Investment Agreement
⚡TL;DR
- An investment agreement (IA) is a contract between the investors and the existing shareholders governing the creation of the shares and the related investment.
- IA includes representations and warranties acting as assurances of certain facts and future behaviours of the parties.
- IA often includes a liquidation preference, which gives the investors some preferred shares. This will enable the investors to be paid in priority in case of exit.
Undertakings
- Undertakings of Existing Shareholders:
- Increase of share capital: The existing shareholders assure that it will issue new (preferred) shares.
- General assembly: For the capital increase, an extraordinary general meeting has to be held.
- Proxy: The IA serves as a proxy for any actions that must be taken to fulfil the transaction envisioned in the IA. This notably includes voting in favour of the capital increase.
- Undertakings of the Investors:
- Subscription of the (preferred) shares: The investors undertake to subscribe to the shares, which can either be preferred (see Liquidation preference below) or not. The subscription can be made in cash or via set-off (e.g., convertible loan).
- Undertakings of the Company:
- Approval of resolutions: The newly composed board has to convene a constitutional meeting and approve several resolutions (i.e. to grant the signing power to the new directors).
Closing
The effective implementation of the share transfer is regulated. To this end, a place and date for the closing are decided, and the closing actions and deliveries (i.e., signed employment agreements or resignation letters from each resigning existing director) are listed.
The closing actions act as a checklist that must be fulfilled before the closing of the transaction.
Representations and Warranties
Representations and warranties are critical components of an IA, providing assurances about certain facts and conditions of the parties involved. As such they impact the amount of risks related to the parties.
- Representations are statements of fact as they exist at the time the agreement is made, such as the status of assets or compliance with laws.
- Warranties, on the other hand, are promises that these facts will remain true for a certain period.
These clauses protect parties by allowing them to seek remedies if the stated facts are inaccurate or if breaches occur, ensuring trust and reliability in the transaction. Such remedies usually include an indemnification (in cash or in share) preceded by a period during which the breaching party has the right to cure.
In practice, representations and warranties are given by the company, the founders, and the investors.
Example
For example, in a startup investment agreement, the company may represent that it owns its intellectual property and warrants that it will maintain this ownership through the terms of the agreement.
If it turns out that the company does not own the intellectual property, the investor can claim a breach of warranty and seek compensation.
Liquidation Preference
Liquidation preference is a key term in venture capital, ensuring investors recover their investment before common shareholders during liquidation events like mergers, acquisitions, or IPOs. This mechanism protects investors by giving them priority in payouts, which can be crucial for mitigating risks. This is organized by giving investors some preferred shares.
Essentially, liquidation preferences function like a waterfall. Investors with preference get their designated amount first, and only then are the remaining proceeds distributed to other shareholders. This mechanism ensures investor protection and prioritizes their returns.
There are two types of liquidation preferences:
- 1x Non-Participating: Basic protection where investors get their initial investment back.
- 2x Non-Participating: Investors receive double their investment. This could be 3x, etc.
- 1x Participating: Investors get their preference amount plus a share of the remaining proceeds.
Triggering events
In the event of a triggering event, the liquidation preference clause will find application. These are listed in the investment documentation and usually include:
- Exit: Majority shareholders sell their shares.
- Liquidation: Company dissolves, and assets are distributed.
- Merger/Reorganization: Company undergoes a merger or reorganization.
- IPO: Company goes public and offers shares on the stock market.
What about having multiple types of preferred investors?
Preferred shares can come in different classes, especially in later financing rounds like Series B. In these cases, new classes of preferred shares might be introduced. Metaphorically, new preferred pools are therefore introduced below the waterfall. This means that investors in these new classes could get their investment back before those in earlier classes, who will then recover their investment before any common shareholders receive their shares.
This setup is often based on a "last in, first out" principle, meaning the most recent investors have the highest priority.