If your client is looking to raise equity investment for its business, there are some things that need to be thought about early on, to make the process as smooth as possible. Andrew Fleetwood gives you the lawyer’s take on the four basic legal components of an equity investment deal.
- Due Diligence
After the heads of terms are signed, practically the first thing that you’ll receive is a due diligence questionnaire. Each firm has their own style, but they cover common headings.
- Company records
- Share capital
- Accounts, including management accounts
- Borrowing and banking arrangements (including asset finance, invoice discounting)
- Key contracts with suppliers and customers, including standard Ts & Cs
- Employees and pensions
- Main assets (excluding land and buildings)
- Intellectual property
- Land and buildings
- Regulatory compliance (including health and safety, environmental matters, data protection)
So if you are planning to get a business to market to raise equity, it would make sense to start gathering information together under these headings, early on. A strong due diligence pack is part of effective marketing – being on the front foot inspires confidence in the investor. But a weak package, and delays in producing information, exposes your client to price chips, indemnities and delays.
It’s important not to air dirty linen in public, so we quite often create a “safe” folder, where we can upload everything, before we pass it on to the investor. We assess for gaps and potential issues, so we can solve them before providing the information, or show a clear route map to solving an issue. Sensible investors know that nothing is ever perfect, but we can inspire confidence by showing we are aware of the problems and sorting them out.
Investors might also undertake a separate detailed due diligence of the key management team, with questionnaires that can be quite intrusive, going into their finances, private life and health in some detail.
- The Investment Agreement
This is the key deal document. It has three main parts:
- the investor’s share subscription, setting out how many shares the investor is buying and for how much;
- the ongoing management of the company, supplementing the articles of association;
- the warranties.
Share subscription – the investor gives money to the company and the company gives the investor shares in return. This is important: the other shareholders are not getting any money at this stage. Their shareholdings (ideally) will increase in value, but they will not, in a typical investment deal, receive any money. Part of the proceeds may be used by the company for repaying directors’ or shareholders’ loans, which is a common way of getting value out, although this will all need to be agreed up front – investors like to see that their money is being used to build value in the company, rather than de-risk the existing shareholders.
The ongoing management of the company – this is usually a nuanced discussion. The investor will often want board representation and may want to have a veto over certain key decisions. The board will want to pursue its business plan with as much flexibility as possible. There are certain standard compromises, depending on the stage the company is at and the level of investment. You’ll often find restrictive covenants imposed on the senior team, preventing them from leaving and setting up in competition, or poaching key staff and customers. Again, there are some standard compromises, but it is important that the management team know what they are signing.
The warranties are the contractual protections for the investor. They are a set of statements that must be true. If they are not true, then the investor can typically sue the company and certain key individuals in the business. The protection against being sued is to make disclosures against the warranties in a disclosure letter (more below). At the earliest stage of investment, the warranties can be very basic: often little more than the business plan was sensibly prepared. But more mature businesses may have to give extensive warranties. The warranties are typically given by the company to an unlimited extent, with named individuals (e.g., the founders) also giving the warranties, but typically with a capped liability.
- The Disclosure Letter
The disclosure letter qualifies the warranties given in the investment agreement. For example, a warranty might say that the Company is not involved in any litigation. If the Company is currently suing somebody, you would give details of that in the disclosure letter. This is where good preparation of the due diligence package comes into its own. Ideally, there will be nothing mentioned in the disclosure letter that hadn’t previously come to light in the due diligence exercise. There are few things that slow down deals and lead to more ill will than a late disclosure of a material problem! And note that some warranties cannot be disclosed against. So, for example, an investor would not be impressed by an attempt to qualify a warranty that the business plan was based on the directors’ honestly held beliefs.
- The Articles of Association
A sophisticated investor will want the company to adopt new articles of association. The articles of association are the basic rules of the company. Depending on the funding round, the investor may want to see certain protections set out in the investment agreement reflected in the articles. They may also want to insert “bad leaver” provisions, where a shareholder can lose their shares if they leave the business. Other typical provisions are drag along rights, where the majority shareholders can force the minority to sell up to a third party buyer, and tag along rights, where the minority shareholders can force the majority to let them sell their shares to a third party buyer on the same terms as the majority.
The key to raising finance quickly is early preparation. Pulling the due diligence pack together and anticipating issues can really speed things up. The investment agreement, the articles of association and the disclosure letter are quite technical documents – and it often comes as a surprise to clients how much additional work there is in getting these documents prepared and agreed after the heads of terms have been agreed. The heads of terms are never comprehensive and a lot of investors’ “standard” positions need careful consideration. Being aware of the legal issues and helping your client prepare for them can make all the difference to the smooth running of a transaction. If you have clients raising equity, call us at the outset and together we can agree a schedule that means your client can get there faster.
If you would like further information on the topic discussed in this article, please contact Derek Hamill by email: email@example.com or by phone: 0131 516 5365 / 07841 920 101. You can also view Andrew’s profile by clicking here.
The information and opinions contained in this blog are for information only. They are not intended to constitute advice and should not be relied upon or considered as a replacement for advice. Before acting on any of the information contained in this blog, please seek specific advice from Gilson Gray.