In the first article published by the Private Equity group we consider some of the key differences between private equity and venture capital transactions.
The nuance is subtle yet significant, and crucial to understand. This article falls into a wider series of legal insights written by our Venture Capital group on the fundamentals of equity transactions.
The difference in a nutshell
Venture capital ('VC') and private equity ('PE') are similar in that both refer to equity investments in companies that are not publicly listed. However, one key difference between VC and PE is the age of the company receiving the investment. VC is typically a form of investment for early-stage, innovative businesses with strong growth potential, whereas PE investments tend to support management buyouts and buy-ins in more mature companies that have an established trading history.
It follows that VC investments usually have a higher risk profile, with the target often having little (or no) track record of profitability but are in need of a cash injection to achieve the next stage of growth. In contrast, PE funds traditionally invest in more mature companies to reduce inefficiencies and drive business growth through increased margins, new sources of revenue and bolt-on acquisitions.
Key differentiators from a legal perspective
Despite the terms PE and VC often being used interchangeably, the standard terms and processes implemented in a PE transaction are not as transferrable to a VC transaction as one may think. There are key distinctions between the two and we have highlighted some notable differences below.
1) Equity and Funding Structure
VC firms normally take a minority equity stake (less than 50%), often alongside other VC firms. This equity ownership is obtained in a series of successive rounds (series A, B, C, D and so on). In contrast, PE firms usually invest in larger, more established companies and require a larger stake, often a controlling majority share (more than 75%) and buyout the entire business.
Whereas VC transactions are often structured as a direct investment into an existing corporate entity, PE deals are more typically structured as a buyout involving a number of new companies established for the purpose of the transaction. If the founder/management team holds shares in the target company, the new PE investor will invariably insist on a reinvestment of part of the proceeds of sale of their target shares – i.e. a "rollover" - to ensure that the founder/management team has sufficient skin in the game and is suitably motivated to drive the value of the newco group. As such, the management team's investment will often take the form of shares in newco subscribed for in cash, known as "sweet equity" and an exchange of some of managements' target shares for shares in newco, known as "rollover equity".
2) Leaver provisions
Across both PE and VC, leaver rights are a common feature. They ensure that if a founder or employee shareholder leaves a company prior to exit, some or all of their equity is made available to incentivise a replacement without diluting the other shareholders. The category of leaver determines what happens to the leaver's equity.
There are often multiple categories of leaver in a PE transaction, whereas VC deals normally only cover 'good leaver' and 'bad leaver'. In a PE deal these will typically look something like:
- "Good leaver" – an employee who leaves in circumstances where they are generally not culpable, for example, death, incapacity, or wrongful termination; and,
- "Bad leaver" – an employee who leaves in circumstances where they have done something wrong such as gross misconduct, criminal offences or other summary dismissal.
However, in VC deals it is more common for 'bad leaver' to cover scenarios such as voluntary resignation and breach of any restrictive covenants, with founders arguing that 'good leaver' should be more broadly defined as all other scenarios. This is more beneficial than PE transactions where the definition of 'good leaver' is intentionally very narrow to ensure that management are committed to the target business for the full life-cycle of the investment.
In PE deals, the categorisation of a person as either a good leaver or a bad leaver will usually determine the price at which they are required to sell some or all of their shares in the company on departure. However, in VC deals it is common for a proportion of a good leaver's shares and all of a bad leaver's shares to automatically convert into deferred shares, avoiding pre-emption implications that are common in PE transactions.
On a PE transaction, a leaver's "sweet equity" and "rollover equity" will generally receive different treatment as management will argue that their reinvestment is value they have already created and so should be protected from any leaver arrangements.
3) Vesting
In light of more beneficial leaver provisions, a key feature in VC transactions is the vesting schedule linked to the leaver provisions. Commonly, the vesting schedule allows a founder to 'earn back' their equity over time where they are deemed to be a good leaver.
Vesting will usually occur on a 'cliff' basis meaning that a defined percentage vests straight away or on an anniversary of the investment, after such time the vesting will occur monthly or quarterly (usually across a period of 4 years). Vesting may also be aligned with performance or upon hitting certain milestones and can be accelerated on the occurrence of certain specified events, such as the sale of the company or if the founder is wrongfully terminated without cause.
In contrast to VC transactions, vesting in PE deals is typically only relevant where the concept of 'intermediate leaver' is introduced (and consequently the circumstances in which a manager is considered a bad leaver scaled back from catching any leaver not considered a good leaver) to capture the circumstances in which a manager is neither a good leaver or bad leaver, but who leaves within a specified period after completion of the buyout.
4) Ratchets
A ratchet is a common feature of PE deals. It is a mechanism which increases the amount of equity held by managers if certain performance targets are reached and therefore allows the management team to get a larger slice of the proceeds on exit if the target business exceeds its projected performance.
Contrastingly, in VC deals, a ratchet is used to implement anti-dilution rights to protect an investor against a decrease in the valuation of the company following the VC's investment. Early stage companies often go through numerous rounds of VC investment. During this process, the company may find that their valuation has dropped in between rounds (commonly referred to as a 'down round'). An anti-dilution ratchet aims to protect a VC investor by entitling them to extra shares (at no or minimal cost) to ensure that the average price per share paid by the investor is adjusted to avoid the investor having overpaid in the previous round of investment.
5) Drag along
A drag-along provision enables a majority shareholder who wishes to sell their shares to force the minority shareholders to sell their shares too. It is a common investor protection in both VC and PE deals as investors know that any potential buyer is unlikely to be willing to buy anything less than 100% of the target.
Most PE investors require an unfettered right to exercise a drag along. However, on VC transactions the drag right is typically only exercisable by the majority shareholders acting together, including the investor majority. This importantly gives an investor the right to exercise a drag right but also the ability to block another shareholder from invoking a drag right. This avoids a situation whereby an investor can be dragged into an exit that it does not approve.
For further information on drag and tag provisions, please visit our recent article on the topic.
