Who Is Looking Out For The Interests Of The Founders? – Shareholders

UK Private Capital (formerly, the BVCA) aims to standardise
Series A transactions and focus negotiations on (fewer) key points.
The increasing use of AI to generate initial drafts based on
standard terms like these, which are effectively created by VCs and
their lawyers, will likely only accelerate this trend.

While not necessarily unfair, this raises the question:
who is looking out for the interests of the
founders? Currently, founders lack a formal platform with
industry-accepted tools to negotiate effectively. This article aims
to provide some guidance.

1. Leavers and (Reverse) Vesting

On leaving the company the customary-ish position here is that
all the shares held by a founder are forfeited if that event is
owing to fraud, gross misconduct or breach of any
compete-restrictions or any employment agreement (in other words, a
bad leaver). On departure for any other reasons (that is, a good
leaver) the forfeited shares are only those that are not vested.
The standard vesting period is typically 36 or 48 months on a
linear basis save that there will be likely be an initial 12 month
cliff where no vesting applies.

What may additionally be negotiated is that:

– Resignation: the UK Private Capital terms
flipped in 2023. Previously resignation would amount to being a bad
leaver event. It is to be applauded that an industry body
representing VCs was able to consider that a resignation should not
necessarily lead to a founder losing everything. Sadly, some term
sheets we see resile from this and re-flip. This has led to
intermediary positions where, for example, the founder must not
resign during an initial period but thereafter can resign and be
considered as a good leaver (though this tends to apply to more
mature businesses).

– Pre-vesting: there can be an iterative
discussion that the founders have already earned some of their
shares and those earned shares ought not be subject to vesting.
This tends to apply to the “older” companies or to
founders who have already navigated (even if only in part) vesting
procedures in a prior seed round. This will be a Series B
consideration, but we have seen this apply on a Series A. Be wary,
this may be implemented as an adjustment to the vesting
percentages; vesting in its standard format only applies to a good
leaver – forfeiture of all shares on a bad leaver event does
not look at the vesting schedule, so if a bad leaver is intended to
keep shares a specific change must be made. Lastly, it should be
clear to all these provisions should not apply to shares purchased
or to be purchased by the founder for value.

2. Other thorny deal terms

Lastly, here are some thoughts on some common areas to consider
in investor-driven financing documentation. Of course there are
more:

– Lead investor: we are seeing fewer term
sheets with the principal investor being prepared (at least,
expressly) to take the “lead investor” role. Without it,
alignment can become problematic if there are multiple investors
contributing meaningful amounts. Please consider carefully at term
sheet stage the process as between investors and the likely input
from those that are less involved. Some of the terms defined by
reference to share percentages need to be considered too. For
example, if it is likely that some VCs will be marginally below an
investor director appointment right threshold, how would the
balance on the board be impacted if on a pre-emptive round that
threshold is exceeded? Will there be further VC appointee director?
Or does this remain as previously? Does an observer right need to
be considered? Moreover, when making warranties, will these be made
to all the investors or just the VC that ought to have been the
lead? If more than one, it would be an odd conclusion if one
decides to make a claim and the other(s) decide to pass? These may
seem like the driest form of lawyers’ points, but if not
resolved at the outset more time can be lost later when less of it
is available.

– Anti-dilute: this form of down round
protection has now been the market standard for 20 years plus.
There are two types, one used in the US (and adopted by the NVCA)
and another used in Europe. It is regrettable that the latest round
of changes the UK Private Capital terms were not adjusted to adopt
the NVCA model, for that it is the original and is more widely-used
(including across the Middle East). It is also simpler
administratively. There are many articles on the internet to
explain the differences; but what is important to note is that both
lead to a balancing equity correction in favour of the VC if a down
round occurs. The rebalancing is very rarely substantial unless the
down round is significant; this must therefore be primarily
regarded as an anti-embarrassment provision. I have written a lot
about these clauses (as in my experience not many actually read
them), but I will restrict myself to:

A sunset provision should apply on the basis that there is no
longer any embarrassment. This can be after a period of time
(suggest, 12–24 months) or upon the occurrence of a higher
price round. In any event Series B VCs (who were not part of the
Series A) are always loath to agree to this compensation for
earlier round investors.

The underlying math is designed for one application only. This
is because the corrective measure arising from a prior down round
in not actually factored into the weighting used in the formula,
unless adjusted. In nearly all circumstances, when the formula is
retained that adjustment is not made. It is possible to argue that
few really understand the formula and even fewer actually care
about the result it delivers other than the fact that it delivers
one (and it is “standard”). But one thing is for certain,
the founders (as they are rarely also investors) are diluted the
most.

We are seeing instances where these terms are integrated into
seed rounds. These clauses were designed for Series A and onwards;
we would caution founders against agreeing to them on an earlier
financing where the underlying valuation is less formulaic.

– Investor consents: even though investor
consents now tend to take a common form, I still am asked about
these. They are a major change in governance for the founder
(especially those who have not undertaken a meaningful seed round).
The three areas on which I ask founders to consider are:

The capital related consents, that is the need for an investor
consent to agree to issue shares or rights to shares. There is a
lot to unpack here, including the legitimacy of a VC being afforded
a veto in circumstances where they have the ability to pay-to-play
through pre-emption but decline. But that is for another day; the
veto has become “standard”. What is left is that the
founders should consider whether further issuances are contemplated
shortly after closing or whether any option plan is to be
implemented so that these can be excluded from the consent right
(essentially, they are pre-approved);

The business-related consents, as these come from a customary
template, these should be assessed as whether they are appropriate
or germane to the business. If they are not, the offending consent
rights should be amended or deleted; and

The nature of the investor majority which decides matters is
different for each business. If it relates to a percentage and that
percentage is too high, this will mean that smaller investors will
wield power beyond that merited from the capital they have
introduced.

– Founders’ warranties: the UK Private
Capital terms are based on warranties being given by the company.
We see the VCs departing from their own standard terms, by
inserting that the warranties must additionally be given by the
founders. Standardisation here is problematic, this is because the
limitations (of liability) set out elsewhere in those terms are
based on the warranties only being given by the Company. Additional
terms need to be added to protect the founders here as (for
example) they should have a liability capped at a much lower value
than the total funds raised. We commonly see drafts where these
protections are (hopefully, mistakenly) omitted in the opening
draft.

– Deal fees: information on deal fees is less
widely available and is to some extent anecdotal. As to arrangement
fees there is a fair amount of disagreement between VCs as to
whether they should be chargeable at all and, if not, whether they
are to be baked into the underlying valuation. We find that some of
the larger VCs with an international footprint are less keen on
deducting an arrangement fee from introduced funds. Elsewhere we
see fees calculated at 2–3% of those introduced funds, though
we are seeing a slight nudge beyond that from time to time. A
contribution to VC legal fees is typically capped at the first
£30k of fees accrued. Founders who have been through a seed
round will be accustomed to a quarterly monitoring fee (at say
£20k–£30k per annum). This mostly (but not
always) falls away on a Series A. For those VCs with – let us
say – a PE heritage, this monitoring fee may be replaced with
a director’s fee contribution. This can be up to £50k per
annum (which in our opinion is on the high side). In all cases, we
suggest that these fees should at least be discussed, the final
agreement being heavily coloured by the weight of bargaining
power.

3. “We want to reward our people, but we run the
business”

It is surprising to me that non-voting shares are not introduced
at an earlier stage. The first gating moment tends to be upon the
implementation of (if in the UK, a tax-efficient) option scheme. In
most (but admittedly, not all) instances shareholders other than
the founders who become stakeholders at an early stage are less
interested in voting and management. The chief requirement is a
right to a future economic return, perhaps as a compensation for
reduced income. It’s an easy change to the articles and gives
more decision-making authority to the founders through the later
aspects of their corporate journey.

4. Housekeeping: the Register of Members, Cap Table, and Share
Certificates

Many of my founder clients do not appreciate that their company
must have a Register of Members. This is distinct from making
filings at Companies House and is not the same as a cap table. As a
matter of law the entries in the Register of Members are the
primary evidence as to identity of the shareholders and the shares
they own. The cap table must reflect this; it is not supposed to be
the other way round. We are now beginning to see tools which can
help with these tasks. We recommend creating the Register at an
early stage when there are fewer shareholders. Recalling the
requisite detail at a later stage is sometimes not straightforward.
Before the term sheet stage, please ensure any promises to issue or
transfer shares are fulfilled or clearly documented for completion
at closing. Unresolved share promises often surface during
financing rounds. This can frustrate VCs, risks losing momentum and
can delay closing.

As to the cap table, it is common to see shares and options
(allocated and unallocated) being treated together. This has a
clear function in terms of calculating fully-diluted share capital.
But it is more useful if the totals are also calculated separately
by reference to shares, allocated and unallocated options. In terms
of consent rights and voting, these will relate to (voting) shares
only. The definitive documents when it comes to resolutions and
consents will refer to shares only. Voting percentages are highly
relevant to the definitive documents, so – to avoid
surprises, especially for those heading directly to Series A
(without a prior seed round) – it is preferable to have these
set out clearly at term sheet stage.

Share certificates are an outdated legacy. They are not legal
proof of ownership and serve little purpose. Shareholders
frequently lose their share certificates and replacing them is an
administrative burden that can be complicated by uncooperative
shareholders. A simple one line change to the articles can be made
to enable shares to be uncertificated with certificates being
available only on request (i.e. to a VC).

5. Diligence and Disclosure; they are not the same.

We get asked a lot about this. In short:

– Diligence is the exercise whereby an investor seeks
information about the company, its assets and liabilities before
committing to the transaction. This information is provided in an
online data room. On a Series A this is typically run by the
company with limited involvement from counsel. We recommend that
work is begun on this as the term sheet process starts (and any
pitch deck must be consistent with those documents uploaded). It is
essential that the folders are structured and populated on a
logical basis. Our data room schema can be found here.

– Disclosure is a formal response to the warranties (broadly,
legal promises) required to be given by the company and the
founders to the VCs in a Disclosure Letter, which contains
statements of fact to counteract the circumstances where the
warranties are not true. If properly drafted an investor will not
be able to bring a warranty claim in respect of that disclosed
matter. Previously, a general disclosure of all documents in the
data room was sometimes accepted, but the standard has reverted:
founders must now provide specific, detailed disclosures for them
to be effective.

These are arduous (and frankly, boring) exercises for the
founder, more so than on a seed round. If the company has reached
an element of maturity by Series A, consideration should be given
as to whether a person other than the founders has sufficient
knowledge to front this exercise, thereby alleviating the burden on
the founders.

6. “What? The company does not own the intellectual
property”

A general principle of English law is that the first owner of
any intellectual property is the person who designed or created it.
The important rights here are usually copyright and/or patents. One
of the exceptions in in both cases is that the company will be the
first owner if the copyright or patent is designed or created by
employees in the normal course of their employment.

Early-stage companies often use contractors rather than
employees. These contractor agreements must assign all intellectual
property rights to the company. Correcting this oversight later
with a separate assignment document can be challenging if the
contractor is not easily contactable or has emigrated to the
foothills of the Carpathians.

Since intellectual property is often a company’s primary
asset, VCs will almost certainly require ownership issues to be
resolved on or before closing.

7. Initialisms: CLNs and ASAs

There is plenty on online commentary on (debt and equity-based)
CLNs and ASAs. My colleague, Mark Ward, has provided a good summary
which can be found here.

When using CLNs, it is crucial to pull out all stops (or the
tarot cards) to set a reasonable valuation cap. A cap that is too
low can give early lenders an excessive discount. Stacking, that is
the accumulation of multiple CLNs, can be a blight too. VCs may
require those notes to convert on a same price paid basis.
Alternatively, they only come in at a much lower valuation (nearer
to that cap) or simply walk away if they feel that value has been
excessively eroded.

As to ASAs we are regularly asked about EIS and SEIS, whether as
part of a Delaware Flip or otherwise. My tax colleagues have
updated their overview of these schemes following the 2025 budget
(which can be found here). As an overall comment (to a question
regularly posed to me), the more nuts and bolts aspects to this,
such as making the requisite filings directly to HMRC, are normally
handled by the founder or the company, possibly with help from an
accountant.

8. “We just gave the shares back”

In those rare what-if moments or at 3am in the morning, some of
us do consider how we would reform the maintenance of share capital
rules. Share capital rules exist to protect creditors, as
shareholders have limited liability for the company’s debts.
Because creditors rely on the stated share capital (or so it is
said), the process for reducing it (that is by cancelling or buying
back shares) is intentionally complex.

No practising lawyer invented these rules. But they did invent
the ruse technique to circumvent them, essentially creating a
separate class of deferred shares with negligible value. This means
that when shares are forfeited, they can be converted into these
deferred shares, rather than being handed back to the company. This
does need an amendment to the articles, but it is worthwhile step
to take early on, particularly for handling leaver shares.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.