Knowing how to draft an investment agreement prior to a new investment being made in your company is important. This article discusses the key provisions that should be included in an investment agreement and identifies the ways in which a company can both protect itself and create certainty around its relationship with a new investor.
What is an investment agreement?
An investment agreement is a contract between a company and its shareholders and an investor governing a proposed investment in the company.
The investor can be an existing shareholder of the company and therefore may already have entered into a shareholders’ agreement with the company and its shareholders at an early stage pre-investment, or it can be a new investor. The investor may also be a lead investor representing a syndicate of investors.
The terms of the investment will depend on the type of funding the company requires (for example, is the investor to commit to multiple rounds of funding? Is the investor required to give immediate interim funding before the main round of investment takes place?) and the nature of the funding arrangements will dictate the bargaining power of the parties when negotiating the investment agreement.
Why is an investment agreement important?
When a company decides to accept new investment, there can often be various conditions and risks that come along with the funds. Finding a way to identify and manage these issues can enable a company and an investor to effectively monitor its risk profile. This can be particularly important to start-up companies and companies going through early rounds of investment to ensure that all parties are clear on what the investor is entitled to, both now and in the future.
Putting in place an investment agreement will create legally binding arrangements that will address how the parties to the investment agreement allocate risk and will set out the rights and obligations of each party, including provisions to make sure that all parties know what to do if things go wrong and a party wants to raise a dispute or to exit from the investment arrangements.
As an investor, if you are going to receive a minority shareholding, you may want to use the investment agreement to make sure that you have rights and reasonable protections set out in writing to ensure that your money is used in the way you envisaged and that you have an adequate say in the strategy of the company to justify your investment. Ultimately, you will want a contractual legally binding document that sets out how you are going to get a return on your investment.
Is there a difference between an investment agreement and shareholders agreement?
There can be many similarities between an investment agreement and a shareholders’ agreement.
The main difference between an investment agreement and a shareholders’ agreement is that a shareholders’ agreement is a contract between a company and its existing shareholders (although new shareholders can be included in a shareholders’ agreement by signing a deed of adherence to the agreement) to set out rules on the conduct of the shareholders and the rights and obligations that they have with respect to the general operation, management and strategy of a company.
An investment agreement in contrast, is specifically geared towards a particular investment for which the investor may be given equity in the company or alternatively leverage arrangements might be put in place (effectively a loan to the company). The investor can already be an existing shareholder or may be a new third party investor.
What are the main provisions that should be included in the investment agreement?
The table below sets out some key provisions that should be included in an investment agreement to establish the rules between the investor, the existing shareholders, and the company in which the investment is being made.
|Parties involved||Identifying the parties to the investment agreement is important. If the investor is being given share capital in the company then both the company and the shareholders will want to ensure that the investor is contractually bound to comply with any existing obligations placed upon shareholders generally. |
The company will also want to make sure that the entity that will end up holding the shares, if it is not the investor itself, is accountable to some extent. The company might require that entity to either sign up to the company’s shareholders’ agreement (if there is one) or become a party to the investment agreement. If there is more than one investor, then the company may want all investors signing up to the agreement, or alternatively one investor could sign up on behalf of the others, if the investment is being made by a syndicate of investors.
The investment will most likely need to be in compliance with any shareholders’ agreement the company may have and the articles of association of the company, which may impose certain conditions on the investment. For example, if shares are being issued then the other shareholders may need to waive any preferential rights, they have to purchase those shares before they can be given to an investor. In some cases, the shareholders (or a certain majority of them) may need to approve the transaction as a whole before it can proceed.
Alternatively, the company and the investor may agree to keep the investor’s rights separate and create a separate class of shares for the investor.
|Tranche payments||A tranche is another word for portion and is used in financial terms to mean a portion or segment of funds. Tranches of funding can be segregated according to certain conditions or milestones. There may also be trigger events that must occur following the first tranche of funding, before another tranche becomes available to the company. |
The investment agreement should set out how many tranches of funding there will be and the amount of those tranches, and whether any conditions are attached to those tranches – and if so, the agreement should also set out what will happen if those conditions are not met or not met by a certain deadline.
A common right for investors is the ability to waive or amend conditions if the company does not reach the scheduled milestone. Some common conditions to a first tranche being completed are adequate due diligence being done on the company by the investors, any regulatory or competition clearances having been obtained and the investment agreement and any ancillary documents having been approved by the company (and its shareholders if necessary). The investment monies may also have restriction upon them as to what they can be used for (a particular project for example).
Some common conditions for further tranches of funding include the relevant milestones having been achieved, that there has been no material adverse change to the financial status of the business and that the company remains solvent.
Hand in hand with such conditions is the point of return on the investor’s investment. The investment agreement should state how the return is calibrated (issue of shares, payment of an interest rate or a return rate, for example) and when repayment (if any) of the investment should start.
|Warranties||It is common for the investors to ask the company and its directors/management for warranties as to the performance and status of the company as a way of mitigating risk that the company is not as attractive as it appears. |
A warranty is a statement that facts or circumstances about a company are true at a certain point in time. If a warranty turns out to be untrue, then the party relying on the warranty may be able to claim damages if it suffers a loss as a result of the statement.
Sometimes investors negotiate fixed damages into the investment agreement that are payable if there is a breach of the warranties and these payments are designed to be genuine pre-estimates of loss from a breach of warranty which make the claiming process quicker and simpler in theory (these damages are often referred to as ‘liquidated damages’).
Investors with bargaining power may ask for the warranties to be repeated at completion as well as at signing (or may ask for warranties to be repeated prior to each tranche being released). This gives investors further protection as it means that the warranties are accurate at a more up to date point before the shares are issued. Investors with bargaining power may also ask for clauses that give them an exit route if there has been a change in the business that can be considered materially adverse (note that when a change is considered to be materially adverse should be defined) before the transaction completes.
A company is wise to push for a cap on the total amount of warranty claims an investor may make and additional caps on individual liability of directors or management. Usually warranties also have a monetary limit that must be reached before a claim can be brought by an investor.
|Board representation||An investor may be given a number of shares that entitles them to have their interests represented on the board of directors of the company or to observe company board meetings. |
Depending on what is set out in the company’s articles of association or shareholders’ agreement, the investor may be able to appoint one or more directors to the board at some point during or following the investment and may be able to demand that board meetings must contain those investor directors in order to be considered to be validly held.
The directors may also decide on a set of ‘reserved matters’ which are certain decisions or strategic actions that cannot be taken without the consent of the investor director, in effect giving the investor director a veto right over certain matters.
The company may want to think carefully before it gives away board availability or dilutes the shareholding of the company by such an extent that meaningful control in the company is surrendered, as it may make it harder to operate the company and achieve the strategy of the business. In most cases however, the cost of receipt of a large investment is the sharing of the management decisions of the company and in the case of investment by experienced investors, this level of involvement may be welcomed by the company.
Under the Companies Act 2006, any director the investor appoints will nevertheless have to comply with its obligations to act in the best interests of the company and its shareholders as a whole and so will need to declare any conflicts of interest as and when they arise between the investor and the company.
|Restrictive covenants||The company may agree to include promises (called restrictive covenants) in the investment agreement in exchange for the investment, that state that the company management will not try to compete with the business, or its key personnel will not leave the business to join a competitor, within a certain amount of time after the investment has been made. |
These covenants are designed to protect the investor’s investment and to ensure that there is not a deterioration in the quality of management of the company or the trading and commercial position of the company immediately after the investment is made.
|Confidentiality||Before entering into the investment agreement an investor may have had to sign a separate confidentiality agreement (usually if the investment opportunity was offered to more than one investor). |
The parties will want to ensure that confidentiality provisions protect the sensitive commercial information of the parties and cover who can make announcements and publish information about the investment or the investment process.
Depending on the parties involved, there may be certain regulations that need to be complied with and the agreement should make room for these obligations to be fulfilled without requiring the consent of any of the other parties.
|Exit strategy||It is important to include an exit strategy in the investment agreement to be prepared for what happens if there is a dispute between the parties, or if the investor wishes to stop investing or transfer its shares or if the company goes insolvent. |
The investment agreement should set out what happens to any those shares – whether they have to be offered to the shareholders or the company itself before they are offered to an independent third party. The investment agreement should also be clear on how the investment is paid back (if at all) in the event that the company goes insolvent.
The parties may plan for an exit, such as the company being listed on a stock exchange or being sold in a private sale within a certain time frame and a company would be prudent to include provisions governing how the key outcomes in this process should be achieved.