When company founders welcome new investors, they will typically enter into a new set of articles of association and a new investment agreement to govern the ownership structure of their business going forwards. These documents are often referred to as the company’s “equity documents”.
This blog post provides a brief overview of some of the initial considerations and concepts for founders and entrepreneurs to understand when approaching a negotiation of their company’s equity documents with an investor for the first time.
A company’s articles of association are contained in a public document, which is available for all the world to see at Companies House, and their provisions bind all shareholders of a company. For this reason, the articles normally contain fairly “vanilla” information, such as the rights attaching to shares of certain classes and details of restrictions on share transfers.
By contrast, investment agreements (sometimes called shareholder agreements), only bind their signatories and are completely private documents. More sensitive arrangements (amongst the shareholders) are typically documented in an investment agreement.
#1 Prepare to give warranties under personal liability
In an investment agreement, warranties are contractual statements of fact given by the founders (and sometimes also by the company) that give investors comfort that there are no major problems lying in wait for them in the business.
Obvious examples include statements that there is no pending or threatened litigation against the company or that there are no major pollution concerns at one of the company’s physical sites.
Typically, the founders of a business will be required to “give” these warranties personally. That means the founders will be required to make contractual statements of fact in the investment agreement about the health of the business and its assets and, if those statements prove to be false, the founders can be held personally liable for the related loss.
Once a set of warranties have been agreed, the founders will sign a letter to the investors, on the date the investment agreement, to make “disclosures” against those warranties.
Where a disclosure has been properly made, it will serve to protect the founders from losses an investor might claim were caused by the relevant matter (even where there would otherwise be a breach of the warranties).
#2 Who will bear responsibility for the warranties
Warranties are typically given by the founders themselves and sometimes also by the company.
Typically, the founders’ liability to their investors will be “joint and several”, meaning that they are each individually liable on behalf of one another for all claims and losses suffered by the investor should a warranty turn out not to be true.
Joint and several liability often comes as a surprise to founders going through the investment process for the first time as it means one of them could, in theory, have to pay out for the others’ liabilities.
Where multiple founders give warranties, the warrantors will typically enter into a contribution agreement amongst themselves, to agree what proportion of claims they will each be responsible for (behind the scenes).
Importantly though, experienced lawyers representing founders will go to great lengths to limit the founders’ liabilities in relation to the warranties in the first place.
#3 Prepare for investor due diligence
Prior to signing an investment agreement and funding a company, investors will go through a process of due diligence.
The diligence process will typically begin informally and progress to much more detailed and formal legal, financial and management reviews.
When preparing for the diligence phase, founders should ask themselves a series of questions, including the following.
- Do they have the latest versions of their most important agreements, fully signed and dated and securely stored somewhere easily accessible?
- Are their monthly management accounts and related records professionally finished and easily interpreted?
- Are their company secretarial and shareholder records in good order?
Negative findings during the diligence phase may put investors off immediately or, if not, may lead investors to seek contractual protections against any issues that have been identified, typically by way of indemnity.
An indemnity is a powerful way for a party to an agreement to seek compensation for specific losses they incur as a result of a specific event.
#4 Are you ready to stand behind your business plan?
Founders will typically have submitted a pitch deck to their investors prior to the initial pitch process.
The so-called “deck” will likely evolve into a more formal business plan as preparations are made for the initial investment.
Founders are normally expected to “stand behind” their business plans (i.e. to give warranties about how reasonable, realistic and carefully prepared the business plan is and to take personal responsibility if it proves not to be).
Moreover, further rounds of investment may rely on the company achieving certain financial or commercial thresholds set out in the business plan, such as revenue targets.
Founders are therefore well advised to think carefully about the content and preparation of their business plan before getting into the investment agreement phase.
#5 What shape are your accounting records in?
During the diligence phase, investors will expect to see professional accounts, properly prepared in accordance with accounting standards and laws.
Where management accounts (i.e. accounts kept by management to track performance through a financial year) are properly maintained on a monthly basis to a high standard, further credibility is won in investors’ eyes.
As with business plans, investors will typically expect founders and entrepreneurs to stand behind their accounts, i.e. to warrant that they give a “true and fair view” of the position of the company, particularly as the accounts form the starting point for investors’ valuations of the business.
Founders are often required to warrant the management accounts as well (albeit usually to a lower warranty standard than for their annual accounts).
#6 Assign your intellectual property
Particularly in the software and information technology sectors, the designers and programmers of a company’s software will, by default, retain an ownership interest in the intellectual property of the code and designs of a programme, normally in the form of copyright.
All founders and employees who may have a claim to personal ownership of any intellectual property will typically be required to sign that ownership over to the company and to pledge to the company any future ownership in any new developments.
This approach ensures that the company has complete ownership and control of its products and technology (critical for when the shareholders come to sell the company later), but it also protects the company from later claims from those individuals should there be any disputes about ownership further down the line.
#7 What type of securities will be issued?
Typically, founders in the early stages will hold one class of ordinary shares in their company. Ordinary shares are typically entitled to equal treatment in terms of dividends, voting power and return of capital.
Preference shares
Where investors enter the fray, they will normally demand that their shares entitle them to preferential rights. Different types of preference shares will rank ahead of ordinary shares for dividend income and/or on a sale of the company, for example.
Convertible loan notes
For early-stage companies, investors may insist on an issue of convertible loan notes (or a similar instrument). Convertible loan notes create a debt owed by the company to the loan note holder (a safer way of financing an early-stage company) but with the right for that debt to be converted into equity (i.e. shares) in the company, once the company’s valuation reaches a specific level or a certain trigger event occurs, allowing the investor to participate in gains if the company grows in value.
All manner of other instruments (classes of shares, types of note etc.) are issued to investors, many of which will combine debt-like characteristics to protect investors’ downsides and convertible or equity-like characteristics to participate in any upside.
#8 What other controls will investors expect?
Rights attaching to classes of shares are typically set out in the company’s articles of association, but further rights will often be granted to investors under the investment agreement.
Typically, investors will want a veto over any important decisions that directors make relating to the business. For example, investors will normally need to sign off on activities like agreeing to acquire another business or selling any part of the company.
Investors will also typically want to appoint a board member or observer (an investor director) to participate in the company’s board meetings, to receive the papers circulated to board directors and to wield a veto power over certain day-to-day business actions decided at board level, such as incurring capital expenditures or indebtedness over certain thresholds.
#9 How to coordinate multiple investors
Multiple investors may be planning to participate in an investment round. If so, it will be helpful to appoint a lead investor to represent all the investors as lead negotiator, saving the founders and their lawyers from carrying out multiple negotiations with different investors.
It is also sensible to request a lead investor to coordinate investor consents throughout the lifetime of the investment agreement, again to save the board having to go out to every investor to seek consent for important decisions.
#10 Will you create a share option scheme for your employees?
Share option schemes are widely seen as positive ways to incentivise and motivate employees of early-stage companies. These are complex areas of tax and law, which require careful advice to implement correctly.
Options typically enable shareholders to purchase shares at a “strike price” (normally a low price) upon the occurrence of a “trigger event”, for example the sale of the company, enabling the employee to purchase shares for a low price and immediately sell them to the purchaser of the company for a higher price, thereby receiving a windfall payout for their service and loyalty to the company over the years.
In the context of an investment agreement, the investors will need to understand and accept the effect of any employee option scheme, particularly relating to the dilution of the investors’ position in the capitalisation table (i.e. what effect the exercise of options by employees will have on the investors’ percentage of ownership in the company).
#11 Expect restrictive covenants
Investors and co-founders typically expect key members of management to agree not to do certain things during the company’s initial growth phase.
These limitations are included in a set of restrictive covenants, which will normally prevent key members of management from:
- working for competitors within a period of time after leaving the company;
- dedicating their time and efforts to working on other endeavours; and
- leaving the company and then poaching customers and/or employees.
#12 Prepare for “Exit”
Typically, the end goal, both for investors and for founders themselves, is to seek an exit from the business, by which we normally mean either a listing on a stock exchange or a sale of the company to another investor or trade buyer.
Normally, investors will be seeking to exit within a set period of time. Three to six years would be a typical timeframe for larger investors in more developed companies, whereas investors who are used to funding very early-stage companies, such as angels and seed investors, are typically more patient and might be willing to hold on for six to ten years.
The investment agreement will typically lay out some ground rules for specific types of exit and will require founders to make commitments to work towards an exit over time.
Next steps
That rounds up our brief introduction to some of the core elements of agreeing to accept investor funds. There is a great deal more detail to this process, of course.
The most important point to close on is that, once the dye is cast, and the investment agreement is signed, there is very little going back, so it is critically important that founders are well advised from the outset.
About Clearlake
Clearlake Law provides fractional general counsel services to organisations across multiple technology sectors doing business in the United Kingdom.
Please feel free to reach out directly to Dan Stanton on dan.stanton@clearlake.law or 0204 570 8741 to learn more about how we work with company founders.
