Investment Agreements – a Legal Maze

A question that is often asked by both investors and entrepreneurs is, “what is needed to document an investment transaction?”

As an entrepreneur you may be mazed by the legalese pertaining to investment documents. When you sell shares in your company, at a bare minimum, all you technically need is to issue shares (paper or electronic) and be paid for them as long as you comply with security regulations (mainly using applicable “exemptions”). For example, when you sell shares to family and friends, you don’t need much paperwork. In other words, documentation is discretionary.

The buyer of shares is only protected to the extent provided by the applicable Corporations Act (in one’s jurisdiction) and the Articles of the company unless she has purchased a control position (over 50%) or has entered into other agreements at the time of purchase.

When you begin to sell shares to arms-length investors (e.g. Angel investors), the common practice is to use a Subscription Agreement. This agreement is mainly to ensure compliance with securities regulations. It also describes the offering (i.e. share class and associated rights) being purchased and the price. It will also have the usual legal representations and warranties by the Company and the purchaser. Subscription agreements are fairly standard and don’t very greatly within any legal jurisdiction. Some law firms have taken much of the regulatory portions out of the Subscription AgreementĀ  and have come up with a second investment document called a General Investor Questionnaire to ensure compliance with securities regulations.

Before making an investment, investors will often want to see a Term Sheet that defines the conditions and requirements under which investors will subscribe. The Term Sheet is usually negotiated and agreed to among the investors and the Company. Sometimes, it is included as part of the Subscription Agreement.

Because minority investors have little clout, they want to have additional assurances (some of which may have been covered in the Term Sheet) from the Company about how the Company will be governed and how they can buy or sell shares. This is the purpose of a Shareholders’ Agreement often referred to as a SHAG. This is a document signed by all (or most) of the shareholders of the Company and by the Company itself. These can be very simple or very detailed and complex. Unlike Subscription agreements, these may vary greatly from company to company and are often the result of lengthy discussions. A SHAG among a small group of shareholders in a lifestyle business may be quite different from that of a high tech, high growth venture. SHAGs spell out the process for appointing a board of directors, any decision-making constraints (e.g. spending caps), how shares can be bought and sold – both among shareholders and from the Company, special rights (eg reporting obligations), reverse vesting conditions, what happens to the shares of a deceased principal, and anything else you may want to throw in there.

As a company grows and new investors are brought in from time to time, SHAGs tend to be frequently updated. In an attempt to simplify matters, some lawyers are replacing SHAGs with other Agreements such as:

  • Investors Rights Agreement
  • Voting Agreement
  • Right Of First Refusal (ROFR) & Co-Sale Agreement
  • SHAG lite (to cover what’s not included in the above)

Using the three agreements (as opposed to one) is the current NVCA and CVCA market approach. While VCs may like this approach, it may not be ideal for seed rounds where legal expenses should be kept under control.

Whether this simplifies matters or not is debatable. Many prefer fewer documents that need to be managed – especially angel investors.

Often, investments are made without a SHAG or the other documents. That happens because it can take a long time to nail down a SHAG. This would disadvantage the investor more than the Company’s founders. Buyer beware.