In the final part of our investment documents blog series, we will dive into 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 investment details. It includes the actions required to close the investment and the structure of the investment itself. Besides, the investment agreement typically consists of the representations and warranties of the company and the existing shareholders. Once the investment agreement has been approved, everything is set for the investment.
Requirements for the Investment
The investor may set out some requirements that need to be fulfilled before the investment can take place. If the parties have agreed on an option pool to be set aside for the employees, creating the option pool is typically presented as a prerequisite for the investment. Or if the investor is investing using preferred shares, the creation of the share class is generally 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 in which the investment is made. This can be, e.g., a common share, a 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, the 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 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 is the first closing, the second tranche is the second closing, and so on.
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., suppose the investment is made with the plan to expand into a new market. In that case, the conditions precedent for the second tranche investment can be specific 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 particular representations of the company’s status to the investor. Representation and warranties are a statement that everything in the company has been handled professionally 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, verified the material facts relating to the company, giving representations and warranties to the investor means that the company and shareholders giving these may be held personally responsible in case the information provided is not accurate.
The representations and warranties as such are, to a large extent, boilerplate text covering the following areas:
- Organization of the company and its subsidiaries, i.e., the company is validly established and 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 accurate, and 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 company’s agreements 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 boilerplate text, finding a startup that would have done everything by the book is rare. 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, these issues are typically fixable, and 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 specific 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 more serious attention on the administration is required as more serious investors come in.
Besides fixing issues, other undertakings typically include actions agreed upon during the investment negotiations. E.g., if the company plans to expand internationally, it may be required to recruit a person experienced in sales in the focus market to the team.