While US VC and angel investors increasingly show interest in investing in English and Irish holding companies, they come with different expectations than their UK counterparts. Those UK early stage companies wishing to raise capital in the US should be aware of the differences in the way early stage funding works on the other side of the Atlantic.
Some of these differences are mainly nomenclature and reflect the oft-observed dynamic of the UK and US being “two countries divided by a common language.” For example, common stock and ordinary shares, and preferred stock and preference shares, are pretty much alternative terms for the same kinds of equity, although, of course, there are differences between UK companies law and US corporation law.
Some differences are more substantive. For example, some US investors may press you to “flip” and put in place a Delaware holding corporation over your existing UK company (The pros and cons of ‘flipping’ will feature in next week’s blog).
Early stage UK investment is driven by SEIS and EIS tax schemes
UK early stage investment is heavily driven by the substantial UK governmental support provided through the SEIS (Seed Enterprise Investment Scheme) and EIS (Enterprise Investment Scheme) tax incentives (Venture Capital Trusts also play a role). These incentives only benefit UK taxpayers. To qualify for SEIS and EIS incentives, the companies and the investments must meet a number of requirements. One of these requirements is that the investors can invest only in ordinary shares – these shares have the same rights as the shares held by entrepreneurs.
SEIS and EIS investments are typically made by UK angel investors and early stage SEIS and EIS qualifying funds. While the SEIS limit is low (a company can only raise £150,000 under SEIS), companies can raise up to £5 million over one or more 12-month periods under EIS (subject to a company gross assets limit).
US angels prefer convertible debt offerings
In contrast, while US “friends and family” investors and some US angels may invest in common stock, most early-stage US professional angels prefer to invest in convertible debt (or, less frequently, convertible equity). This is structured to convert, in a subsequent Series A (i.e., first) convertible preferred stock round, into convertible preferred stock at a discount to the price in that Series A round (typically also subject to a cap on price).
As highlighted below, convertible preferred stock gives holders preferred rights. The use of convertible debt at the seed stage puts the US professional angels in parity with later stage venture capital investors, rather than, as in the UK, subordinate to them.
So, if professional angels want to be in parity with later stage venture capital investors, why are they prepared to invest in convertible debt rather than insist on directly buying convertible preferred stock? Mainly because, at this early stage, there is a desire to minimise legal fees, and negotiating and documenting the preferences and shareholder arrangements that are typical in a venture round involve significant legal expense (even though the lawyers typically cap their fees in a Series A venture round).
Understanding the terms of Series A convertible preferred stock
The terms of Series A convertible preferred stock/preference shares in the US and the UK are quite similar. Convertible preferred stands in front of the common/ordinary shares held by entrepreneurs in an exit scenario. Additionally, at this stage (if not before), entrepreneurs should expect more detailed shareholder agreements that address such matters as board representation, “reverse vesting” (i.e. forfeiture) of some founder shares if the founders leave within a specified period, “drag along” rights that facilitate a sale of the company as a whole (and “tag along” rights that protect the minority from being left behind) etc.
In the US, Series A investors will also want “registration rights” that put them in a position to force an initial public offering (IPO) so that they can freely dispose of their shares without violating US law.
These days, US Series A convertible preferred stock rounds typically start at a minimum of $5 million (at current exchange rates, around £3.3 million). Levels below are considered seed investment. In the UK, in contrast, Series A VC rounds may start as low as £1 million, sometimes even less.
Want to learn more (further reading)?
This stuff is pretty dense. You can find out more about how US venture capital fundraising works by reading Brad Feld and Jason Mendelson’s book “Venture Deals: Be Smarter than Your Lawyer and Venture Capitalist.” Their book provides a very clear description, written for entrepreneurs, about how venture funding works in the US.
Next Week: To flip or not to flip? …
Article produced in partnership with Daniel Glazer and Robert Mollen at Fried Frank Technology.