In this second blog in a series on equity investment, I discuss how the deal takes shape and what investee companies should expect from the documentation provided by their investor.
Initial discussions between company and investor will focus largely on the feasibility of the business model and the proposed share price and equity stake to be taken by the investor. Once the company and investor have shaken hands (virtually these days) on the broad terms of an investment, it will then be time to put the meat on the bones of the deal.
Some investors might be content enough to invest by simply applying for shares and not insisting on any specific protections. However, most investors (particularly investment syndicates or venture capital firms) will have their own investment agreement which they will ask the company and its directors to sign up to.
Sometimes called a subscription and shareholders agreement, the investment agreement will set out the terms of the investment. It will specify who is investing, for what number of shares and at what price and with deal with the practical formalities of issuing those shares.
It will contain a list of positive and negative obligations on the company and its directors which shall apply for as long as the investor hold shares. Positive obligations might include obligations to carry out the business in accordance with the business plan, to maintain good accounting practices, to provide regular financial information to the investors, to maintain insurance for the company and to generally operate the company in accordance with good industry practice and standards.
Negative obligations will comprise a list of matters which the company cannot implement without the express consent of the investors. This will likely include restrictions on issuing new shares, borrowing money, recruiting senior employees or increasing their salaries, appointing new directors, paying dividends or materially changing the nature of the business. This is just a sample as the list of negative obligations is likely to be considerably longer. Usually the consent of a certain proportion of the investors is required for these matters. Requiring unanimous consent from all investors (particularly if there are a large number of investors) might prove unworkable in practice, so an appropriate balance will need to be struck. The directors may also be asked to grant restrictive covenants in favour of the investors not to compete with the company nor to entice away staff, customers or suppliers for a period of time should the director ever leave the company.
Investors will want the right to appoint an Investor Director to attend board meetings. Such Investor Director will be the eyes and ears of the investors on the board. Investor Directors are experienced non-executive directors who bring valuable expertise. From the company's perspective they will ideally want an Investor Director who is a good fit, who adds value and who might have industry knowledge to open doors which otherwise might not have opened. Consideration will also be given as to who the chairperson of the board might be as part of these discussions.
Another key component of the investment shall be warranties. Investors will expect that warranties are given to them on the date the investment takes place. At the very least the company will be asked to grant those warranties, but usually the directors or founder shareholders will be asked to grant those warranties personally too. Warranties will cover a broad range of matters such as the company's accounts and financial records, share capital, intellectual property, employees, key contracts and any matters pertaining to litigation or disputes. This is merely a sample list and the extent of the warranties may be influenced by the nature of the deal and the amount being invested.
Warranties are an important protection for the investors as they want to have some assurances in relation to the Company. As noted above, the directors are often asked to grant those warranties personally which will create some 'peril' or risk for those individuals. As such they will want to be thorough in their assessment of the warranties to ensure that they are correct. To the extent that the warranties are not correct, the directors will want to 'disclose' the true position to the investor in the disclosure letter.
The disclosure letter will accompany the investment agreement and will be an important protection for the warrantors as it gives the warrantors the opportunity to disclose the true position relating to any warranty. By way of example, if a warranty stated "the company has not received any notice of any litigation or dispute of any kind", but in fact the company had recently been issued with a claim for unfair dismissal, then the warrantors would be entitled to disclose the true position relating to that claim in the disclosure letter. If a matter has been fairly disclosed the investors will not be able to bring a claim for financial damages for breach of warranty in relation to that matter. Warranties may feel onerous to those granting them, but the disclosure letter provides the warrantors with a good opportunity to manage the risk. From the investor's perspective, the disclosure letter also helps flush out any issues that have not previously been revealed in due diligence.
Articles of Association
The investment process will involve documentation other than just the investment agreement and disclosure letter. In my next blog I will discuss the articles of association and other documents which form part of a typical investment transaction.
Morton Fraser has an experienced team of corporate lawyers in Edinburgh and Glasgow who advise both investors and companies on a wide range of equity investments and corporate transactions. Please do get in touch should you wish to discuss any of these matters.
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