The purpose of the Investment Agreement, in the context of a venture capital investment, is to provide a legal framework for the relationship of the parties. Consequently, it will deal with the principal obligations of the management, the Company and the investor at the time the investment is made as well as ongoing obligations for the life of the investment. Typically, a venture capital investor will be subscribing for a minority stake of voting share capital and will therefore not have control of the board. However, the investor will want to ensure that they are suitably protected.
Top six key issues to consider:
Due Diligence
The investor will undertake a detailed due diligence process to investigate the affairs of the Company. The investor should insist that any problems discovered are rectified before investing. Intellectual Property is a common area where difficulties can occur.
For example, all intellectual property required by the Company for its business should be assigned to the Company by its founders and any potential disputes with the founders should be settled before completion.
The investment agreement might therefore contain a condition precedent dealing with these matters or perhaps an acknowledgement by the founders that all relevant intellectual property is vested in the Company.
Failsafe Conditions
It is vital to ensure that the investor's equity is not subscribed until, for example, the bank facilities are in place and management equity has been subscribed. The investment agreement will be conditional upon completion of these matters so that the investor does not find itself in the position of having subscribed for the equity and then the Company finding itself without funds for the project because of a last minute hitch. Care is required when drafting these conditions to ensure that they are not circular.
Typical conditions might include:
(i) the passing of shareholder resolutions creating the necessary share capital and authorising its issue and adopting new articles of association;
(ii) the managers having subscribed in cash for any shares;
(iii) the receipt by the investor of a satisfactory accountants' report, audited accounts and management accounts of the Company;
(iv) each member of the management team having entered into his service agreement;
(v) the Company having unconditionally available for immediate drawdown its term loan and working capital facilities;
(vi) keyman insurance having been taken out for the benefit of the Company over the lives of each of the key managers;
(vii) delivery of certificates or reports on title.
It is usual to include a clause permitting the investor to waive any of the conditions in writing, so that completion can proceed if for some reason a non-essential condition remains partly or wholly unsatisfied.
Rights to Information
One of the most important functions of the investment agreement is to regulate how the the Company conducts its business. Following completion, an investor will need to monitor its investment but will not be involved in the day to day affairs of the Company. Company law delegates management of the business to the board. It is usual, therefore, for the investor to have the right to appoint at least one non-executive director. The Investment Agreement will also often contain a right for the investor to appoint an observer to attend board meetings, where no director has been appointed by the investor.
The investment agreement should therefore provide that regular board meetings are held and that an agenda is circulated at least 7 days beforehand. Monthly management accounts should be prepared within 21 days of each month end and circulated to the investor.
It is worth including a clause to cater for the situation where the Company does not comply with its obligations to provide this information. Such a clause would provide that the investor may appoint accountants or other professional representatives to attend the Company's premises to examine the Company's books and records, to discuss the Company's affairs, finances and accounts with its directors and senior managers and prepare any documents to which the investors are entitled under the agreement.
It is standard practice to include an obligation for the Company to prepare annual budgets and to provide these to the investor not less than 30 days prior to commencement of the period to which they relate. It might also be appropriate to include an additional obligation for the Company to present the annual budget to the investor so that it can be discussed.
Additionally, management should be obliged to inform the investors of any approach from a third party to purchase the Company or its business. It is also usual to provide that the investors will not be required on an exit by way of trade sale or IPO to give warranties in connection with the sale of their shares, other than warranty as to title.
The investor should also be informed of any outside interests of the management shareholders.
The requirement to keep an investor fully informed is not only good corporate governance but the legitimate right of an investor with a large amount of capital at risk.
Restriction on Management
The investment agreement will contain a number of negative covenants to prevent the management or the Company from undertaking certain actions without the investor's consent. There is a standard list of these restrictions which include, for example, issuing further shares, amending the Memorandum or Articles, borrowing more than a specified amount of money, incurring major capital expenditure, expanding into new business areas, entering into transactions outside the ordinary course of business, amending the management's service agreements or the bank facility letter and taking on employees over a certain salary.
Undertakings given by the Company which fetter its statutory powers (for example, to increase its share capital) will be unenforceable against the Company. This principle was discussed by the House of Lords in Russell v Northern Bank Development Corporation Limited (1992). Such restrictions are capable of binding the directors and shareholders and other parties to the investment agreement even if the Company cannot itself be bound. The Company should not therefore be a party to any such restriction and it should be given by the shareholders.
Additionally, there should be carefully drafted confidentiality and restrictive covenants to prevent management from leaving the Company and setting up in competition. Those that are commonly sought are covenants not to compete and not to solicit or deal with customers or employees. These will normally reflect the covenants contained in the management's service agreements. They are repeated in the investment agreement so that they can be enforced directly by the investor and, in some cases, it may be easier for the investor to prove loss. The restrictions might be considered to be more "reasonable" in the context of the investment agreement since the investor has a legitimate interest in protecting the goodwill of its investment. A further advantage is that if the service agreement has been breached by the Company, the restrictions in the investment agreement will remain unaffected.
Restrictions have to be "reasonable" and this can be a matter of debate. Generally, the shorter the period and the more limited and well defined the scope of application, the more reasonable and therefore the more enforceable it will be. Investors need to consider their objectives should there be a breach of such restriction. It may be better to err on the side of caution in order that the restriction is more likely to be enforceable, rather than take a chance by having a longer period that may be held to be invalid.
Warranties by Shareholders
The extent of the warranties is the area which usually causes the most debate in the negotiation of an investment agreement. In theory, the warranties could be given by the Company itself but any payment by the Company for damages in respect of the breach would only reduce the value of the Company. The warranties, that the Company and its business are as the investor expects them to be, should be given by the existing shareholders.
The purpose of warranties is two-fold. Firstly to compel disclosures of any "nasties" before completion of the investment and secondly as a means of redress should matters not turn out as warranted.
The investor will wish to ensure that disclosures against the warranties are fairly made. The shareholders should not avoid liability by swamping the investor with extensive disclosures which cannot readily be absorbed or the implications not easily appreciated.
It is standard market practice not to accept any disclosure against the business plan. A revised business plan should always be prepared reflecting the implications of the disclosure.
The shareholders will always seek a limitation of their liability under the warranties. While the investor will wish the limit to be the amount invested, management shareholders will seek to limit their individual liability and three times salary is a common compromise.
Underperformance of Management
The investor will have relied on the projections contained in the business plan when making its investment. However, these projections cannot be absolutely warranted by management, other than that they were prepared based on reasonable assumptions. It is therefore entirely possible that the Company will not achieve the projections in the business plan. Management will be in control of the Company's business and an investor with a minority interest will need certain rights of control to kick in if things start to go wrong.
An underperformance clause can be inserted which will give the investor the right to serve a notice on the Company ("Underperformance Notice") Underperformance can be defined in several different ways. For example, if the Company has failed to pay the investor under the terms of its loan stock, or an event of default has occurred on the Company's banking facilities, or if the Company has failed to achieve targets in the business plan.
In these situations, once the Underperformance Notice has been served, an investor may be able to exercise its drag rights under the Articles of Association to effect a sale of the Company or take control of the business by appointing additional directors to the board or removing existing directors.
The Underperformance Notice is a very useful tool to enable the investor to take control if management fail to perform.
Final thoughts
In addition to the investment agreement there will be a number of other documents that will need to be agreed such as the Articles of Association and the terms of management's service agreements. The investment agreement should be drafted with these documents in mind to ensure that they are consistent.. As subsequent rounds of investment are often required for venture capital backed companies, getting the investment agreement right can assist with future funding. Remember also that the parties will continue to work with each other so retaining a harmonious relationship during the negotiations is key. Venture capital investment is an inherently risky business and the terms of the investment agreement can play an important part in minimising those risks from the investor's point of view.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
