The most appropriate venture capital exit strategy will be influenced by factors such as market conditions, the company's growth stage, investor preferences, regulatory considerations, and stakeholder alignment. The most common Liquidity Events are:
- a trade sale;
- an initial public offering (IPO); or
- a secondary sale of shares to another investor.
Exit provisions
Exit provisions in the investment documents set out the rights and procedures governing how Investors may exit their investment, providing a structured mechanism for Investors to realise returns on their capital (Exit Provisions). The key Exit Provisions most commonly found in the investment documents include drag-along rights and tag-along rights, redemption rights and qualified Liquidity Events.
Drag-along and tag-along rights
Drag-along rights enable a specified majority of shareholders, or a specified investor majority, to require the remaining shareholders to transfer their shares where that majority has accepted an offer from a third-party purchaser. This ensures that Investors can deliver a clean exit by enabling a purchaser to acquire 100% of the company, without which a small minority of shareholders could withhold consent, delay completion or prevent the sale. It can also increase the overall value of the investment, as purchasers are often willing to pay a premium for full ownership and control of the company.
Tag-along rights are designed to protect minority shareholders by providing them with the right, where the majority propose to sell their shares to a third-party purchaser, to participate in the sale by requiring the majority to procure that the purchaser also purchases the minority shareholders' shares on the same terms and for the same price per share, subject to any agreed differences arising from share class rights or management incentive arrangements. This right provides Investors with the assurance that they can exit alongside the majority shareholders, which can make the investment more attractive and secure. Without such protection, minority shareholders could be left with limited influence and fewer opportunities to exit their investment on the same economic terms as the majority.
For a more detailed discussion of drag along and tag along rights, please refer to our previous article Drag along and tag along rights: Balancing exit certainty and minority protection.
Redemption rights
Redemption rights provide Investors with a mechanism for their shares to be purchased back by the company after a certain specified period or under specific conditions. These rights are commonly exercisable after a period of five to seven years, or where agreed liquidity milestones, such as an IPO or sale of the company, have not been achieved. Accordingly, redemption rights do not depend on the existence of a willing third-party purchaser or favourable market conditions. This gives Investors a degree of protection against becoming locked into a long-term investment with no clear exit route.
Qualified Liquidity Events
Qualified Liquidity Events are a safety net and value preservation tool for Investors, with the "qualified" requirement preventing the company from pursuing an IPO or sale that fails to deliver a minimum level of value or liquidity to Investors. In addition, the investment documents may provide that meeting the qualified Liquidity Event threshold triggers certain consequences, including the automatic conversion of shares carrying enhanced consent or veto rights into ordinary shares. Commercially, this is important for two key reasons:
- first, it protects Investors from being forced into an exit that does not generate an adequate return on their investment; and
- second, certain share classes, often preference shares, may carry special consent or veto rights in relation to a Liquidity Event.The investment documents may provide that, once a qualified Liquidity Event threshold has been met, those shares automatically convert into ordinary shares and the enhanced rights fall away. This prevents a small group of shareholders from blocking a high-value exit and allows the drag-along provisions to facilitate a clean exit for Investors.
Registration rights
A further consideration arises where a company may pursue a listing in the United States. Registration rights are a US securities law concept that is less common in United Kingdom and European transactions. These rights are necessary because, subject to certain exceptions, securities generally cannot be offered for public sale in the United States unless they have been registered with the Securities and Exchange Commission. Unlike in many European jurisdictions, a company listing in the United States is not required to register all of its outstanding shares. Shares that remain unregistered may be difficult to transfer, which can significantly reduce their value. As a result, Investors will often require the company to enter into a Registration Rights Agreement.
A Registration Rights Agreement typically grants Investors demand registration rights, allowing them to require the company to register their shares for sale, and piggy-back registration rights, enabling them to include their shares in a registration initiated by the company. Such agreements also commonly allocate the costs and potential liabilities associated with the registration process. Although registration rights remain primarily a US-focused concept, their relevance may increase as cross-border venture capital activity continues to grow and more companies consider accessing US public markets.
We would also like to thank Feras Alobaidli, Alex Siddle and Oliver Perkins for their contribution to this article.
If you have queries on any of the issues covered in this article please contact one of our experts: Dhruv Chhatralia BEM, Matthew Judge, James Bryce, Caroline Colliston (as the tax representative for the corporate articles), Darren Ormsby, Gemma Gallagher, Gary MacDonald, Paul Pignatelli, Scott Kennedy, Will Munday, Alex Stoughton, Francesca Kinsella, Graham Tait and Rosie Spencer.
