Investment Agreements – A Comprehensive Guide

Every startup founder dreams of catapulting their vision into reality, and for many, this journey begins with securing the right funding.

The cornerstone of this crucial step is a solid investment agreement, connecting ambitious startups with investors who believe in their potential. Navigating the intricacies of investment agreements is paramount, not just for securing funds but for safeguarding your startup’s future. 

This article highlights the essential elements, legal nuances, and potential pitfalls of investment agreements, focusing on equity investments.

Whether you’re a first-time founder or a seasoned entrepreneur, mastering the art of investment agreements is a critical step in turning your startup aspirations into tangible successes.

1. Before concluding an investment agreement

Before any signatures are put on paper, several preliminary steps are crucial, depending on the nature of the investment and the parties involved.

These steps ensure that both startups and investors are on the same page, setting the foundation for a fruitful partnership.

1.1 Types of investment

The founders ought to decide on the type of investment before going through with any procedures. While this article focuses on equity investments, there are also two popular alternatives: convertible loans and simple agreements for future equity (SAFE).

You can read more about the comparison between these popular investment types from our article here.

1.2 Term sheet

In order to align the expectations of all parties, it is wise to conclude a term sheet prior to moving forward with due diligence and the investment agreement itself. The term sheet acts as an initial non-binding commitment, outlining the key terms of the prospective investment.

For an equity investment, the key terms include the valuation of the company, the investment amount, the ownership stake to be given in return, and other critical terms like voting rights and liquidation preferences. A more thorough explanation of these terms can be found here.

It is important to note that term sheet negotiations should not be taken lightly: even though term sheets generally include a clause stating that these are non-binding, you should not accept terms that do not suit you and instead spend some time negotiating the starting point.

A well-negotiated and thought-through term sheet saves time in the investment process moving forward.

1.3 Due diligence

Due diligence is the investigative process that in some instances follows successful negotiations for a term sheet. Due diligence is often conducted on the legal, financial and taxation matters but also sometimes operational due diligence is conducted.

The scope of the due diligence is determined by the investor. Advice for the founders and the startups is to maintain good governance and administration at all times which makes the due diligence process smoother and contributes to the investment process.  

The conclusion of due diligence signifies a mutual understanding and readiness to proceed with the investment, provided both parties are satisfied with their findings.

Oftentimes, post-closing obligations are born out of the results of the due diligence: these are issues that should be addressed and mended but they are not so critical to block the deal moving forward. 

2. Key terms of investment agreements

The investment agreement builds on the term sheet, detailing the preliminary terms with additional rights and obligations for the involved parties.

2.1 Investors’ rights

One of the core components of any investment agreement is the delineation of investors’ rights. These rights can include, but are not limited to:

  • Voting Rights: Detailed provisions on voting rights, including which decisions require investor input, ensure investors have a say in critical company matters without stifling the operational freedom of the founders.
  • Right of First Refusal: This right allows shareholders the first opportunity to purchase additional shares before the company offers them to outside parties, protecting their shareholding against dilution.
  • Information Rights: Regular, detailed financial and operational reports keep investors informed, enabling them to provide valuable guidance and support.

Clearly defining these rights is vital to prevent misunderstandings and conflicts down the line. For startups, understanding and negotiating these rights is essential to maintain balance and ensure that the founders’ vision for the company can be realized without undue interference.

2.2 Founders’ obligations

Founders’ obligations are crucial in any investment agreement as they outline the expectations and responsibilities of the startup’s founding team post-investment. These obligations often include:

  • Reverse Vesting for Founders’ Shares: This mechanism ensures that founders earn their equity over time, protecting the startup and investors if a founder departs early. It aligns founders’ interests with the long-term success of the company.
  • Confidentiality: Founders are usually required to keep proprietary information confidential, safeguarding the startup’s trade secrets and business plans.
  • Non-compete and Non-solicitation: These clauses prevent founders from starting or engaging in similar businesses that directly compete with the startup or from soliciting customers and employees away from the startup for a specified period.
  • IP Transfer: Founders are required to transfer any intellectual property related to the startup’s business to the company to ensure all operational assets are legally owned by the business.
  • Devotion: This requires founders to commit their full time and attention to the startup, ensuring that the company receives the necessary leadership and direction to grow.

These obligations are designed to protect the investment and ensure that founders remain committed to the startup’s success.

2.3 Conditions precedent

Conditions precedent are specific milestones or requirements that must be met before the investment is finalized. These typically include:

  • Agreements Between the Founders and the Company: This can involve the transfer of intellectual property rights to the company, ensuring all operational assets are under the company’s legal ownership, conclusion of management board member agreements or putting the previous oral agreements in writing.
  • Adopting Necessary Shareholders’ Resolutions: This includes resolutions for issuing new shares and possibly amending the company’s articles of association to accommodate new investment terms.

These conditions serve as safeguards for investors, ensuring that the legal and operational frameworks of the startup are in order before the investment proceeds. Once the conditions precedent have been fulfilled, the investors shall subscribe to the newly issued shares and complete the investment.

3. Considerations for the startup’s founders

As a founder of a startup, there are important considerations to keep in mind in the closing and post-closing stages of the investment.

Adhering to these makes sure you will not fall into legal pitfalls and ensures a smooth process for you and the investors alike.

3.1 Closing

A critical step in the investment procedure is the closing stage. Some critical aspects to keep in mind in the closing stage include:

  • The Company’s Articles: The issuance of new shares must adhere to any limitations or procedures outlined in the company’s articles of association. These include issuing the shares with an issue premium (ülekurss) and making sure that the share capital of the company is large enough to accommodate the investment. Learn more about the nuances of the share capital from our article here.
  • Previous Investments: The conversion of convertible loans or other prior investments into equity must be considered, as these can affect the total share distribution and ownership percentages. If you are planning on giving employee stock options, the option pool also has to be taken into account in the cap table. You can learn more about employee stock options from our article here.
  • Representations and Warranties: Both parties make certain declarations about the state of the company and the validity of the investment. It’s essential for founders to accurately disclose the company’s financial and legal standing, minimizing the risk of future disputes.
  • Shareholders’ agreement: This agreement outlines the rights and obligations of shareholders, including governance, voting rights, and exit strategies. It’s important to establish clear rules that govern the relationship between shareholders to prevent conflicts and ensure the company’s smooth operation.

Ensuring a thorough understanding and careful consideration of each of these elements is crucial for a successful closing of the investment. It not only secures the necessary funding for the startup but also establishes a strong foundation for the partnership between investors and founders, setting the stage for future growth and success.

3.2 Post-closing

Post-closing obligations focus on addressing any issues discovered during due diligence that are significant enough to require action but not so critical as to prevent the investment from closing.

This phase ensures that the company adheres to agreed standards and conditions, maintaining the trust and confidence of investors in the startup’s potential and governance.

As an example, review of data protection policies and employment agreements are often post-closing obligations.

In conclusion, closing an investment round is a big milestone in a start-up’s lifecycle and being prepared makes this easier on all parties.

Whether you are a start-up founder or an investor, our knowledgeable team is here to help. Get in touch with us!

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