Determining “certainty of asset” is a key element of any investment. When an investor takes a minority position as it does in a typical venture or growth capital investment, the approach to ascertaining certainty differs based on the risk appetite and the alignment of the investor and the portfolio company. This article explores and compares the typical U.S. and UK approaches to warranties and disclosures in venture/growth financing transactions.
Warranties are assurances provided by a company to the investors intended to confirm the accuracy of certain statements and conditions about the company’s state of affairs. Both the U.S. National Venture Capital Association (NVCA) model stock purchase agreement and the UK’s British Private Equity & Venture Capital Association (BVCA) subscription agreement include a series of model warranties relating to the issuing company and its business. A key difference between the U.S. and the UK is the approach to warranties.1
1. U.S. vs. UK Approach to Warranties
In general, warranties help mitigate risks for investors by giving them a greater insight into the operations and integrity of the underlying business and the bundles of contracts that constitute the company. Depending on the size of the transaction and sophistication of the investors and company, the warranties may serve as the key element of an investor’s diligence, as they typically cover the essential elements of the company’s operations that would determine whether or not an investor would want to invest in such company. These warranties serve two functions: 1) force disclosure of information and 2) set boundaries around what the parties agree is the state of the company at the time of the investment that also influence recovery of damages if proven wrong. Warranties tend to ask questions of the “average” company so that they are generally not heavily customized. A warranty is sort of like ordering a Big Mac®or Royale with Cheese; the investor is buying something standardized.
However, if there is no available ketchup and mustard for that order, the store needs to tell you what is missing since you expect it. You can then decide to buy it still (or ask for a discount). Disclosures are the equivalent of the cashier telling you they are all out of ketchup and mustard but otherwise have a Big Mac®for you. Disclosures modify warranties to give a more specific understanding of the asset. Any matter that is disclosed serves to modify the warranty accordingly such that the combination of information makes it true as of the point of measurement.
2. NVCA
The NVCA model stock purchase agreement includes a robust set of warranties expected in venture financing agreements. The NVCA’s approach emphasizes comprehensive coverage of all critical areas that might affect the company’s valuation and operational integrity.
Most critically, the NVCA model is built around the concept of successive rounds of investment building to a sale or IPO of the business. As such, the warranties tend to be closer to a full set of trade sale warranties in many respects as it helps the company prepare each round of financing for an exit event. Additionally, the NVCA model is built around disclosure exceptions (i.e., the warranties are true EXCEPT as disclosed in specific details) where the issuing company has the greatest ability to manage the disclosure efficiently. The U.S. market is focused on rapidly educating investors. The principal goal is to provide investors with a complete and accurate picture of the company’s status, ensuring informed decision-making at the time of investment rather than as a tool to settle damages later.
Notably, the NVCA model forms are essentially silent on procedures for breaches of warranties except to normally include a time limit for claims for breaches of warranties, unlike the BVCA model forms. While the U.S. is known for being a more litigious country than the UK, this is often a curious difference between U.S. and UK practice. However, this is largely due to the sheer volume of deals and repeat players in the U.S. As a general matter, U.S. investors do not view the warranties as a practical means of recourse short of a fraud claim since the reputational effect of an investor suing a portfolio company for breach of contract can be quite damaging to new deal flow for the investor. Additionally, most U.S. companies are built for high growth, high cash burn strategies, so the available assets for recourse in most cases would be the cash contributed by the same investors anyhow. As such, the NVCA forms typically omit mechanics around claims against the warranties as not worth spending lawyer time on the negotiation relative to the benefits.
Finally, U.S. investors generally eschew founder warranties as not meaningful and off-market. This is again largely a function of deal volume and more historical repeat play in the U.S. The investors may be investing in a serial entrepreneur with whom they trust to build the business because they have seen the entrepreneur build previous businesses. Additionally, most U.S. investors do not practically expect the value of any real or perceived recourse on the founder warranties outweighs the relationship harm of the pressure it is perceived to put on the founders.
3. BVCA
As the name of the organization—the British Private Equity & Venture Capital Association—suggests, the approach taken by the BVCA originally evolved from that used in private equity deals. The warranties seen in the BVCA model documents are significantly broader in scope but far less specific than the warranties provided by the NVCA model documents. Similar to a trade sale, the BVCA model also requires extensive disclosures, often via detailed schedules that are not meant solely to address exceptions to warranties. As a private equity environment typically has one investor taking a significant or controlling stake in a company, the underlying structure of the BVCA warranties was not originally intended for multiple rounds as a company grows and bringing in multiple future investors. The BVCA approach to warranties is much broader but also less likely to prompt the issuer to actually make specific disclosures. Thus, the investor expects to bear the burden of figuring out what is missing, and they are often expecting to be in position to seek recourse from a company far more readily.
With respect to recourse, BVCA documents typically incorporate certain negotiated limitations on liability in respect of the warranties. While similar to the NVCA in that they both often include a time limit for claims, the BVCA has a more fulsome set of procedures similar to a trade sale for claims including limitations on who can make a claim among investors, overall liability caps (usually exempting fraud), and often “baskets” for claim sizes. Unlike a trade sale, it is not atypical for the total cap on liability to be equal to the total investment amount.
In addition, UK and European investors have historically sought to require the founders to provide the same warranties, therefore exposing them to direct liability for contractual breach beyond a fraud claim. However, it is typical in those cases for each such founder’s liability to be capped at a salary multiple of 1-2x the founder’s gross salary (absent fraud). In recent years however, the UK venture/growth investor community has increasingly given up on using founder warranties as evidenced also by the recent removal of the term in the BVCA model documents.
Disclosure under the BVCA is generally broader and less focused than under the NVCA. In the UK, a company will prepare a separate disclosure letter, which will contain both general disclosures (i.e., matters deemed to be within an investor’s knowledge, such as information available as part of the company’s public record at the UK’s Companies House) and specific disclosures that modify warranties. As the market has globalized and moved closer towards standard venture capital and away from private equity, the disclosure exercise became more akin to that under NVCA documents, with targeted disclosures against the warranties. The warranties, however, remain much broader than that of their U.S. counterparts.
4. Worlds Colliding?
In either jurisdiction, it is reasonably rare for reputable investors to bring a claim on warranties except in situations that rise to the level of fraud. This is due to the fact that investors would be bringing claims against the money they put in anyhow, so there is little upside value in a claim except perhaps a basis to claim a bigger percentage of the company. However, that usually comes at the expense of the relationship with the founders, who are often critical to the business. Claims tend to be used only in extreme situations where founders or management are engaged in true bad behavior, as most investors are loath to gain a reputation as being hostile to founders.
Practically, the U.S. model is very battle-tested for the venture capital model: raise successive rounds, get strong information from the best source (the issuer) and set the company (and the investors) up for exit. The UK model is increasingly moving this direction as the more venture-capital style of deals promulgate in Europe as compared to the historical private equity approaches. It seems unlikely these changes will happen overnight, but over time we expect increased convergence of the content of warranties, and approaches on liability and disclosure.
For more information on warranties and disclosures in the UK and U.S., please contact Wilson Sonsini attorneys Michael Labriola or Stacy Kim.
[1] One important but subtle point to highlight is the name of these provisions. In this article, we refer to warranties to mean both “representations and warranties” in U.S. parlance. U.S. law generally considers representations to be statements of fact (e.g., a company owns a particular asset), and warranties are promises about a state of an asset or condition (e.g., an asset is warranted to be in operable condition for the use as intended). There is not an appreciable difference under U.S. law as to the difference in a breach of either. By contrast, many venture practitioners in the UK consider a meaningfully different view of representations. Under UK law, representations are legally factual statements that are used induce a party to enter into a contract. Thus, if a representation is not true, then the underlying inducement is invalid, and the aggrieved party may be permitted to void the contract and/or rescind the payment and share issuance. As a result, UK venture practitioners tend not to use the term representations where possible to avoid a presumption of a more substantial remedy notwithstanding that many statements will end up being de jure representation even if not expressly named as such.
