What are the key elements of an investment agreement?
What are the different types of investment agreements?
What are the differences between an investor agreement vs shareholder agreement?
We will look at what is an investment agreement, investor contract vs shareholder agreement, investor rights agreement, different types of investment agreements, key terms and conditions and more.
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What is an investment agreement
An investment agreement or business investment agreement is a contract to formalize a transaction between an investor and a company whereby the investor acquires an ownership interest in a company in exchange for an investment of some kind.
In other words, an investment agreement allows a company to obtain capital in exchange for giving away a percentage of the ownership of the company to the investor.
Companies need capital to scale
Startups, growing companies and businesses need capital to scale, grow operations, hire additional staff and increase their output.
To access capital, a company may have many options such as debt financing or equity financing.
Let’s look at different types of investment agreements to have a better understanding of what this means.
Types of investment agreements
There are different types of investment agreements out there.
The most common investor agreements are:
Let’s briefly look at each.
Stock purchase agreement
A stock purchase agreement is a type of investment contract whereby a person, the investor, acquires a percentage of the shares in the capital stock of your company in exchange for capital.
Following the investment transaction, the investor becomes a shareholder of the company.
Stock option agreement
Stock option agreements can be nonqualified stock options or qualified stock options.
A stock option gives you the “option” to buy the company stocks in the future at a price determined when the options were granted.
The purpose of the stock option is to allow a person to have the possibility to purchase the company stocks in the future for a fixed price.
If the value of the company’s shares goes up, you can then exercise your options and purchase the common shares below the share market value.
Convertible debt agreement
A convertible debt agreement is signed when a person or business agrees to lend the company some money but have the option to convert the loan into an ownership interest in the company.
The convertible debt agreement will define who may have the option to convert the debt into equity.
Some convertible debt instruments allow the lender to either demand the payback of the loan or elect to convert the loan (or principal and interest) into securities of the company.
Restricted stock agreement
A restricted stock agreement is a type of investor agreement whereby the company agrees to issue shares to an individual in exchange for that person’s time and efforts into the company over a period of time.
If the person does not contribute time and effort over a specified period of time, then the person cannot claim ownership of the stocks.
Deferred compensation
Deferred compensation is not an “investment agreement” per se as the person does not receive equity ownership in the company.
A deferred compensation agreement is when a person agrees to work for a company today in exchange for future compensation, salary or bonus.
Elements of an investment contract
Investment contracts, also known as investment agreements or investors agreements, are one of the most widely used investment instruments used by businesses of all sizes.
Let’s look at the elements of an investment agreement to see how it is formulated.
Parties
The ideal scenario is for all the shareholders of the company, along with the investor, to be a party to the investor contract agreement.
Adherence
In the investment agreement, you typically see an adherence clause (where a future transferee of the stock is required to be subject to the same terms and conditions of the investment agreement.
By signing a deed of adherence (or joinder agreement), the new shareholder will be deemed to be an original party to the investment agreement and bound by its terms.
Investment tranches
In an investment contract agreement, the parties can agree to have the investor invest in tranches or provide part-payment.
This is usually the case to tie the investment with certain targets or milestones such as revenue targets, market launch or product development.
Investment tranches are linked to defined targets
An investor may impose investment tranches linked to the following conditions:
- Completion of the due diligence
- Delivery of a business plan
- Tax clearance from the tax authorities
- Investment approved by the board of directors
- Investment approved by the shareholders of the company
- Intellectual property rights assignment
- Insurance coverages
Investment tranches are typically seen in strategic structured finance deals to even out the financial risk on the parties.
Investment warranty
Another key term of an investor contract relates to the investment warranty.
The investor will require the company to provide a warranty that the statements made by the company are true and accurate.
The investment warranty can cover aspects relating to the company’s financial position, product, company’s share capital, company liabilities, litigation, taxes and more.
Disclosure letter
For an investor to assess an investment opportunity, it needs to have all the relevant information about the company to decide if the investment is worth it, how much to invest and what are the risks associated with the investment.
With this objective, the investor will require the company to provide a disclosure letter setting out all the potential and material ‘issues’ affecting the company.
With a disclosure letter, a company actively discloses material information to an investor
In the disclosure letter, the company will relate information about potential lawsuits, important liabilities, risks, conflict or other material aspects that the company actively brings to the attention of the investor.
Investor rights
As part of the investment agreement key terms, you have the investor rights.
The investor rights represent certain rights mutually negotiated between the investor and the company allowing the investor certain rights and privileges.
Content of the investor rights agreement can include:
- Rights relating to the initial public offering
- Rights related to the sale or transfer of the shares
- Rights to receive management reports
- Rights to receive financial statements
- Rights to sit as a board observer
- First right of refusal
- Preemption rights
Each investment deal will have its own particularities.
The more an investor takes risk, the more the investor will negotiate rights and privileges
The more an investor invests in a company (the more risk the investor takes), the more the investor rights agreement will be drafted to favour the investor.
Investor consent regimes
The investor contracts can provide for an investor consent regime whereby the company agrees to consult with the investor or obtain an investor’s approval before proceeding with certain management decisions such as:
Some investors want to be involved while others are passive investors
Some investors will want to be hands-on and involved in the operations of the company while others may take a more passive approach.
An investor consent regime will be designed to allow the investor to have a certain level of control over management decisions that may potentially impact the company valuation or the attractiveness of the business.
Restrictive covenants
Restrictive covenants are contractual provisions limiting a shareholder’s ability to sell or transfer his or her shares in the company.
When a person invests in a company, the expectation is that the key personnel remain in the company and continue to have “skin in the game”.
Investors want founders to have skin in the game
An investor will probably not invest if the founders, key personnel or shareholders leave right after the investment is made.
To protect the investor against this risk, the investor will impose restrictions on the ability of certain individuals to sell or transfer their shares.
Board representation
It is common to see that investors demand to have one or more directors appointed on the company’s board.
They will also require that at least one or more of the investor’s directors be present at a board meeting to have a quorum and allow decisions to be made.
Exit strategy
The investment contract agreement will also provide for provisions intended to have the parties work towards a possible exit of the investor within a set timeline.
An investor will typically want to realize profits on the company stocks by selling the company or listing the company on the stock market.
Most investors want to see a clear path to realizing profits within a few years
Without a meaningful exit strategy, the investor runs the risk of having his or her money tied up in the company for many years to come.
That’s not desirable for many investors.
Investment agreement vs shareholder agreement
An investment agreement is designed to protect a new investor whereas a shareholder agreement is designed to protect the rights of existing shareholders.
The objective of an investment agreement is to govern the “investment” whereas the objective of the shareholder agreement is to govern the “interests” of the shareholders.
Investment agreement protects the investor, shareholder agreement protects shareholder interests
In a shareholder agreement, you’ll typically find provisions relating to:
- Voting rights
- Protection of minority shareholders
- Appointment of rights
- Rights or restrictions on share transfer
- Confidentiality provisions
- Appointment of board members
- Removal or appointment of specific shareholders
- Buy-back rights
- Rights to dividends
- Stock valuation procedure
The interests of a shareholder vs investor are generally aligned but in certain cases can conflict.
The investment agreement and shareholder agreement will act as two important instruments in managing the investment and the internal relationship of the shareholders.
Investor agreements templates
An investor agreement template will have certain standard clauses and other provisions designed for the particulars of a unique investment.
The investment agreement templates can have the following sections:
- Definition and interpretation
- Investment
- Subscription
- Completion
- Application of subscription monies
- Agreed business controls
- Investor director and information
- Confidentiality
- Founders’ undertakings
- Warranties
- Accounting and information rights
- Investor consent
- Transfer of shares
- Non-competition
- Assignment
- Third-party rights
- Limitations on and times for bringing claims
- Restrictive covenants
- Costs and expenses
- Intellectual property
- General provisions
- Deed of adherence
Investment agreement FAQ
How do you write an investment contract?
An investment contract should describe the terms of the investment and what the investor gets in return.
You must draft your investment contract in such a way that you include the basics such as:
- The parties
- The investment
- The purpose of the investment
- The rights of the parties
- Investor’s return on investment
- Reporting and control
- Restrictions or obligations of the parties
- Date and signature
Some investments are in cash while other investments are in assets
You must write your contract so it is clear what is the consideration the company is getting in exchange for the share issuance.
What is the purpose of the agreement?
The purpose of an investment agreement is to protect an investor who will become a new shareholder of the company.
Typically, the investor’s objective is to make a profit on the investment while the company’s objective is to raise capital.
The terms and conditions of an investment agreement will generally cover:
- The investment
- The investor’s return on investment
- The company’s reporting obligations
- Exit strategy
What are the elements of an investment contract?
Although investment contracts can vary from one transaction to the next, typically, you can expect the following elements:
- Parties
- Adherence
- Investment tranches
- Investment warranty
- Disclosure letter
- Investor rights
- Investor consent regime
- Restrictive covenants
- Board representation
- Exit strategy
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