In my last blog, I addressed the issue every new business owner faces of where to obtain their start-up capital. I focused in particular on issues to consider when utilising family and friends as investors in the business.
This week, I’d like to delve a little deeper into formalising funding arrangements by drawing up investor agreements.
Start-ups that enter into arrangements with any type of investor should always formalise those arrangements with a legal agreement.
Agreements serve the purpose of providing a written record of the understanding the business owner and their investors have about the arrangement and the specific terms they are agreeing to. Having these terms documented is always wise when it comes to matters concerning money and to protect both parties in the event that their circumstances change and decisions need to be made or revised as a result.
Formal agreements also provide the opportunity for business owners and investors to consider and agree how they will handle situations that you don’t necessarily expect to arise, such as a dispute, death or early exit.
The bare bones of an investment agreement should include the following:
- Date, names and addresses of each of the parties entering into the agreement.
- The amount of money being invested, how the investment will be used and what the investor can expect to receive in return for their financial contribution.
- Payment terms including when and how payment is to be made, whether in one lump sum or spread across multiple payments, listing the dates and amount of each payment to be made.
- Any deliverables to be achieved by certain dates or products and services to be developed and when they are due to be delivered.
- The term of the agreement and how long it is valid for, as well as the return on investment to be delivered and how the agreement will be terminated. Options for how each party can terminate the agreement early should also be outlined.
Beyond that there are different types of agreements you might put in place, depending on the role the investor will play. Below is a quick summary of the additional elements these different types of agreements might include:
Shareholders or partnership agreements
- Objectives – The specific aim of the business and activities it will perform.
- Roles and responsibilities – What each shareholder is responsible for and will do. What decisions they can make individually and which ones require all shareholders to be involved in making, like selling the business. It should also spell out what remuneration each shareholder will receive.
- Profits – How they will be used and whether they will be reinvested for an initial period or distributed to shareholders that want to take the cash.
- Additional funding – How the company will be funded to meet the growth, operational and development needs of the business.
- Exit – How shareholders can exit and who they can sell their shares to. How the value of the shares will be determined. How to handle the death of a shareholder and whether their shares will be sold to existing shareholders, or if the deceased estate and beneficiaries can retain ownership and what their role and rights will be in relation to business decisions.
- Restraint of trade – Whether shareholders can have interests or a role in other businesses including similar businesses.
- IP ownership – Who owns intellectual property brought to the business or developed by it. What will happen if a shareholder than brought IP to the business decides to leave?
- Dispute resolution – How disputes will be handled and resolved. Will mediation or an independent expert be brought in to resolve the matter, so it doesn’t have to proceed to court and incur costs for doing so?
Angel investor term sheets or agreements
- Seat on the board – Angel investors will typically expect to have a seat on the board of the company and therefore a voting right in business decisions.
- Equity type – There are different types of shares that can be issued by a company. Initially, a start-up company might issue ordinary shares, or the same type of shares that the founding owners hold. As the business grows and develops it might structure things differently and issue different types of shares that provide different entitlements to the shareholders, such as preferred convertible shares. Angel investors will want to be clear about what class of share they are obtaining with their investment.
- Anti-dilution clauses – These are clauses designed to protect the conversion price of the shares that angel investors hold, which may be affected by additional funding provided to the business. While some dilution is likely to occur, those that invest early on and bare a greater burden of risk will want to see better returns and reward to match that risk, compared to later investors who come on board when the business concept has been proven.
- Right of first refusal – This is the first right to purchase shares held by other investors before they are offered to an outside party. This enables an angel investor to consolidate their ownership.
- Liquidated preference – Terms designed to ensure the investor gets their investment back in the event that a business owner decides to sell early and potentially at a loss to the investor.
Venture capital term sheets
The terms here will be much the same as for angel investors, with a few additional clauses:
- Information and management Rights – VCs might require certain information and reporting to be provided on a monthly or some other regular basis so they can monitor the progress of the business.
- Restrictions on sale of shares – Because the business is often tied to the expertise of key founders or employees, investors might place restrictions on the ability of those founders to sell their shares, until such time as the investors have sold their interest and made an appropriate return on their investment.
- Exit strategy – VC investors typically expect to realise their investment through a trade sale, float or IPO, so might include the right to make this happen within a certain timeframe. Alternatively, they might incorporate a clause to force the founders to buy their shares back.
Regardless of the type of investor’s agreement you end up entering into, there are a couple of key considerations you should always have at the outset.
Here are my top five tips for business owners planning to bring an investor on-board:
- Be clear about your reason and objectives for obtaining an investor.
- Give detailed thought to what your investor wants to get out of the business.
- Establish a fair means for rewarding each of your dollar and “sweaty-equity” investments.
- Expect the unexpected, plan for it and deal with it as soon as an issue arises, to prevent it from escalating.
- Seek financial and legal advice.
Marc Peskett is a Director of MPR Group a Melbourne based business that specialises in providing, business advisory, tax, grants and funding services and outsourced accounting to small and medium enterprises.
MPR Group are holding a full day workshop on 21 June to help business owners including start-ups, develop their annual business plans and budgets. To register click here.
You can follow Marc on Twitter @mpeskett