While the term sheet and the shareholders’ agreement are quite familiar documents to the founders already in the early stages of the company, the investment agreement is less familiar. In this article, we take a deeper dive into the elements of the investment agreement.
What is the Investment Agreement?
Whereas the term sheet is the starting point the investment agreement is sort of the final step. The investment agreement is the document that sets out the details of the investment. It includes both the actions required to close the investment as well as the structure of the investment itself. Besides, the investment agreement typically includes the representations and warranties of the company and/or the existing shareholders. Once the investment agreement has been approved everything is a set of the investment.
Requirements for the Investment
The investor may set out some requirements that need to be fulfilled before the investment can take place. E.g. in case the parties have agreed on an option pool to be set aside for the employees, the creation of the option pool is typically presented as and a prerequisite for the investment to take place. Or if the investor is making the investment using preferred shares, the creation of the share class is typically required before the investment.
The investment agreement defines requirements for investment, called closing requirements. These include
the signing of the required agreements (such as the investment agreement and the shareholders’ agreement),
taking necessary resolutions (e.g. approval of the investment by the existing shareholders of the company and decision on issuing the shares),
investor subscribing the shares, and
payment of the investment by the investor.
Structure of the Investment
The investment agreement stipulates the instrument the investment is made in. This can be e.g. common share, preferred share or a convertible loan. Also, a combination of several instruments is possible (e.g. some investors investing in equity and some using a debt instrument).
Besides the type of instrument, investment agreement also stipulates the number of instruments and the subscription price (e.g. 10.000 common shares at 50 euros per share).
Closings and Tranches
Investment can also be in tranches. This means that the investor is not investing all the money at once but in two or more instances.
Each tranche is invested in an event called the closing. The first tranche in first closing, second tranche in second closing and so one.
Typically, multiple tranches are used to protect the investors: The investors will put only a part of the funds until certain conditions are met. These are called conditions precedent for the tranche in question. E.g. if the investment is made with the plan to expand into a new market, the conditions precedent for the second tranche investment can be certain revenue achieved in that market by a certain date.
Representations and Warranties
In the investment agreement the company, typically with the founders and sometimes with other shareholders, gives certain representation on the status of the company to the investor. Basically, representation and warranties are a statement that everything in the company has been handled in a professional manner and in compliance with applicable laws.
While the investor has made due diligence of the company and should have as a part of this process verify the material facts relating to the company, giving representations and warranties to the investor mean that the company and shareholders giving these may be held personally responsible in case these are not true.
The representations and warranties as such are to a large extent boilerplate text, covering the following areas:
Organization of the company as well as its subsidiaries, i.e. the company is validly established and is not in bankruptcy.
Authorization and good standing, i.e. that the company and the founders are in good standing and authorized to execute the transactions.
Capitalization of the company, i.e. all shares are fully paid for and the capitalization table includes all shares and rights entitling to shares.
Liabilities of the company, i.e. the investors have been given a true view of the financial condition, the assets and the liabilities of the company.
Nature of disclosure, i.e. all the information provided to the investor is true and that no information material to the investor's investment decision making has been left out.
Intellectual property rights, i.e. that the company has all rights required for its business and that the company (and not e.g. subcontractors or founders) holds intellectual property rights.
Contracts, i.e. that all the contracts of the company are made at arm’s length basis for business purposes and that all the contracts are valid and in force.
Compliance, i.e. the company follows all applicable laws and regulations.
Employment matters, i.e. that the company has complied with all employment agreements and applicable laws, regulations and collective bargaining agreements.
Litigations, i.e. there are no pending or threatening litigations or disputes.
Taxes, i.e. the company has duly paid its taxes and filed tax returns.
While the representations and warranties are typically a boiler-plate text, it is rare to find a company that would have done everything by the book. Thus, the warrantors disclose these issues in the so-called disclosure letter, annexed to the investment agreement.
As untrue representations and warranties may lead to the personal responsibility of the warrantor, including all potential issues in the disclosure letter is in the interest of the company and the founders. Also, typically these issues are fixable and quite often dealing with these issues is included in the investment agreement as an undertaking after the closing.
Undertakings After the Closing
The investment agreement may contain the responsibility to perform certain undertakings after the closing. This may include e.g. fixing some issues or performing certain actions.
During the due diligence phase, the investor may have identified some issues with the company that did not constitute a deal-breaker, but which should be handled going forward. With startups, these issues are typically related to the compliance and administration of the company. Early-stage startups rarely have done everything by the book, but as more serious investors come in, more serious attention on the administration is required.
Besides fixing issues, other undertakings typically include actions agreed upon during the investment negotiations. E.g. if the company is planning to expand internationally, it may be required to recruit a person experienced in the sales in the focus market to the team.
Interested in other investment documents? Find out more below: