In this article, we discuss investor contracts in brief and explore various entities that make up this document.
Private equity is a lucrative business model. Despite the risks involved in backing growing companies, massive returns balance out the risk factors. These categories of investments provide higher and quicker returns in comparison to traditional investment methods. The private equity market is expected to grow and reach $5.8 trillion by 2025. Investment agreements are the binding force in this intricate structure.
Private equity dealings involve monetary transactions ranging in millions. The investment horizon for such funds is usually between 4 – 6 years. Since growth phase startups are the common recipients of such funds, needless to say, legitimate paperwork is required to safeguard the interests of all stakeholders involved in the deal. This is the primary role of investor agreements.
What is an investment agreement?
An investment agreement is a legal document that details all terms and conditions mutually agreed upon between an investor and the recipient company. Investments are done usually in the form of cash, wire transfer, and in some cases in the form of tangible assets. Nevertheless, every investor expects a considerable rate of return on their investments. The fund receiving company must state the actual rate of return, achievable timelines, and details of how and when the returns will be transferred to the investor.
The terms and conditions set in an investor contract are irrevocable and binding to both parties. Any discrepancies on either side qualify for a legal contest. In some cases, where funding involves multiple shareholders, a contractual dealing helps to protect the rights of minority stakeholders. This is a reliable method of power distribution in the investment process. Each investor has a clear view of their contribution and the corresponding returns. Some common scenarios where one requires an investment agreement are:
- New investor on board: Investors must know every detail of the deal covering all aspects of protecting their interests.
- New company selling shares: A startup typically raises funds by selling company shares to prospective investors.
- Troubleshooting: Small companies and big corporates alike might run into disagreements surrounding investment terms during the funding cycle. An investor agreement provides a quick reference to clarify and contest discrepancies.
What is included in an investment agreement?
An investment contract in many ways is an identity docket of all parties involved in the deal. Thus the basic information in these agreements includes specific details of the investor as well as the company such as names, addresses, and date of entering the agreement. Once the credentials of all stakeholders are established, other important information detailed in the contract are:
- The exact amount of investment and their sources especially in the case of multiple investors
- Form of investment – cash, wire transfers, or assets
- Percentage of equity shared by the company
- Promised rate of returns
- Important dates and timelines
- Mode of transfer of returns, interest rates
- Variables involved in investment success
- Possible risk factors
- The extent of investor involvement in the company management
- Contingency plans in case of bankruptcy or if the company is dissolved
- Reporting procedures for stakeholders
- Signatures of all stakeholders
Thus the investment agreement is a comprehensive document detailing all aspects of an investment deal. Every stakeholder is presented with a clear view of their contributions and expectations in return. Without these agreements, million-dollar investments run the risk of misappropriations. In the next section, we discuss some of the common types of investment agreements.
Types of investment agreements
Though the basic information included in investment agreements are the same, the actual structure varies with the nature of investments. Especially with the advent of the startup culture, investment markets have developed an innovative tool to enable and ease the funding process. In this section, we discuss four commonly used investment agreements:
- Equity Investment: In this type of investment, the investor agrees to buy shares in a company in exchange for funds. Once the funds are transferred based on the terms of the agreement, the company issues the promised shares according to the pre-agreed timelines. The type of investor contract used here is known as the share subscription agreement.
- Venture Debt: Venture debt is an alternative to equity investments. This is usually granted to startups that have seen a couple of rounds of venture funding and not in a position to dilute equity further. In these cases, financial institutions such as banks loan the funds with fixed interest rates. The principal loan amount is usually 30% of the most recent funding round. Startups use venture debt to acquire capital assets crucial to the business. Venture debt involves three types of investor agreements:
- Loan agreement: Details the loan amount, terms of fund release, and repayment conditions.
- Security agreement: While granting venture debt, investors need the funded company to grant them security over the existing company assets. A security agreement details the terms of these arrangements
- Warrant deed: Venture debt do not need any collateral or direct equity shares, but a warrant from the company on its common equity. This helps mitigate the risks involved in just high-risk investments.
- Convertible note: A convertible note is typically used by seed investors. In the initial stage of a startup, it is difficult to determine the valuation of a company. In these situations, investors are granted convertible notes in exchange for their funds. These convertible notes are later converted into equity once the startup has seen a couple of investment rounds. The two types of investor contracts used in such deals are:
- Deed poll: This carries all the terms and conditions involved in the issuance of the convertible notes
- Subscription agreement: This details the subscription details, i.e. the amount granted by the investor and the number of convertible notes subscribed to.
- SAFE or Simple Agreement for Future Equity: SAFE is an investment agreement created by Y-combinator as a quick solution for startups to match with potential funders and secure funds. It is a standard template with very few variables. Thus it allows high-resolution funding. Both parties just need to agree on one variable – the valuation cap. SAFE does not indicate any maturity or expiration dates as well. SAFE is a single-page agreement and saves time in negotiations and legal fees.
Writing an Investor Agreement
An investor agreement is a legal contract. Thus one is not at liberty with the content, writing styles, or language. Early startups must work with a legal consultant to draw up such contracts unless they are following templates such as SAFE. Here is a basic guideline for how to write an investor agreement:
- Write opening recitals: All investor contracts begin with ‘opening recitals’ which primarily includes the date of entering the agreement and the names and addresses of the investor as well as the company receiving the funds.
- Prepare “Whereas” statements: Opening recitals are then followed by “Whereas” statements that essentially define the role of an ‘investor’ and ‘company’ receiving funds. The ‘whereas’ statement is then followed by the ‘therefore’ statement which sets the context for all mutually agreed terms.
- List Articles: Articles are investment terms that both parties agreed to during negotiations. They list out details such as the amount of money being invested, the utility of this investment, the rate of return on investment, and timelines for achieving the same. In all investor contracts, articles are listed one by one as ‘Article 1’, ‘Article 2’, and so on.
- Payment terms: Once all the terms are listed, the next section requiring clarity in an investor contract is the payment terms. In some cases, the investor transfers the funds all at a time. In other cases, payments might be spread out over a certain period. Based on the nature and type of payments, both parties must include payment-related details in the contracts. This involves information such as bank details, payment amount, and credit timelines.
- List deliverables: The next section is all about the promised deliverables, the ROI. Usually, companies set benchmarks based on which they begin to return profits to their investors. So this section also sets out due dates for these. In many cases, investors gain management rights in the funded company: a board seat, voting rights, or direct involvement in day-to-day activities. If such is the case, this must be mentioned in this section.
- Terms of contract: The “term” of a contract is essentially the time till which the investment agreement is valid. This begins with the start date of the agreement and the end date when the investor should have received all the promised returns. An important point to be included here is the process by which contract termination will take place. This section must lay out clear guidelines for a normal cessation as well as contingency plans in case of situations demanding premature contract terminations such as bankruptcy. All the foreseeable risks must be mentioned in this section with the clause that under these circumstances, the investor cannot expect to receive promised returns.
- State the law and jurisdiction in the contract: This is a crucial section considering the legal implications involved in an investor agreement. The law varies from state to state. Thus the stakeholders involved in an investor agreement must have clarity about the state of the jurisdiction governing the contract.
- Signatures: Once all these crucial points have been set out and agreed upon, both parties are required to sign the contract in presence of two witnesses. Though not mandatory, it is best to have a notary as one of the witnesses. Two copies of the contract are made and handed over to both parties for their records.
Sample Investor Agreement
All the points discussed in the previous section comprise a standard investment agreement. However based on the type of investment, jurisdiction, and some variable clauses, this contract varies with every deal. The form and content might vary based on the formats used by the legal counsel’s office as well. However, the one prescribed by the SEC is treated as a standard. Here is a sample investor agreement.
Investor Agreements vs Shareholder Agreement
The terms investor agreement and shareholder agreement are sometimes used interchangeably. In the case of equity deals, this might work. But otherwise, there are fine differences between the agreements designed for investors and shareholders. Here are the two basic differences between the two contracts:
Investor agreements document all transactional details involved in a funding process between investors and the fund receiving company. The only parties involved in the agreement are the ones who give the funds and the ones who receive them.
Whereas, shareholder agreements define a company’s relationship with all its shareholders. An investor might be included in this agreement if they eventually become a shareholder. Apart from timelines for equity distribution, this agreement defines details of the extent of involvement of shareholders in a company and the management’s role in their appointment.
Investor agreements are limited to details involving one particular deal. All terms and conditions included in this contract are limited only to the workings of the current deal. All stakeholders commit to certain obligations governing only the current deal. These are not overarching features involving both parties.
Meanwhile, shareholder agreements detail the overall relationship of a company and its shareholders. Terms of these contracts are binding till the time one of the parties chooses to terminate it. These contracts are not situational. All obligations listed in these agreements have to be adhered to by both parties for a long-term.
Interested in Investment Agreements for your Company?
Well-defined investor agreements are important to build good faith between investors and the company receiving funds. Clarity of equity distribution or any other forms of return on investment is a must to build stable relations in the industry. Eqvista is a pioneer in handling such long-term investor relations. Here is a list of our comprehensive services. For further details, reach us today!