There is a growing trend for equity investment deals by private individuals (known as ‘angels’) in young and small private companies. This note addresses what might be expected in terms of the legal documentation involved, as well as some of the practical issues concerning deal management.
(Note: this guide needs to be updated to mention the new Seed Enterprise Investment Scheme (“SEIS“), although the EIS is still available to investors in startups raising over £150k and also to companies raising a further round of finance once they have made use of the SEIS)
As opposed to larger scale venture capital firms and private equity funds, business angels are private individual investors who chose to invest directly in private companies in return for an equity stake in the target investee company and (potentially) a position on its board of directors. Typically, business angels are high net worth individuals acting individually or together as a syndicate and they are often capable of investing amounts from £10,000 to in excess of £2 million.
Business angels often seek to invest under the Enterprise Investment Scheme (EIS). The EIS was introduced by the government to incentivise wealthy people to invest in high growth companies, principally by making the investment tax efficient. To comply with the EIS, investors have to subscribe for ordinary shares and any preferential rights will often be negotiated under the investment agreement in a manner which will not prejudice EIS relief.
Once an investor likes a business plan (or ‘investment memorandum’) enough, the investor will usually provide the entrepreneur with an initial draft of the heads of terms. This will set out the main terms, rights and requirements of the investor’s proposal which it expects in consideration for its equity investment. The heads of terms is usually marked ‘subject to contract’ with the exception of such clauses as confidentiality and exclusivity. Sometimes a separate confidentiality agreement is signed at the outset when the business plan is received.
The investor’s investigations will normally cover separate financial, legal and technical due diligence. Other types of commercial due diligence, such as market analysis, may also take place. The nature and scope of any due diligence will vary and will normally depend on the company’s stage of development.
The investor’s lawyers will be asked to conduct an element of legal due diligence on the target investee company. The extent of this will depend on the trading history of the target and the investor’s appetite for information about the target. In any case, the scope of due diligence will usually cover areas such as the constitution and structure of the board and shareholders, intellectual property, employment contracts, existing financing arrangements, existing licence, research and development and other collaboration agreements, property arrangements and key commercial contracts.
Timing and approvals
As a matter of good corporate governance, an equity investment should be considered and approved at board level, particularly the preparation and disclosure of the business plan, the execution of the heads of terms, confirmation and release of information in response to a due diligence questionnaire, the execution of investment documents, the new issue of shares to the investor and the appointment of an investor director to the board. All meeting and approvals in this regard should be minuted.
The target company is also likely to require shareholder approval as part of the investment process in order for new shares to be issued to the investor, new articles of association to be adopted, the subscription and shareholders agreement (also referred to as an investment agreement) executed, the appointment of the investor director approved and the existing rights of pre-emption in relation to the issue of shares waived or disapplied. These shareholder resolutions can either be passed by convening a general meeting or by passing shareholders’ written resolutions remotely.
If the target company has existing equity or debt investors, their consent may also be required as a result of any right of veto they have in any existing investment or loan agreement. This will normally become evident from the due diligence exercise, although it is more expedient if the target company obtains letters of consent beforehand.
Although not a pre-requisite, advance clearance from HMRC is likely to be a material condition of an investment by a business angel as it’s important to ensure that the proposed deal is a qualifying investment for the purposes of EIS relief.
If the incoming investor subscribes for more than 50% of the share capital of the company, the share issue may result in the target company breaching any change of control clauses in its commercial contracts. If this is the case, the target company will need to seek consent to the investment round from the relevant third party before completion.
a) Articles of association
The articles of association form part of the company’s constitution and are therefore binding on the company and all of its shareholders, officers and directors. This is different to the position under the investment agreement which is a contractual relationship between selected shareholders. A further distinction is that the articles are a public document, whereas the investment agreement remains private. Therefore, because business angels will jeopardise their EIF relief by having any preference to capital (liquidation) or income (dividends), they usually subscribe for ordinary shares but ensure that they have contractual protection in relation to preferences incorporated in the investment agreement.
The articles of association adopted at completion often include the following matters:
Redemption: As a means of guaranteed exit, the investor may require the company to redeem its shares in specific circumstances. The redemption amount payable on the investor’s shares will usually be the subscription amount plus a premium to provide the investor with a suitable rate of return.
Anti-dilution: These provisions ensure that an original investor is not prejudiced by subsequent investment rounds at a lower valuation than the investor’s original investment round. Non-investor shareholders should be aware that such provisions are likely to set a precedent for further rounds and are likely to further dilute the founders’ shareholding in the company. The founders should consider negotiating a ‘pay to play’ provision, which is designed to ensure that an investor loses their anti-dilution rights in the event they do not participate in future rounds of funding, thus incentivising it to invest further.
Performance ratchets: These are designed to incentivise management by allowing managers who are shareholders to increase their percentage holding in the company either by reference to achieving a pre-agreed internal rate of return on the investor’s original investment within a specified time period or the company being sold for a minimum pre-determines price.
Voting: There is generally one vote per share, although some investors may seek enhanced voting rights on certain trigger events (e.g. the removal of a director). With regard to founder and/or employee shareholders, investors often try to introduce a share vesting schedule to incentivise the person concerned to remain with the company and to penalise them if they leave before the expiry of the vesting period. Unvested shares are either redeemed by the company at nominal value or converted into non-voting deferred shares.
Permitted transfers: An investor will seek freedom with regard to transfers of its shares in the target company, but will also try to impose restrictions on share transfers by the target company’s other shareholders to prevent a dramatic change in the ownership of the company. An investor will usually agree to certain permitted transfers to close family members and family trusts for tax planning purposes and, in the case of corporate shareholders, to and from group members and affiliates.
Pre-emption on new issues and right of first refusal on transfers: These will govern the order in which new shares or existing shares are offered to the company’s shareholders. This is usually on a pro-rata basis, however the investor may insist upon having the right of first refusal ahead of all other shareholders.
Employee leavers: These provisions ensure that a company’s shares and value remain with persons actively involved in its business, thereby incentivising the management team. Therefore, employee and/or director shareholders who leave the employment of the company may find that they are forced to transfer their shares depending on the circumstances in which they left.
Tag along: These rights ensure that the majority of shareholders cannot sell their shares to a third party without the minority shareholders also having an opportunity to sell some or all of their shares.
Drag along: These rights ensure that a sale of the company is not frustrated by minority shareholders and work so that investor controls both the timing and the price of their investment exit.
Specific rights: These usually take the form of veto rights which restrict actions of the company unless they are carried out with the consent of the investor or a percentage of the shareholders (e.g. acquisitions, borrowings, disposals and capital expenditure).
Board composition: The right to appoint a director to the board of the target company or the right to send an observer to board meetings will usually be a pre-requisite for the investor.
b) Investment agreement
The investment agreement covers the following:
It sets out the basic terms of the transaction, including the amount to be invested and the shares to be received.
It defines the legal relationship between the investor, the company, the founders, directors, managers and the company’s other shareholders.
It governs the ongoing contractual relationship between the investor, management and some or all of the other shareholders of the company.
The investment agreement will usually contain the following provisions:
Conditions: The conditions precedent (e.g. the passing or resolutions) for completion to occur.
Information rights: The investor is likely to insist that financial information such as management accounts, cash flow forecasts and audited accounts are prepared and delivered to it promptly prior to completion.
Board representation: While some are keen to have a vote at board level, other investors prefer to appoint an observer to attend and rely on their rights of veto on key management decisions under the investment agreement. The investor may not want to be a director because of conflicts of interest (each director is required to act in the best interests of all shareholders together both present and future) and potential liability (although the investor could always ask for an indemnification agreement).
Restrictive covenants: Investors will want employee like restrictive covenants form shareholder managers to tie directly with the investment, as opposed to being put in separate employment contracts.
Exit rights: The investor will want to ensure that it is clear on what timing and basis they will exit, as well as an acknowledgement that no warranties are to be given by the investor on an exit.
Warranties: The founders and existing shareholders will be required to grant warranties to the investor, the main purpose of which is to elicit as much information as possible about the company and its business prior to the investor making the investment. Warranties also provide an investor with a right of recourse in the event that a warranty is subsequently found to be untrue, although these actions are rare.
Warranty limitations: The warrantors will seek to protect themselves by making disclosures against the warranties in the disclosure letter and limiting their liability for claims by reference to financial caps, time limits etc.
c) Disclosure letter
A disclosure letter is given by the warrantors to the investor, which together with attached exhibits providing appropriate evidence, will detail matters inconsistent with the warranties. If disclosure of a particular document or fact if accepted by the investor, it will render the matter in question not actionable and the investor will be deemed to have knowledge of, and therefore accept, that the warranty is qualified by the point fairly disclosed in the disclosure letter.
d) Service agreements
The investor will want to ensure that the key employees are suitably tied into the target company by way of a service contract in a form that the investor is happy with.
e) Ancillary documents
The principal ancillary documents necessary are the shareholder resolutions, completion board minutes, share certificates and Companies House forms, all of which should be registered and filed as required by the relevant regulations.
Before completion, any powers of attorney are approved and executed so that those able to attend the completion meeting are authorised to sign on behalf of others. The legal advisers involved will need to agree that all conditions have been satisfied and decide on the precise mechanism for completion and the sequence of events. In practice, the execution pages are normally circulated by email and exchange will be agreed on the basis of electronic signatures. When all documents have been signed, the investor will instruct the transfer of their funds and the legal advisers will agree to speak and confirm completion by phone.