term sustainable growth and profitability are being prioritised, which goes hand in hand with a notable emphasis on later-stage funding rounds. Investors are taking a more focused yet cautious approach to valuations and the importance of proper due diligence. This was perhaps less of a concern in the heady days of 2021, given the amount of capital being deployed into “hot” deals back then.

Equity market volatility and a preference for strong growth plans also means that conventional VC exit opportunities are less available, with UK (and indeed global) IPOs falling to their lowest levels since 2010, although equity conditions do appear more promising as macro-economic conditions stabilise.

Consequently, UK businesses are having to look for other avenues to raise more money, often resulting in a higher degree of share-capital structuring. For example, “down-rounds”, when a company offers additional shares for sale at a lower price than the previous financing round, have become more prominent as exit opportunities are limited and companies start to run out of money, forcing the crystallisation of a lower valuation. Down-rounds usually trigger anti-dilution provisions to protect investors by ensuring that they can maintain their ownership percentages through a bonus issue of shares or adjustment to the conversion ratio of preference shares to ordinary shares (the latter being more common in the US). Increasingly, “pay to play” provisions are being introduced into company constitutional documents to ensure future commitment to capital-raising by existing investors. If current investors do not provide new cash for a next round of financing, their shares can be consolidated at a specific ratio while being converted into ordinary shares, leading to a potential significant drop in their value. General restructuring or “flattening” of the cap table has been a common theme in rescue-financing for companies that have been unable to raise further funds in turbulent times; this often forces a complete rethink and overhaul of the cap table to save the company and ensure that new funds are secured. Convertible instruments (such as convertible loan notes) remain popular in the market to avoid crystallising a down-round and delaying valuation discussions until the markets return to a healthier state for capital raising.

ESG has become mainstream, with investors demanding due diligence across the ESG landscape. Due to consistent pressure and scrutiny, ESG investing, particularly in relation to the renewable energy transition, has become a major priority. Ventures that demonstrate a commitment to ESG principles are likely to attract greater interest from socially conscious investors and to gain a edge in fundraising. Notably, the form documents as recently issued by the British Venture Capital Association (BVCA) have included provisions to ensure compliance by high-growth companies with a number of ESG concerns. This is a welcome development and ensures that venture funds are imposing their limited partners’ requirements onto their portfolio companies.

Climate tech, artificial intelligence, fintech, and life sciences and biotech continue to dominate the VC landscape in the UK. According to HSBC Innovation Banking, climate tech and AI were the most popular start-up segments in 2023, with 29% (USD6.2 billion) of UK VC investment going into climate tech businesses and 21% (USD4.5 billion) invested in AI ventures. The UK also retained its substantial lead in Europe as the top spot for biotech investment, receiving GBP1.25 billion, which accounts for 41% of total venture capital invested in biotech businesses across Europe (according to a report by UK BioIndustry Association).

UK university spin-outs in the life sciences sector continue to thrive, making up the highest proportion of university spin-outs in 2023; in particular, the number of AI spin-outs is rising rapidly. Biotech has notably been a strong area of growth; according to the UK BioIndustry Association, UK biotechs secured GBP1.8 billion in equity financing last year and lead Europe with the highest number of clinical-stage companies. The UK’s relative strength in this area shows no sign of waning. In January 2024, Oxford University spin-out Genomics raised GBP35 million to develop its risk estimation technology to help predict diseases and cancers.

Given the increasing concern for climate change and pressure on governments to set and achieve net zero targets, the top funded climate tech areas were electric mobility, EV battery and autonomous mobility. This includes capex-heavy companies focused on the energy transition. Beyond autonomous mobility, AI ventures offering generative AI solutions were most attractive due to the growing interest from corporates in implementing this type of AI into business practice to streamline content creation and enhance efficiency.

Many venture capital funds established in typical fund domiciles (eg, the Channel Islands and Luxembourg) are marketed into the UK. VC funds in the UK are typically structured as an English limited partnership under the Limited Partnerships Act 1907, with a single general partner (usually a fund-specific Special Purpose Vehicle within the manager’s group) and a number of investors who come in as limited partners. The general partner has unlimited liability for the debts and obligations of the partnership (although, in practice, it is likely to be a limited company Special Purpose Vehicle itself), whereas the liability of each limited partner is limited to the amount of its capital commitment to the partnership. The general partner is responsible for the day-to-day management of the fund, which is usually delegated to an appropriately authorised investment management entity within the manager’s group. Limited partners often play a role in overseeing manager conflicts of interest, replacement of key persons and other material decisions relating to the fund, either through a limited partner advisory committee or by a vote amongst all the investors.

Fund documentation typically consists of a limited partnership agreement setting out the terms of the fund, supplemented by a subscription agreement to be executed by each investor and subject to additional terms agreed bilaterally in a side letter between the general partner and any investor who negotiates such terms. A manager will also generally issue a private placement memorandum in relation to the fund, summarising the key terms of the fund and containing other marketing information and regulatory disclosures, including risk factors.

Most VC funds are established as private fund limited partnerships (PFLPs), which benefit from a lower administrative burden compared to other limited partnerships. A VC fund structure may also include alternative investment vehicles or parallel funds to accommodate investors with specific tax or other structuring or investment requirements.

Some VC funds in the UK take the form of publicly traded vehicles known as venture capital trusts (VCTs), which must meet a number of qualifying conditions. VCT investors (including retail) benefit from certain reliefs from UK taxation. As a result, VCTs are mainly marketed to UK investors.

The principal return to VC fund principals is a share of the fund’s profits, referred to as “carried interest” or “carry”, which ensures economic alignment between the manager and investors.

Carry structures vary depending on the respective bargaining positions of the manager and investors. Under the typical distribution waterfall, a manager might expect to take 20% of profits above an ~8% “hurdle”, also referred to as the “preferred return”, meaning that investors must see a return of invested capital plus 8% before the manager takes a share. The waterfall operates in principle in the same way for VC funds as for private equity buyout funds. However, in a VC context, the hurdle may not be an IRR or compound interest calculation. Rather, carry entitlement can often be contingent on achieving a multiple on invested capital (MOIC).

Carry is typically calculated on a “whole-of-fund” rather than deal-by-deal basis. This structure often includes a “catch-up”, whereby, once the preferred return is met, the manager receives a larger share of profits until they have caught up to a pre-agreed percentage of total profits. Less commonly, it includes “super carry” arrangements, whereby the manager takes a larger slice of profits if the fund meets a specified return. Although 20% carry (above the applicable hurdle) is still the baseline for VC funds, it is more common for fund principals to take super carry on a VC fund than for private equity buyout strategies.

The manager also receives a management fee (usually 1.5–2% pa of capital commitments) to cover its overheads. While management fees have generally been trending down over recent years, it is still common to see a 2% fee on a VC fund, which may be a reflection of smaller fund sizes in a VC context than for a typical private equity buyout fund.

Other key market standard terms in VC funds include:

• provision to remove the manager for certain “cause” events (in which case the manager may forfeit some of its carry entitlement) and, in some cases, on notice without cause;
• establishment of an investor advisory committee with oversight over manager conflicts of interest and other matters which could harm the investors’ investment; and
• key person provisions under which the departure or insufficient availability of certain key manager personnel triggers consequences such as suspension of the investment period or, occasionally, termination of the fund, unless investors approve its continuation.

VC funds are classified as alternative investment funds, or AIFs, and are therefore subject to the UK Alternative Investment Fund Managers Regulations 2013 (AIFMR) and associated FCA rules. The AIFMR are derived from and, so far, since Brexit, remain broadly aligned with the rules under the EU AIFM Directive. However, the FCA is consulting generally on the UK asset management regime and so there may be deviations from the European position in coming years.

The AIFMR governs various aspects of the manager’s conduct in respect of the fund, including in relation to marketing, reporting and disclosures to investors, the appointment of a depositary, and ongoing operating requirements and restrictions, including on valuation, leverage and delegation. The requirements under the AIFMR apply in a more limited way for non-UK managers than for UK managers.

VC funds are not themselves authorised or regulated in the UK. However, UK managers of VC funds must have appropriate FCA permissions. Non-UK managers may market UK or non-UK VC funds to professional investors in the UK if they meet certain conditions, including that appropriate cooperation arrangements are in place between the FCA and the supervisory authority in the manager’s jurisdiction.

VC funds structured as limited partnerships are also subject to the Limited Partnerships Act 1907, which imposes some basic duties on the partners, including the registration and notification of changes in the partnership to Companies House. Funds which are established as private fund limited partnerships (PFLPs) are subject to fewer of these duties and, most notably, need not publicly disclose the capital commitments of limited partners. The new Economic Crime and Corporate Transparency Act 2023 seeks to increase transparency in relation to limited partnerships, with key changes including more detailed information and notification requirements to Companies House.

London as a financial centre is a significant market for all classes of asset, including VC, and the UK more broadly is seeking to continue to position itself as a centre for tech, fintech, cleantech and innovation more generally, backed by home grown and overseas VC investors. A significant portion of VC funding in the UK is channelled into biotech and other innovative enterprises spinning out from the UK’s world class universities, such as Oxford and Cambridge. Many London-based corporates are also now moving into the VC space through their own venture funds, adding a new set of players to the market – these may be dedicated funds in the traditional sense, or investing from their balance sheet.

In addition, since Brexit, the UK government has been focusing on promoting investment by UK pension funds (including local government pension schemes, in particular) in UK infrastructure and “levelling up” projects. To some extent, this is driving additional capital into UK VC funds, which are investing in such projects.

Similarly, although the UK does not have a sovereign wealth fund, the British Business Bank, a government-backed economic development bank which seeks (among other things) to stimulate growth in early-stage businesses and the UK economy more widely, is a big investor in VC funds.

The UK VC market also has a burgeoning community of impact investors with an investment mission focused not only on generating returns but also on having a positive environmental and/or social impact. Many impact strategies are focused on SMEs or start-ups that are seeking to bring an idea to market in order to effect positive societal change in their communities, which means there is thus often an overlap between VC and impact investments. The UK has been a significant contributor to the growth of impact strategies, including through initiatives driven by British International Investment (formerly CDC), the UK government’s development finance institution.

Due diligence (DD) is an important part of the venture capital investment process and must be distinguished from DD in mergers and acquisitions. A “lighter-touch” approach is generally adopted in VC, although intensity and standards do change with rapid shifts in economic conditions. It is important to remember that many ventures vying for seed and early-stage financing may not have been trading for very long, so the scrutiny of previous activity and corporate structure can be limited.

Investors will initially assess the investment opportunity’s business model and conduct market analysis to understand the venture’s industry, market potential, competitors and sustainable growth prospects. As a venture capital investment is quite often viewed as an investment in the founders, the management team will also be closely checked to evaluate their experience and expertise. Often, with seed level investments, founders may be asked to provide warranty coverage to the investors, although this practice is waning. Due to the sectors on which venture capital investment tends to be focused, the venture’s intellectual property (IP) position will also typically be a key area of DD scrutiny.

Risk management is crucial, and involves assessing the company’s legal and regulatory compliance, financial health, and IP protection. Financial statements, contracts, licenses, assets, policies, and IP rights will be reviewed to identify potential legal risks and liabilities. For life sciences and technology venture companies, most of the worth of which lies in intangible assets, detailed IP due diligence is crucial. Depending on the sector, ESG considerations will be prevalent at all stages to address a company’s adherence and commitment to ESG standards.

Disclosure is essential and complementary to the DD process by drawing out material information that will provide a full picture of the business. Companies that produce a detailed and thorough disclosure letter to investors, as required by the subscription agreement, will be viewed in a positive light and have higher chances of passing the DD checks and receiving funding. Getting this wrong may jeopardise a transaction or put the founders and how their business is being managed under further scrutiny.

The typical timeline of a new financing round for a growth company can range from a few weeks to a few months, depending on several factors, such as the structure of the deal, efficiency of negotiations, level of due diligence required and legal and regulatory issues. The stages of the financing round generally include:

• a preparation phase involving collaboration between the company and existing investors to prepare the term sheet and pitch the proposal to new investors;
• negotiating the term sheet and essential conditions of the investment;
• conducting due diligence on the company’s founders, business model, financial statements, IP rights, and legal and regulatory compliance;
• drafting of key legal documents – subscription agreement, shareholders’ agreement and articles of association – and other ancillary documents such as corporate authorities; and
• completion of the deal involving execution of the legal documents and the transfer of the investment funds to the company as consideration for the issuance and allotment of shares to the investor(s).

The relationship between existing and new investors will be a balancing act. A balance must be struck between protecting the interests of existing investors who may want to maintain a certain level of control of the company, while preserving their economics, and satisfying the interests of new investors demanding preferential treatment. New share classes and rights will be created, inevitably diluting the equity and rights of existing investors and founders alike. With every new financing round there will be different expectations for the company’s growth strategy and ultimately exit prospects, often creating a tension between investors with different expectations on exit horizons.

Usually, if the financing round involves multiple new investors, there will be a lead investor, who will take a more active role, and several minor investors, with the investor group usually sharing one counsel for efficiency. The company will have its own counsel, and existing investors may choose to have separate counsel also, to ensure their interests are represented and protected in the negotiation and document-drafting stages.

The existing shareholders’ agreement will determine investor consent matters and detail specific share-class rights. Generally, significant decisions, such as major changes to the business model or new financing rounds with severe dilution effects and changes to company control, will require approval from all existing shareholders.

In the early stages of financing, ordinary shares are generally held by the founders and key employees. Ordinary shares have voting rights attached but, in a venture context, their holders are usually last in line to be paid out in a liquidity event, after creditors and preferred shareholders (preferred shareholders are usually the venture investors, sitting above the ordinary shareholders in the “waterfall”.

In early-stage financings, the most common methods of raising funds are through convertible loan notes (CLNs), advanced subscription agreements (ASAs) and preferred equity. The type of method chosen will depend on, among other things, the maturity of the business and the type of funding that the situation requires.

CLNs and ASAs are convertible instruments that allow investors to invest money into a company to be converted into equity at a future date, depending on its terms.

• A CLN is a debt instrument with an interest rate and maturity date upon which the CLN will either convert to equity or the company will be obliged to repay the loan and any accrued interest. CLNs provide security to investors in an insolvency situation, as convertible debt ranks ahead of shares in insolvency, so they are viewed as a safer investment than equity. CLNs will generally offer a discount for the investors upon conversion of the note, incentivising the investor for advancing the funds at a potentially riskier point in the company’s trajectory.
• An ASA is a convertible equity investment similar to a SAFE (Simple Agreement for Future Equity) in the US, which has all the hallmarks of a convertible loan note without the associated debt.This potentially allows investors to take advantage of SEIS/EIS tax relief in the UK (see 4.1 Subsidy Programmes) provided the characteristics of the ASA meet the HMRC guidelines and the company is eligible for such relief. ASAs will typically be triggered to apply subscription funds for equity at a future financing round. Unlike with CLNs, if the company becomes insolvent, investors are not considered unsecured creditors or holders of equity.

For both instruments, the discount rate may be applied at the time of conversion to reward early investors with a more favourable price per share compared to new investors. A valuation cap may also be introduced to give investors certainty on the maximum valuation at which their instrument will convert. Convertible instruments are often favoured in seed rounds because venture companies may have a limited financial history, making valuations uncertain and therefore delaying discussions around valuation until a third-party investor ascribes a valuation to what would be a more mature company.

Preferred equity refers to shares which have preferential rights to the ordinary equity, normally introduced at seed level investments and beyond. Investors will receive shares outright in exchange for their investment. Preferred shares take priority over ordinary shares, meaning preferred shareholders will be paid out before ordinary shareholders in the event of liquidation. The general principal upon liquidation is “last money in is the first money out,” and preferred shares aim to achieve that economic protection. Each round of financing often introduces a new class of preferred shares which ‘stack’ on top of one another with the ordinary equity at the bottom.

Typical key documents representing a financing round in a growth company include the following.

Term Sheet

A non-binding document, used as a basis for key legal documents, outlining the fundamental investment terms and conditions between the company, the investors and sometimes the founders. The term sheet plays a pivotal role in shaping the deal and serves as a road map for further negotiations.

Subscription Agreement

A binding contract between the investors and the company detailing the number and class of shares subscribed for, payment terms, and warranties from the company to the investors.

Shareholders’ Agreement

A binding contract between the shareholders, founders and the company which regulates the relationship between them all. The document is private and, therefore, houses matters which require confidentiality. Key provisions will include, inter alia, investor protections such as consent matters, information rights and board representation, as well as founder undertakings and covenants. The investors who are subscribing to shares in the company will be signatories to the shareholders’ agreement, as well as current investors. Not all shareholders have to be privy to this agreement, but it is generally recommended.

Articles of Association

The company’s constitution setting out the rights attaching to the shares including liquidation preference, procedures for the issue and transfer of shares such as pre-emption (and any such restrictions), exit provisions, and governance of board and shareholder meetings.

The British Private Equity & Venture Capital Association (BVCA) publishes standardised templates for the Subscription Agreement, Shareholders’ Agreement and Articles of Association for post-seed financing rounds. The purpose of these documents is to promote industry-standard legal documents, allowing investors and founders to focus on commercial, deal-specific matters, thereby reducing the frictional cost of capital to investors and companies alike. The latest update to these documents was in February 2023.

Ancillary documents to the key legal documents include the following.

• The management rights letter from the company to the investor outlining matters of company management and control in which the investor may participate. These are generally seen with regulated venture capital funds to ensure they can meet reporting requirements, amongst other rights.
• A disclosure letter from the company to investors setting out the disclosures against, or exceptions to, warranties given in the Subscription Agreement.
• The founder service agreement setting out a founder’s obligations, director duties, and the equity vesting schedule.
• Confirmatory IP assignment agreements, sweeping up any concerns relating to historical IP.

The key terms investors can secure in a downside or winding-up scenario with respect to other investors, founders and employees are as follows.

Liquidation Preference

This dictates the order and amount investors and other shareholders are returned if a liquidity event occurs. The mechanics of the liquidation preference structure are similar to other venture-friendly jurisdictions, layering share classes to create a preference stack, assigning a liquidation preference multiple for each class of shares, and participation rights (ie, non-participating preference v participating preference). If the company is wound down or sold for a lower valuation than the original investment, investors holding preferred shares have their subscription monies returned in priority to (potentially) other preferred shareholders lower in the preference stack and, ultimately, in front of the holders of ordinary shares, such as the founders or employees.

Voting Rights

Investors will want to secure voting rights that provide them with influence and control in major decisions, such as the sale or winding down of the company.

It is very common to attach anti-dilution provisions to preference shares and for the benefit of a preference class as a whole. They operate to compensate/rebalance the investor’s shareholding if the company raises a new round of finance at a lower valuation than the previous financing round. Such provisions will attach to a class of preferred shares and protect investors in a new round of financing either through issuing bonus shares or altering the conversion ratio of preferred shares to ordinary shares. Anti-dilution protection usually functions by applying a mathematical formula to calculate the number of new shares which the investors will receive, for no or minimal cost, to offset the dilutive effect of the issue of new shares at a lower valuation.

A pre-emption right, also commonly known as a “right of first refusal”, provides investors with the opportunity to subscribe to shares on a new issue or other shareholders’ existing shares on a transfer before they are offered to third parties.

Both anti-dilution provisions and pre-emption rights are prevalent in UK VC transactions, and feature in the BVCA shareholders’ agreement and articles of association standard templates.

The extent of investors’ control and influence over the management of the venture will vary, depending on the terms negotiated between the investors and founders. Typical market standard rights in relation to a company’s corporate governance include the following.

Director Appointment Rights

An investor or group of investors will be given the right to appoint at least one director to the company’s board. This right is usually commensurate with having to maintain a specific shareholding percentage, eg, 10% of the company’s share capital.

Observer Rights

Sometimes an investor will not want to be exposed to the fiduciary obligations that come with being a director, instead preferring to appoint an observer to the board. An observer will not have voting rights, but can attend and speak at meetings, and relay information back to investors. Often, the observer role is also used train up more junior members of the investor’s team.

Consent Matters/Veto Rights

Investors will cast votes in or be given the power to veto certain matters, such as:

• issuing new shares or amending share classes and rights;
• mergers and acquisitions;
• significant changes to the business plan and budget;
• changes to board composition;
• entering into significant investments or debt;
• exits which are not a qualifying sale, such as a secondary market transaction or winding down of the company; or
• IPO and related party transactions.

Consent matters are usually split into ‘value leakage’-type vetoes which affect the investor’s economics, as compared to more operational vetoes, which become less relevant over time as the management team gains experience.

Information Rights

The company will provide investors with specific information on a regular basis relating to the performance of the business, strategic growth plans and financial reporting to assist in keeping the investor informed on their investment (particularly if they do not have a board seat) and to satisfy their fund reporting obligations.

The subscription agreement will contain a schedule of warranties which are contractual statements of fact made by the company (and sometimes its founders) as to the condition of its business. The warranties ensure confidence in the investment and constitute a right to bring a claim for damages should something prove to be untrue and the investor can demonstrate loss. Warranties typically relate to the ownership of shares, assets and IP, employment, the financial health of the company, any legal issues, such as involvement in disputes, and the accuracy of information provided. Sector-specific warranties are also important, depending on the industry in which the company operates.

The normal recourse in the case of a breach of a warranty is to make a contractual claim against the company itself – which essentially means the investor would be looking to recover monies from their own investment. As such, disclosure becomes very important so that the investor is entering into the transaction “eyes open”. The founders may (rarely) give warranties as well. If they do, it is typical for their liability to be capped at a multiple of their salary, which is more common at seed-stage investments. Usually, the subscription agreement will contain a provision prohibiting an investor from bringing a claim without the consent of the majority or all of the shareholders. To mitigate the risk of breach and conflicts that arise in bringing a claim, thorough due diligence and detailed disclosure at the time of the investment are crucial.

In the US, it is standard for the warranties to be representations as well. This is not the position in UK venture capital deals because it gives rise to a misrepresentation claim where the remedy is recision or a claim in tort, rather than contractual damages, and can therefore have unintended consequences due to the different remedies.

Restrictive covenants and undertakings are a common feature of deals found in the shareholders’ agreement. Restrictive covenants limit the activities of founders and key employees, both during and after their employment with the company. For example, covenants will restrict founders from being involved with any competing business or acting in a way that harms the venture. Restrictive covenants must be time limited and jurisdictionally concise to ensure enforceability.

Undertakings are positive obligations put on the company and founders to perform certain actions or achieve milestones. They can be specific, such as rectifying an issue discovered in due diligence, or general, such as taking all action necessary to protect the company’s IP.

Breaches of covenants and undertakings will generally be remedied by specific performance or contractual damages.

Government Programmes

The UK government incentivises investment in small and medium-sized, unquoted trading companies through tax relief schemes available to individuals. The three most commonly associated with venture capital are the Enterprise Investment Scheme (EIS), the Seed Enterprise Investment Scheme (SEIS) and Venture Capital Trusts (VCT) relief. The schemes are expected to be available until 5 April 2035.

Each of SEIS, EIS and VCT relief serve a different purpose.

• SEIS is designed for early start-up, seed capital and can be used in advance of an EIS investment. Investors benefitting from SEIS may include directors (allowing business angels to impart business advice alongside investment).
• EIS relief has a similar set of requirements as SEIS, but with higher thresholds and limits to capture post-seed investments. Note that directors are generally disqualified from investing via the EIS regime.
• VCTs are tax-approved quoted companies which invest in shares and securities in other qualifying, unquoted, trading small and medium- sized companies. VCT relief offers similar benefits to EIS/SEIS by way of indirect investment, thereby affording investors increased liquidity.

Conditions for EIS, SEIS and VCT Relief

To achieve the different purposes of each scheme, there are prescriptive conditions. However, when effectively managed, the schemes can offer investors generous tax benefits.

Some, but not all, of the key conditions required to obtain the most beneficial tax outcome for investors are listed below (note that, for VCT relief, certain conditions “look through” into the investments made by the VCT).

Conditions of the investee company

• Gross asset test: GBP350,000 (for SEIS); GBP15 million immediately before issue and GBP16 million immediately after (for EIS and investments made by VCTs).
• Full-time employees: 25 or fewer (for SEIS); 250 or fewer (for EIS and investments made by VCTs).
• Maximum limit: GBP250,000 on, and in the three-year limit before, the SEIS investment taking into account other state aid (for SEIS) and GBP12 million (across all schemes (ie, EIS, SEIS and investments made by VCTs).
• Annual limit: GBP5 million (broadly, across all schemes).

Conditions of the investor

• Holding period requirement: generally, EIS and SEIS shares need to be held for three years to ensure the most tax efficient outcomes, whilst for VCT years produces the best tax results.
• Investor claim limits: GBP200,000 per tax year (for SEIS and VCT relief); GBP1 million per tax year (for EIS).

Note that the above conditions assume that the company in which the investment is being made is not a “knowledge-intense company”. For investments in such companies, certain limits and thresholds may be increased. For example, the total amount of scheme (including EIS, SEIS and VCT) financing which a company can receive is increased to GBP20 million; the annual limit increases to GBP10 million; and the amount of EIS relief from which an investor can benefit increases to GBP2 million.

Tax Benefits of the EIS, SEIS and VCT

Income tax

The EIS, SEIS and VCT relief offer upfront income tax deductions of 30% of the investment for EIS and VCT relief, and 50% for SEIS. Note, however, that the reliefs can be withdrawn in certain circumstances where the relevant holding period requirement is not met.

EIS and SEIS reliefs may be carried back to reduce prior-year income tax bills. The schemes reduce income tax liabilities to nil, but will not create a deficit.

Capital gains tax (CGT)

The schemes may also allow CGT relief in certain circumstances. If the relevant shares have been held for their requisite holding period and income tax relief was obtained at the time, gains on disposal should be exempt.

An individual can also defer gains made on other investments into EIS investments made within a period beginning one year before and three years after the EIS investment. In such circumstances, a future EIS loss may shelter a recrystallised gain (which would be charged at the rates of CGT when brought back into charge).

Inheritance tax

EIS and SEIS shares qualify for “business property relief” in respect of inheritance tax (and so should be exempt) if they are held for two or more years. 

Other Tax Benefits Available in the UK Which May Benefit the Venture Capital Market

The UK tax system is favourable to VC investors.

• Dividends – there is no withholding tax on dividends in the UK, and the receipt of dividends, whilst taxable, is subject to a number of exclusions which may apply (including specifically, one relevant to dividends from VCTs).
• Interest – interest is subject to 20 % withholding tax which can be offset against income taxes payable by UK resident individuals. The UK has an extensive double tax treaty network which seeks, where possible, to limit double taxation for non-UK residents. Individuals investing in trading companies, broadly, controlled by either directors or five or fewer persons, may also be able to claim deductions for interest payments on debt obtained for the purchase of 5% or more of the shares. This relief cannot be used in conjunction with the EIS (which should be more beneficial, if available).
• CGT – Business Asset Disposal Relief (formerly entrepreneurs’ relief) allows a 10% reduced rate of CGT up to the lifetime limit of GBP1 million of gains. This relief is relevant to employees and directors who, broadly, also hold a 5% (economic, voting and beneficial ownership) shareholding for a two-year period prior to disposal. Alternatively, Investors’ Relief may be available to similarly limit the CGT rate to 10% on lifetime gains of up to GBP10 million, but for external investors only, and requires a three-year holding period.
• Share loss relief – where an investor has invested in qualifying trading companies, share losses may be claimed as relief against income receipts, if conditions are met to make them “qualifying shares”. EIS shares are qualifying shares for this purpose (and SEIS shares may qualify provided that they meet the general conditions). Shares held in VCTs are unlikely to be eligible.

Venture capital investors are also often keen to ensure that investee companies avail themselves of reliefs and credits within the UK tax system such as “full expensing” and “research and development relief”.

So far, the UK government’s initiatives have primarily involved tax relief. However, it is now focused on enhancing the appeal of the UK for the world’s best and fastest-growing companies as a place to be listed, making London “the global capital for capital” with a market offering innovative capital solutions not seen elsewhere. To this end, the government is committed to a comprehensive programme of initiatives to deliver on various policy goals. These have involved the following.

• Motivating pension funds to invest in riskier/high-growth assets. The Mansion House Compact scheme involves a number of large pension funds and other stakeholders charged with facilitating the deployment of capital into UK high-growth businesses (as direct investments or via funds) to deliver better returns over the long term for UK savers and bring UK pension funds into line with some of their counterparts in other regions, such as Canada and Australia, where they have a larger allocation to high-growth industries.
• Providing investment to UK start-ups through the British Patient Capital and the British Business Bank.
• Seeking to regularise the arrangements governing university spin-offs.
• Regularly convening the UK venture community through its involvement in events such as UK Fintech Week and producing research and reports on how to promote the UK ecosystem (eg, the Kalifa Review of UK Fintech), as well as supporting the UK ecosystem at international conferences.
• Exploring further regulatory change to facilitate secondary trading in high-growth companies under a new regulatory framework, PISCES (see 6.3 Pre-IPO Liquidity) to promote intermittent trading venues.
• Wholesale reform of the UK public equity capital markets regulatory framework to support increased IPO activity as well as follow-on offers.

Founders are generally incentivised if issued shares at the onset of their venture, representing the “sweat equity” associated with an early-stage operation. To ensure there is a longer-term retention plan in place for each founder, vesting provisions are usually built into the articles of association of the company (or, less commonly, into the shareholders’ agreement, although this is a less optimal place for the provisions for enforceability purposes). Such vesting provisions serve reassurance for investors that founders are incentivised to remain with the venture during the specified time period, by implementing a process whereby the value of the equity is earned over time, albeit issued upfront for taxation reasons, in order to benefit from Business Asset Disposal Relief. If the founder were to leave prior to their full vesting period, generally, although this is up for negotiation with investors, a certain proportion of their equity, based on the time served in the venture, would be either transferred/recycled to other founders or other stakeholders or more simply converted into valueless deferred shares. In more serious instances (such as fraud or gross misconduct, ie, a “bad leaver”), all shares held by the founder would be clawed back, transferred or converted into deferred shares to protect the company’s interests.

Key employees are less likely to be issued equity upfront, unless they were onboarded early following the incorporation of the company when share value is low and/or fundamental to the founding team. More commonly, key employees would be rewarded through the company’s share option scheme once implemented. In the UK, the Enterprise Management Incentive (EMI) scheme is the most common type of option scheme to implement for a venture-backed company to reward its employees, as it is a scheme specifically designed for early-stage, high-growth companies (eg, qualifying conditions include that the company’s gross assets must not exceed GBP30 million and it must have fewer than 250 “full-time equivalent” employees. The company granting EMI options must be independent, and it cannot undertake certain specified activities (such as dealing in land). It is possible to obtain advance assurance from HMRC that a company qualifies.

The benefits of an EMI share option scheme include the following.

• No income tax or National Insurance is due on the granting of an EMI option.
• If the exercise price is at least equal to the actual market value of the shares under option at the date of grant, which can be agreed with HMRC, no income tax or national insurance is payable on the exercise of the EMI option.
• If the exercise price is less than the market value, the difference will be chargeable to income tax, and potentially National Insurance at exercise.
• If the employee has held the option and/or the shares for more than two years, Business Asset Disposal Relief (BADR) on capital gains tax (CGT) is available on the disposal of the option shares. BADR reduces the rate of tax to 10% on the first GBP1 million of gains. CGT will then apply at 10% or 20% (depending on the individual’s personal tax rate) for gains over GBP1 million (where gains are defined as the difference between the market value of the shares on exercise and the sum received on sale).

Employees must own less than 30% of the company to participate in the scheme. The maximum value of shares over which an employee can hold EMI options at any time is GBP250,000. Once this limit has been reached, no further EMI options can be granted within a three-year period.

The EMI option scheme is extremely flexible in that the company is able to set any vesting and exercise terms it considers appropriate. This allows for options to become non-forfeitable based on a vesting schedule, and the exercise of options can be restricted to exit events that may be full exits by shareholders or where there is an opportunity of a secondary sale. The above tax benefits will apply whenever EMI options are exercised.

A similar, but less flexible, tax-advantaged option scheme is the company Share Option Plan (CSOP), which allows for options to be granted on up to GBP60,000 worth of shares. Unlike an EMI option, the option price must be set at least at market value, which can be agreed with HMRC, and tax benefits will only arise once the options have been held for at least three years, or are exercised early in certain “good leaver” or on certain change-of-control exit events. Given these restrictions, CSOPs are therefore generally only adopted once a company no longer qualifies to grant EMIs.

Companies may also consider replicating the benefits of an equity arrangement with a cash-based (or “phantom”) share scheme. Under this type of arrangement, employees and service providers are granted the right to receive a cash payment from the company equivalent to the gain that they would have made on a share option. As there are no tax benefits to such arrangements, they are not restricted in structure. As the company would need to fund the cash payments, for a venture-backed company, awards will generally only vest and become payable on an exit event.

Venture-backed companies may also make use of cash-based retention bonuses for key employees which will be paid following the individual remaining with the company for a specified period of time, and potentially achieving certain key milestones within that period. There are no tax benefits available for cash-based arrangements.

In addition to incentive arrangements, the commitment of key employees to the business will be procured through the terms on which they are employed, including through the length of the notice period which would need to be given in order to leave the employment (which will often be coupled with the company’s ability to place a leaver on “garden leave” in order to protect the company’s confidential business information. Following cessation of employment, former employees will continue to owe obligations of confidentiality and may also be subject to covenants restricting them from joining a competing business, poaching employees or dealing with clients of the company for a period following departure. Any such restricted period run concurrently with any period spent on garden leave.

Usually, a founder’s ownership is earned, or vested, over time in order to incentivise them to commit and stay with their company. Reverse vesting is the most common in the UK, where a company will issue all of the equity to the founders upfront but subject to terms under which the company will “claw back” some or all those shares either by repurchase, transfer or conversion into deferred shares if the founder leaves before the end of a specified period. The vesting of the shares may also be subject to the achievement of milestones during the vesting period which, if not achieved, will similarly result in a loss of the shares. One of the advantages of reverse vesting is that the founders, who often own most of the equity, get full voting rights attached to those shares from the point of issue. From the company’s perspective, reverse vesting protects the company against a situation where a founder leaves and takes all their shares with them.

The company is free to set whichever vesting period and milestones it considers appropriate for the business. As the shares are subject to “forfeiture restrictions” the founder will generally enter into a “restricted securities election” with the company to ensure that any liability for income tax is limited to the point of acquisition, and not on a later sale or lifting of restrictions. Founders will generally pay the unrestricted market value for the shares (which at the inception of the company may be nominal value) to ensure that no tax charges arise – any discount would be chargeable to income tax and, possibly, National Insurance depending on the holding structure of the company.

Where key employees are to acquire shares at a later stage in the company’s development, care needs to be taken that those shares are acquired at the unrestricted market value, otherwise an income tax, and possible National Insurance, charge will arise on the difference between the market value and the subscription price paid. Given that there may have been significant growth in value of the company since inception, where options are not being granted (for example, because it is desirable for the individuals to hold shareholder rights, such as the right to dividends or voting rights), it may be appropriate to consider issuing a new class of “growth share” to such employees. Growth shares are a separate class of shares which have rights only to a proportion of the increase in the value of the company from the date of acquisition, rather than including value which has accrued prior to the date of issuance. Shares will therefore be issued with a company value hurdle, below which the shares will not participate in liquidation value. A valuation of such growth shares, taking into account the level at which the hurdle has been placed (which, in order to reduce the valuation, may need to be set at a premium to the company’s market value) will need to be undertaken to ensure, in order to avoid upfront tax, that shares are being subscribed at unrestricted market value. As described above, the employees will generally have to enter into a “restricted securities election” with the company to ensure that any liability for income tax is limited to the point of acquisition, and not on a later sale or lifting of restrictions.

When looking to establish an incentive arrangement for employees, the company will need to consider any restrictions which have been included in its articles of association or shareholders’ agreement in relation to dilution, pre-emption rights and requirements for shareholder approval or investor (director) consent.

The establishment and terms of any share incentive arrangement will be negotiated between the company and its management, existing investors and any new investor at the time of an investment round and the proportion of share capital which will be available to employees, and will therefore dilute investors, will form part of those negotiations. At later-stage investment rounds, where investors are acquiring preference shares rather than ordinary shares, the dilution will be after the return of capital and any associated coupon on the preference shares, and so investors are able to set a minimum return by way of the preference coupon before employees share in the further accrued value.

The shareholders’ agreement and articles of association will detail exit provisions and transfer restrictions which govern shareholders’ rights in the event of an exit trigger such as an IPO, sale of the company, or winding down of the company. Since 2013, a total of 5,899 high-growth companies have exited in the UK via an acquisition or an IPO, according to research by Beauhurst.

Exit Provisions

Liquidation preferences

These dictate the order and amount of investors and other shareholders in capital returned during a liquidity event. The mechanics of the liquidation preference structure are based on the structure of the preference stack, liquidation multiple, and participation rights. If the company is wound down or sold for a lower valuation than the original investment, investors holding preferred shares will most likely have their capital returned before holders of ordinary shares, such as the founders or employees.

Drag- and tag-along rights

Drag-along rights favour majority shareholders who want to sell the company by empowering them to compel minority shareholders to participate in the sale. Tag-along rights are the natural inverse to drag-along rights, which provide protection for minority shareholders by ensuring they can participate in the sale on the same terms as the majority shareholders and not be left in a company where a majority of shareholders have sold out.

Vesting schedules

See 5.1 General. In a liquidation event, a vesting schedule may be accelerated to allow founders to realise the full value of their shareholding earlier than forecast. The same may apply to option schemes, whereby a “single-trigger” acceleration would allow option holders to exit in full upon M&A. US acquirers will be used to a “double-trigger” event, where the exit is only one part of the acceleration but another condition must be met to accelerate in full (ie, a further retention period with the acquiring entity). This is often a discussion/negotiation point in acquisitions and due diligence is required upfront.

Conversion of shares

In the event that the qualifying threshold for an IPO is met, all preference shares will be converted to ordinary shares. Generally, any investor can request that their preference shares be converted at their instruction.

Registration rights

When an IPO takes place on a US stock exchange, investors are entitled to registration rights which include demand rights and shelf and “piggyback” registrations to ensure that all shares are listed.

Transfer restrictions

Transfer restrictions include the following.

• Pre-emption rights on transfer that provide shareholders with a right of first refusal to purchase any shares up for sale before they are offered to third parties.
• A lock-up period of, typically, 90-180 days after an IPO during which shareholders are prohibited from selling their shares to safeguard investors and ensure long-term dedication.
• Consent – shareholders may be restricted from transferring their shares without consent from the board or other shareholders; founders, in particular, may be locked in permanently or for a certain period of time, again to ensure the orderly functioning of the business and that management is retained.

IPO exits have historically been the natural progression for a venture company that has been growing rapidly for a number of years. Various external and internal factors – eg, business performance, competitive landscape and market conditions – play a role in accelerating, delaying, or even impeding a company’s exit and IPO timeline. IPO exits in the UK peaked in the third quarter of 2021, with both the number and value of IPOs of high-growth companies at a record level, representing a combined market capitalisation of GBP20.6 billion.

IPO exits globally have recently experienced a protracted slowdown, driven by high interest rates, rising inflation and the impact of these macroeconomic factors on valuations, as well as aftermarket performance difficulties suffered by recent IPO candidates. This challenge to the global public equity markets has led to an increased focus on regulatory reform, including in the UK and the European Union, to boost the attractiveness of the equity capital markets, and to increased competition from New York as a listing venue. In response to this, the Financial Conduct Authority is implementing a radical restructuring of the UK Listing Rules to attract more companies to London. The Listing Rules reforms have been generally well received by the market. Due to be implemented in summer 2024, they should make the UK one of the most flexible and welcoming listing venues in the world.

There is a tangible market need for secondary market trading prior to an IPO to facilitate liquidity. Faced with the slowdown in IPO activity due to the global economic climate, secondary transactions provide a mechanism for early-stage investors, founders and employees to reclaim all or part of their investments whilst allowing companies to remain private. Investors are more likely to invest, and employees to be retained, if the opportunity exists to sell equity before an IPO. Secondary market trading also means that new investors can tap into the potential of more mature and experienced companies.

It is a common strategy for founders to sell down a portion of their shareholding to incoming investors in a new financing round to receive some liquidity for all their hard work to date. Founders may offer a discount to the investor, and this can help the investor achieve a blended rate for their investment acquisition cost while offering an opportunity for founders to secure their financial future (eg, by buying a house) given that they will have worked on very modest salaries for some time. This is generally seen as a positive experience for both parties, and is very common on later-stage (Series B) transactions.

Some of the key challenges presented by secondary market trading include:

• the lack of transparency and readily available information about private companies compared to public companies;
• regulatory hurdles and compliance with securities law; and
• conflict between companies and shareholders, with the former wanting to maintain control of their equity trading via structured liquidity events such as tender offers and auctions, and shareholders preferring streamlined access to the isolated liquidity event of a direct secondary sale.

Notably, the UK government is currently consulting on detailed proposals for a new secondary market platform to facilitate the periodic trading of existing shares in privately held companies, the Private Intermittent Securities and Capital Exchange System, or PISCES. It will initially be established as a regulatory sandbox, using the financial market infrastructure sandbox regime created by the Financial Services and Markets Act 2023. The government predicts that PISCES will “support the pipeline for future IPOs in the UK, by improving the interface between private companies and UK public markets”. Intended to provide greater protection and regulation than that offered by the current private secondary trading market but remaining a lighter-touch approach than public regulated markets, PISCES will bridge the gap between the two with a standardised and controlled private trading environment.

The legislation is still being drafted, but some of the planned legal and regulatory parameters include:

• shares being traded intermittently during “trading windows”;
• restrictions on the categories of investors that can trade;
• disclosure requirements to investors who may trade in a specific window but not to the public; and
• a market abuse regime tailored to the intermittent nature of trading and the specific risks posed.

With companies remaining private for much longer and readily available exit opportunities limited at present, secondaries are becoming a very important focal point for company shareholders looking to realise some or all of their investment.

A venture capital-backed IPO is the initial offering of shares of a company that has been mainly funded by venture capital investors. For an IPO in the UK, an offering of shares to the public requires the publication of an FCA-approved prospectus. The UK Prospectus Regulation and Financial Services and Markets Act provides that a prospectus must contain the necessary information which is material to an investor for making an informed assessment of:

•       the assets and liabilities, profits and losses, financial position and prospects of the company;

•       the rights attaching to the shares; and

•       the reasons for the issuance and its impact on the company.

When preparing the prospectus, it is important to consider the following.

The “Equity Story”

The equity story is fundamental in highlighting the strengths of the company, its potential for growth and any key risks associated with the business. It includes the description of the business model, its market environment and growth prospects. A compelling equity story for the IPO will include information on market drivers and unique features compared to competitors. The equity story will appear in the prospectus, most notably in the founder’s letter and business overview, but it is also used for marketing and book-building purposes.

Key Employees/Management

The company’s senior management will remain important to the business after IPO, so the prospectus will include a section on directors, senior managers and corporate governance. New share plans for employees and executive directors are usually put in place as part of the IPO process and described accordingly. It is market practice to include a summary of the expected remuneration policy in the prospectus, if the company has made these decisions prior to the IPO, which is then put to the shareholder at the company’s first post-IPO general meeting.

Financial Information

The prospectus must contain audited historical financial information on the company and its group covering the latest three financial years and the audit report for each year. High-growth companies have struggled in the past to meet current track record requirements (for example, pre-revenue companies such as e-commerce and technology companies, acquisitive companies in the biotech, fintech and pharmaceutical sectors and other companies following a “roll-up” acquisitive strategy), which the FCA has taken into account when proposing changes to the UK Listing Rules. 

IP/Data Protection

Companies may find that IP issues not adequately addressed or altogether ignored suddenly become material problems leading up to or following an IPO, sometimes leading to multiple shareholder claims after the IPO causing the share price to tumble. For high-growth companies with a large amount of intangible assets, having an IP strategy in place protects these critical products and services and can maximise enterprise value.

Tax and Structure

Investors may favour companies with a particular company structure, such as the insertion of a holding company that will be the listing vehicle. Additionally, companies might choose to re-incorporate in another jurisdiction if they want to take advantage of more flexible governance requirements or a particular tax structure.

The UK’s National Security and Investment Act 2021 (NSIA) introduced new powers for the government, acting through the Investment Security Unit of the Cabinet Office (ISU) to review investments that it considers may give rise to a risk to the UK’s national security.

Investments of more than 25% into businesses that have activities in one or more of 17 specified sectors may be subject to a mandatory notification obligation, which requires the parties to notify the transaction to the ISU and obtain clearance prior to completion.

Investments that do not trigger a mandatory filing, but which still give the investor material influence over UK activities may be “called-in” for review if the government considers that it may give rise to a risk to national security. This power is exercisable at any time up to six months after the government becomes aware of the transaction, provided this is also within five years of the relevant transaction. Parties may therefore choose to submit a voluntary notification to the ISU, in which case this period is reduced to 30 working days.

Where a transaction is found to give rise to national security risks, the range of potential remedies is broad and can ultimately include prohibition or unwinding of the investment. Other examples of remedies have included restrictions on transfers to the investor of sensitive information, technology or intellectual property, requirements for UK governmental approval of future commercial conduct, requirements to appoint government-nominated board members, and requirements to keep certain capabilities within the UK.

The NSIA regime applies equally to investors of any nationality, both UK and foreign. That said, an investor’s nationality is likely to be a relevant factor, especially when considering any possible links to actors that may pose a security threat to the UK.