For many start-up businesses, securing equity investment can be a confusing and daunting process.
Entrepreneurs often find themselves being bombarded with legal terms and concepts they've never heard of before and are faced with getting to grips with these very quickly. While the procedures and mechanisms in place can vary greatly from investment to investment, we've provided a quick guide to some common phrases and terms which might crop up in a private equity investment. We hope this guide will help entrepreneurs through the investment process so that they can get back to the important job of running their business.
Heads of Terms
This short agreement sets out the main terms of the investment and is usually not binding on the parties (with the exception of confidentiality or exclusivity clauses). This acts as a foundation for the Investment Agreement to be built upon.
Due Diligence (DD)
This is the investor's opportunity to find out more about the company in which they're planning to make an investment. Who are the current shareholders, key financial information, the company's assets and so on. Investors will usually carry out some DD before agreeing Heads of Terms and will look to find out more detail about the company through the Disclosure process (see below).
Investment Agreement (IA)
This is the key document which sets out in detail the terms of the investment. This will contain terms regarding the Investor Directors, Investor Majority Consent and Warranties (see below).
Investment syndicates and government funds (such as the various Scottish Enterprise funds) will often want the right to appoint a director or observer to the board in order to monitor their investment. The company can also benefit from the experience and expertise of the investor-appointed director(s).
Investor Majority Consent
Many IAs contain a list of matters which require "Investor Majority Consent". This is simply a list of things the company can't do without first seeking the consent of a certain number or percentage of the investors. This is in addition to any consents required under legislation.
The IA may contain a number of conditions on which the investment is dependent. Conditions Precedent are conditions which must be fulfilled prior to the investment taking place. For example, a Condition Precedent may be that the board of the company has passed all of the necessary resolutions to enable the investment to take place.
Conversely, Conditions Subsequent are conditions which must be fulfilled within a set period of time after the investment takes place. For example, a Condition Subsequent may be that all necessary Companies House filings in relation to the investment have been made.
The IA will probably contain a number of statements about the company, known as "Warranties". The purpose of these is to establish the factual position on a number of aspects of the company's business - for example "The Company owns all Intellectual Property required for the Company to carry on the business".
The IA will set out who the "Warrantors" are - usually the company and the directors, but this can vary. The Warrantors are those who "stand behind" those Warranties and will be personally liable in the event that any of those Warranties turns out to be inaccurate (a "Breach of Warranty"). The amount of liability per Warrantor can be capped at a certain amount (and will in any case be limited to the investor's loss resulting from the breach of warranty), but by far the most effective way to limit liability in respect of the Warranties is by Disclosure.
Disclosure allows the Warrantors the opportunity to "disclose" against any Warranties. The Disclosure process involves the Warrantors going through each Warranty and considering whether that Warranty is accurate. If there is something which the Warrantors think might conflict with the Warranty, this would be explained in detail in a Disclosure Letter. This is a letter addressed to the investors from the Warrantors and sets out, with reference to each Warranty, the extent to which the factual situation conflicts with that statement.
Taking the example of the warranty "The Company owns all Intellectual Property required for the Company to carry on the business", if, at the time the draft IA is provided to the company, the Warrantors are aware that a key patent used by the company is registered in the name of one of the individual founders rather than the company, a disclosure to this effect would be inserted into the Disclosure Letter. This letter will often be sent to the investors in draft form and the investors may either ask for more information or request that the company takes some action to remedy this prior to or following the investment.
National Security & Investment Act 2021 (NSIA)
Under the NSIA, investment transactions in certain sectors trigger a mandatory notification to the UK Government. If the Government considers the transaction to be a threat to national security, they can block it. If the mandatory notification is not made, it can void the transaction and carry civil and criminal penalties.
Articles of Association
Articles of Association are the rules governing a company. Commonly a company will adopt new Articles of Association as part of an investment. If the company is relatively new and with few shareholders, the existing Articles are likely to be basic and may not be fit for purpose following the investment. The new Articles can also be used as an opportunity for the investors to impose additional controls on the company and can contain provisions relating to Good Leaver/Bad Leaver, Drag/Tag and Pre-emption. While these clauses are commonly inserted into the Articles as part of an investment, they are not unique to investments and should be found in the Articles of any company which has a number of shareholders.
Good Leaver/Bad Leaver
These clauses take effect when an employee shareholder leaves the company. In these circumstances they oblige the employee to sell their shares. The purpose of these clauses is to avoid a situation where the remaining shareholders are working hard to build the value of the company, but in so doing, are also enriching the “leaver” who is no longer making a contribution to the company.
Whether the employee is a "Good" or "Bad" leaver depends on the circumstances surrounding the employee leaving the company and will dictate the terms on which he or she will have to sell their shares. An example of a "Bad" leaver would be someone leaving in circumstances justifying summary dismissal (gross negligence or theft) and as a Bad Leaver they might only receive the same value they paid for the shares. A "Good" leaver might be someone who leaves the company due to retirement or death and the price per share might be fair or market value. A "Good" leaver may also be someone who leaves the company a certain amount of time after the date of the investment.
Drag along/tag along
Drag along is the right of the majority of shareholders (usually around 75%) to accept an offer for the sale of all the shares in the company and require the minority to sell their shares on the same terms (effectively "dragging" them along in the sale).
A tag along is the corresponding right of the minority to piggyback on the sale of shares by the majority on the same terms (effectively "tagging" along with the majority).
Pre-emption on transfer
These clauses say that any shareholder who wishes to transfer their shares must first offer them to all the other shareholders in proportion to the number of shares held by them.
The content of this webpage is for information only and is not intended to be construed as legal advice and should not be treated as a substitute for specific advice. Morton Fraser LLP accepts no responsibility for the content of any third party website to which this webpage refers. Morton Fraser LLP is authorised and regulated by the Financial Conduct Authority.