Legal issues when dealing with investors
Legal issues when dealing with investors
Legal issues when dealing with investors.
This article was written by Michael Buckworth, a partner in Buckworth Solicitors. Buckworth Solicitors is a London based law firm specializing in assisting start-ups on a range of matters. The firm works solely on the basis of affordable fixed fees.
Securing significant investment is often crucial for a business’s development and survival. However, entrepreneurs shouldn’t be afraid to hold out for the right deal on the right terms. Even where the broad commercial deal appears favourable, businesses should make sure that the legal language in any transaction documentation doesn’t create long-term problems.
The right deal
Before talking to prospective investors (or even going out and looking for them), entrepreneurs should have carefully thought through how they see their business progressing. The two most important questions for entrepreneurs to ask are (i) how much investment will be needed to get a beta product to market and subsequently to develop a mass market version, and (ii) what is our exit strategy?
The answers to these questions determine the acceptable parameters of any deal with an investor, particularly where the investor is a first round or seed capital investor. If you calculate that you will need £500,000 over three years to launch and then develop your product with a view to selling the business in five years, there is no point giving away 49 percent of the equity in exchange for £100,000. The next investment round will probably dilute your shareholding significantly and you will find yourself working for a company where you have a small minority shareholding and potentially no effective control of decision making.
The devil is in the detail
Having negotiated a brilliant deal with an investor, don’t throw it away by missing less obvious provisions in the shareholders’ agreement. Shareholders’ agreements are contracts between the shareholders of a company which are binding as between the shareholders who have signed up to the agreement. Provisions within shareholders’ agreements can alter the normal operation of a company as set out in the standard articles of association and the Companies Act 2006.
For example, under the Companies Act 2006, most decisions of a company can be made by the board of directors, generally on the basis of a majority vote. Further, any director can be removed by a majority of the shareholders. A common provision in shareholders’ agreements states that certain decisions require the unanimous consent of all the shareholders (thereby giving a veto right to each minority shareholder). Further, shareholders’ agreements often grant an absolute right to certain shareholders to appoint one or more directors (and to ensure that any director appointed by them remain appointed.) These sorts of provisions can dramatically alter the balance of power within a company.
Another set of provisions that are often included in shareholders’ agreements relate to the rights of shareholders to sell their shares and/or the company. Shareholders’ agreements can create locked periods during which no shareholder can sell their shares – these periods are sometimes as long as 3-5 years in length – as well as provisions forcing minority shareholders to sell in certain circumstances where the majority of the shareholders wish to sell.
In negotiating shareholders’ agreements a smart and experienced lawyer is worth their weight in gold. Provisions contained in shareholders’ agreements can turn a “bad” commercial deal into a “good” negotiated position and a “good” commercial deal into a disaster.
To secure or not to secure
Depending on the type of investor, the type of business and the investor’s motivations in making the investment, some or all of an investment may be made by way of a loan. The default position in such circumstances is to require security to be given by the company over any substantial asset it holds or by the shareholders over their shares.
Start-ups should think very carefully before agreeing to grant security as security dramatically alters both the balance of risk and the balance of control in a business. An investor or shareholder with the benefit of security over all or substantially all of a company’s assets or business is in an extremely strong position to dictate the direction the company takes even if he doesn’t have control of the board of directors or a controlling shareholding.
Where it is agreed that an investor will make all or part of an investment by way of a loan, entrepreneurs should be absolutely clear with their investor up front whether the loan is to be secured. Most (if not all) law firms will advise investors to ask for a security package where a loan is being made. Despite the fact that such a position is often uncommercial and impractical due to the nature of start-ups, it can be very difficult to persuade an investor to proceed against his legal advice on this issue unless it has been discussed and dealt with up front.
The Enterprise Investment Scheme (EIS) is a tax incentive scheme which (subject to certain conditions) enables investors to benefit from a tax rebate against their personal income tax equal to 30 percent of the amount of their investment as well as being able to sell their shares and pocket any capital gain tax free.
EIS carries with it an additional compliance burden on the company and therefore additional costs. While (in my view) it is not worth becoming compliant with EIS in order to attract investors, it is certainly worth structuring a company so that it can become compliant if required by an investor in the future.