Gannons prepared our Investment Agreement which was clear and commercial. Our investors did not come back with many comments which was pleasing.
Methods of investment vary, and each method has benefits and disadvantages along with tax considerations.
It is taken as read we can deal with the legal documentation but what we can also offer is guidance on how to position the corporate structure. Supporting companies and investors over the years has created the knowledge you need.
Please do call us to discuss your investment agreement. We are always happy to provide an estimate of likely costs.
Structuring the investment terms
Methods of investment vary, and each method has benefits and disadvantages along with tax considerations. Our job is to take you through the issues and find workable creative solutions.
An investment can involve a fusion of:
- Ordinary shares;
- Preference shares;
- Convertible loan notes;
- Debt; and
- A charge over assets which can be very helpful if there is commercial property.
The rights attaching to any class of share must be set out in either the articles, shareholders’ agreement or an investment agreement. If preferences are not agreed the investor will be treated in the same way as ordinary shareholders.
In many companies, the ordinary shares carry the right to vote, receive dividends and a return of equity on a sale, liquidation or winding up. If an investor requires added rights ordinary shares can be issued along with preference shares. The idea is that the preference shares provide benefits for investors over and above the rights attaching to the ordinary shares.
Preference shares usually entitle the investor to:
- A right to first distributions: i.e more chance of their money back if the company does not achieve targets and is sold;
- Perhaps 6% to 8% interest on investment – known as the coupon rate; and
- A conversion option to ordinary shares, so gaining more equity upside on an exit event.
Convertible loan notes used as investor protection under an investment agreement
Convertible loan notes are increasingly common. A convertible loan note enables the investor to participate in the upside, and potentially gain control if the business does not succeed. Convertible loans can provide the best of both worlds for an investor.
Terms for the convertible loan note
Terms of the convertible loan note are up for negotiation. There are no hard and fast rules. Ideas we have seen successfully implemented include:
- Interest on the loan note is accumulated or paid at the election of the investor – this builds in flexibility for the investor to either grow his investment or take the cash via the interest payment if the business has funds;
- Conversion rights pegged to growth events – for example at the next financing round the loan note converts into equity at say a discount of perhaps 25% to the valuation achieved at that round;.
- Rights to demand either conversion or repayment of the loan at defined points. Repayment rights are flexible if the investor wants to hedge its bets in the early days of a start up. Repayment rights have to be looked at with liquidation rights as without care the investor could put the business into insolvency.
Debt finance – ideas for investor protection under the loan investment agreement
The big advantage to a loan over equity investment is that upon an exit or insolvency the lender as a creditor will be paid off before shareholders. Ideas to consider for investment terms under the loan investment agreement include:
- Charges can be taken over the company’s assets as security. This is popular in established companies with steady EBITDA or where there is commercial property. But, there is the risk of there not being assets of the value of the loan and other lenders could have a prior charge.
- Founders and or directors can be asked to give personal guarantees. This means there is the risk of personal bankruptcy if the loan is not repaid.
- The lender retains the power to appoint a receiver to run the business in the hope that enough profit can be generated to repay the loan.
- The lender is registered as a secured creditor being paid out before other creditors in the event of insolvency.
The rights attaching to any loan must be set out in either the articles, shareholders’ agreement or an investment agreement. Charges and secured rights do have to be registered at Companies House. If rights are not secured the investor will rank equally with other creditors.
Typical investment terms
The top points we see of importance for investor protection to include in the investment agreement based on experience are:
- Matters requiring investor approval;
- The level of control an investor can exercise;
- The investor’s ability to control the board;
- Level of warranties given by the investee company; and
- What happens if the investor wants out.
Issues reserved for the investor to approve
Investor protection will be enhanced if major decisions require their approval – this is known as a power of veto. Ideas to include in the investment agreement include:
- Significant acquisitions and disposals.
- Dividend declaration and payment.
- Material changes to the company’s business model.
- Significant investments and or future fund raising.
- Long term or unusual contractual commitments. A major contract sold at marginal cost is one of the fastest ways to go bankrupt.
Using control of the board for investor protection
A popular step for investor protection is for an investor representative to have a seat on the board. The constitution of the board can be set down in the investment agreement (or shareholders’ agreement).
Non executive directors under the investment agreement
It is not uncommon for an investor to be granted the right to appoint a non-executive director. For example, in a technology company, the investor may seek to appoint an individual that has industry experience in launching products and taking them to market. That will help in realising a return.
Further rounds of financing
Further investment brings dilution of share capital and often attempts of new larger investors to take control. The influence the investor retains will depend upon the size of his investment, value of the company for new finance rounds and terms set out in the investment agreement.
Future planning can leave the early stage investors in a stronger position.
Access to management information under the investment agreement
As a shareholder alone the investor will have no right to management information. Therefore, information rights have to be set out in the investment agreement. Investor protection may include the right to see:
- Business plans;
- Management accounts;
- Board papers;
Investor protection via warranties in the investment agreement
Generally, it’s the investee company, the founders and directors who give the warranties. We can help you decide whether all managers give warranties, or, more likely, just those with control of the business.
Typical negotiation points under the shareholder investment agreement
Common limitations on the warranties which may require negotiation include:
- The time period during which the investor can bring claims;
- The investor’s knowledge, whether implied or express;
- A cap on the total amount of warranty claims;
- A cap on any director’s liability. For example a limitation of three times salary or remuneration or a de minimis level that must be reached before the investor can claim.
Enforcing any claim under the warranties
The investment agreement should deal with what happens if something goes wrong and the investor brings a claim. Do the warrantors have joint liability, i.e. each liable for the total amount, or several liability, i.e. just liable for their share? If several liability then should there be a separate deed of contribution to apportion any liability under the warranties amongst the directors.
If the business is a flop it is likely the warranties will give little by way of practical investor protection. Other routes should therefore be considered.
Investment terms for exit
On the way in an investor needs to think of the way out. Investment terms should deal with:
- Will the investor be entitled to sell his shares before a trade sale?
- Will the investor be required to first offer his shares to the company, or existing shareholders pro-rata?
- What price will the shares be sold for? Will there be a distinction in price for a “good leaver”, and “bad leaver”?
Whether investors should be in for the long term is becoming an increasingly popular debate. The questions have intensified as the average time it takes to build a business and achieve a trade sale is increasing.
The investee business
The investee business should be thinking about:
- Protecting confidential information;
- Heads of terms for the investment agreement; and
- Incentivising the management team.
Discussions with investors involving trade secrets and confidential information should take place under a confidentiality agreement. That will create a deterrent at the very least. This is in the investor’s interest as well as the company’s as you may not want other investors to know you are in talks.
Heads of terms for the investment agreement
We can assist you with preparing heads of agreement for the investment, which can assist with the whole process of the investment. The heads of terms for the investment agreement will be a base to work from for the purposes of agreeing the terms of the investment.
Points to consider include:
Exclusive negotiating period
Placing time limits on decisions can focus the mind.
Is the investment conditional?
Typical conditions include:
- The investee company’s directors signing new service agreements, approved by the investors;
- Technology and IP protection; or
- Appointment of non executive directors.
Each investment differs. However, from our experience we will know what conditions are required, and what are reasonable.
Is the investor allowed to invest into competing businesses
Investors along with staff can damage the business by taking ideas to set up in competition. The investee business should consider putting some anti competition terms into the investment agreement to protect other investors and the business.
There are no implied duties on investors. That means any restriction has to be documented and agreed in advance.
When is shareholder approval required?
Commonly, approval is required to increase share capital and amend the investee company’s articles of association. Articles of association are often drafted to compliment the investment agreement.
Incentivising the management team
Often investors back people, e.g. their skills, capabilities and knowledge, rather than physical assets. To cover for that, and to provide an element of flexibility, there may be employee share schemes operated. The most common is EMI options.
Investors will be keen to limit the dilution for employee share awards. This is most commonly achieved via an option pool. The standard pool is between 10 – 20% of issued share capital.
Special considerations for investment into technology and IP businesses
Part of the legal due diligence is to ensure the company owns the technology and intellectual property it claims to have invented or own. Issues often arise during the intellectual property due diligence. If they can be sorted out pre-investment this prevents “surprises” at a later date when the business may have been a success and the stakes are higher. For instance, sometimes the company thinks it has acquired its IP rights from a previous venture, but doesn’t have complete ownership.
Licences and revenues
If the investment is intended for technology which will be licenced – a review of the ownership of technology and IP could form the bedrock of the chances that the investment will be successful.
Unregistered rights in technology and IP
Unregistered rights in technology and IP would cover unregistered logos, brand or trading names. If important rights are unregistered, we investigate and put in steps for protection.
Registered rights in technology and IP
Registered rights would include patents, registered trade marks and registered design rights. We conduct a search of the registered rights, and ensure the company has:
- Access to geographical spread, a term for the use of the intellectual property rights protected,
- No detrimental encumbrances.
Helen is a partner and heads up the corporate team, advising start-ups, SME companies, partnerships, entrepreneurs, investors and shareholders. Dual-qualified in the UK and USA and a qualified solicitor since 1998 you couldn't ask for more experience.