Investment Agreement Contract Explained
Investment agreements or investment agreement contracts, as they are also known, are agreements between two or more parties where at least one of the parties promises to be a financing source for the other(s). In many cases, one party agrees to make a loan and retains an ownership interest in the form of an equity percentage in the business or entity to which it has supplied the loan or funding. As a loan, the investing party also receives loan payment guarantees and/or the right to payment of interest on the money it has invested.
Investment agreement contracts may be unilateral or bilateral, though most are bilateral; therefore, the person or entity that is loaning the capital will usually be putting up the majority of the terms of the contract. In a typical investment agreement, the terms of the contract will touch on maximum amounts for loans, warranties about the financial health of the entity borrowing the capital, the required equity share required by the loaner, provisions for collateral and late payment, as well as a few other contingencies . Investment agreements can be made for almost any type of entity needs a loan, be it a corporation, LLC, partnership, sole proprietorship, even large government agencies.
Typically, investment agreement contracts are made between corporations, start-up companies and banks or investment firms. Unlike traditional loans, many investment agreements allow investors to buy into a corporation for a percentage of ownership in lieu of a repayment of funds, should the corporation go under. The wording of such agreements is extremely important because if a lawyer does not carefully craft the wording of the agreement, an investor could end up with a shareholder status when it was never intended by the other party. While this has not historically been a common occurrence, there are always atypical cases that can be problematic and costly to resolve.
Key Elements of an Investment Agreement Contract
A business investment can be broken down formally into a legal contract. Such a contract is known as an investment agreement, and should cover several key components:
Parties to the Contract
This is the section that tells you who the contract is between. The parties to the contract are often an investor and a company or individual looking for money. When entering into an investment agreement you should make sure to have both parties’ names, addresses and any other relevant information to hand so that the contract can be drawn up properly.
Details of Investment
The contract will also need to give precise details of the investment being made. This includes the amount of the investment, how this will be paid (a lump sum or in installments), when it will be made (immediate, quarterly, annually) and any conditions on the investment (the individual or company receiving the investment will only receive it upon meeting certain performance conditions). It may also be a good idea to include details of ownership rights if the investment is going to buy shares in the company.
Rights and Obligations
The contract needs to cover the rights of both parties and any obligations they have to each other. An investment agreement is essentially a contract and all contracts are legally binding, providing they are agreed by both parties with no coercion or misrepresentation. You can be taken to court if either party breaks the contract (this is the ‘legally binding’ part of a contract). This section of the investment agreement will ensure that all rights and obligations are clearly stated so that if one party breaks the contract the other can sue.
Termination Conditions
Investment agreements should also state what the conditions are for terminating the contract. Again, this is just to ensure that everything is written down and mutually agreed and is not often a point of discussion, but is good to have on hand for reference.
Although these are the main components of an investment agreement contract, not all contracts will have them all, depending on the specifics of the investment.
Types of Investment Agreement Contracts
Types of investment contract
Investment agreements come in many different forms, but we shall focus on the following: Joint ventures. This term can refer to various forms of collaborative relationships between two or more companies, such as a simple partnership or a separate entity in wrap-up or consortium type transactions. The key aspect of a joint venture is that the companies combine resources to achieve their common goals. This means that they are jointly responsible for the management of the business and share profits and losses, but also that they will need to negotiate a joint venture agreement which comprehensively deals with all aspects of the relationship. Failing to deal with key factors at the outset can result in significant adverse consequences later down the line. Venture capital agreements. These are specifically designed to support the provision of debt and/or equity finance for relatively large amounts of the seed, startup and growth stages of early-stage businesses. They have a similar purpose to private equity agreements and are usually based on a higher level of expertise on the part of the investor and greater due diligence and active involvement in progressing the business in which they have invested. Shareholder agreements. Companies incorporated in the UK generally have a memorandum and articles of association which set out the principal items of information regarding the company, but shareholder agreements are often preferable to amend or supplement the rights and obligations available to shareholders. This is especially the case as the company structure scales up, where there are multiple classes of shareholders (including employee shareholders) which require further regulation. Equity incentive schemes. This type of scheme typically involves the granting of share or share-based options to employees. The aim is to provide a financial reward, linked to the company’s profitability, to its employees. Further, some equity incentive schemes allow for a plan in a tax-advantaged form, such as the Enterprise Management Incentive (EMI) Option Scheme and Company Share Option Plans (CSOP). This will limit the amount of tax to be paid by employees who exercise their options.
Legal Aspects and Implications of Investment Agreements
When drafting an investment agreement legal considerations are key to ensure the protection of the investor’s rights and interests. Some of the considerations to take into account are as follows: Compliance with local and international laws: the investment should be structured in line with relevant local, state or federal regulations. It is also important to take into consideration international regulations that may affect the investments. Dispute resolution: depending on the type of investments made, investors may want to be protected against any dispute that may arise in relation to the investment. Arbitration and mediation clauses are often requested by investors, which may protect them against costly litigation. Confidentiality: NDA clauses (non-disclosure agreements) may be included in cases where the investor wants to keep certain aspects of the investment confidential, such as amounts invested, percentages of stake, etc. Such clauses are relevant to protect sensitive information that may not want to be disclosed to a wider public.
Negotiating the Terms of an Investment Agreement Contract
Negotiating Investment Terms is a critical part of the transaction, and this section must not be glossed over. Like all others sections in the investment agreement, anything in the investment agreement is up for negotiation. But, the provisions that need to be negotiated the most include:
In negotiating these provisions, being flexible is key. Try to figure out exactly what the investors are trying to achieve, when possible. Then create a solution that meets the needs of both sides. This way, you may be able to make it easier on yourself and your business. If you stand firm on a term, explain it. Maybe the term can stay, but with a twist. Or with some other condition that can fix the term in a way that’s less hurtful to those in the business.
I believe that without communication , none of this is possible. Don’t just agree to point behind your back. Just because everyone else is going along with something doesn’t mean you should too. If you don’t understand something, ask questions. Someone should be happy to explain it to you. And if not, perhaps there’s a reason they don’t want you to understand something.
Be wary of the ask. At times, we can get into a pattern of being told of needs without any explanation. Kind of like children who make demands of their parents without any explanation. They say "I want it that way" and you get stuck in a rut of acquiescing. Instead, try asking why a term is such a big deal to your investors. Understanding exactly what they are concerned about could help you to see the issue differently. The goal is to find a way to meet their needs, without unduly complicating your transaction or pushing away the investors. It may take time, but it’ll be worth it to both you and the investors.
Common Mistakes to Avoid
Common pitfalls to avoid when entering into investment agreement contracts include:
Not clearly drafting investment agreement contracts
This is one of the most common mistakes made by parties – failing to clearly draft investment agreement contracts. If the investment agreement contract is vague, open-ended or unclear, it can be easily misinterpreted by one party to the agreement resulting in expansive liability and damages.
Protection is lost where the investment agreement contract is not properly drafted. Therefore an investment agreement contract should be clearly and concisely drafted according to the law. This will ensure that the parties’ legal position is protected. The key is for investment agreement contracts to be simple and unambiguous.
Inadequate research on the subject matter
A common mistake made by parties is not taking the time to investigate the issues and doing enough homework before drafting investment agreement contracts. Failing to understand the laws and issues is a major problem. Parties have to take the time to do research on the laws applicable to the transaction and all the issues before entering into investment agreement contracts.
Relying on verbal statements or promises
It is very common for parties to rely on verbal statements or promises made in the absence of a written investment agreement contract, but this is a mistake which can be quite costly. Verbal and oral agreements may well not be legally enforceable. Therefore it is important to follow the formal requirements and ensure investment agreement contracts are written, signed, dated and witnessed.
Lack of clarity regarding conditions precedent
Parties sometimes enter into investment agreement contracts without providing or stipulating what is required for the agreement to come into force. Usually specific conditions need to be fulfilled, such as obtaining approval from the Reserve Bank of South Africa, which can take some time. It is important to state whether the contract comes into force immediately or subject to certain conditions being fulfilled.
Not consulting attorneys
Finally, another very common mistake made all too often is parties entering into investment agreement contracts without consulting their attorneys. Guests at a conference I addressed recently indicated that they sometimes spend millions on deals without consulting a legal advisor. This is sheer lunacy! And could prove so costly that it is difficult to comprehend.
At the very least parties should consult attorneys experienced in investment agreement contracts when entering into an agreement. This will ensure that they are properly advised on the laws relating to investment agreement contracts, the elements of the agreement and the conditions.
The Importance of a Lawyer in Investment Deals
One of the key players involved in the corporate investment agreement is the corporate attorney. A good corporate lawyer will assist in preparing, reviewing and negotiating all investment documents, ensuring that the agreement meets the standard of fairness and equity before all parties involved in the agreement and is favorable to the company receiving the investment. Without the expertise of a corporate lawyer, a company seeking investments can sometimes be taken advantage of by investors, especially if an unscrupulous investor takes the lead in negotiating the terms of the contract and drafting the document. Although it has not always been necessary, it is quickly becoming more prudent for a company to involve an intellectual property lawyer when evenly dividing assets and shares, as assets may often include valuable intellectual property. For example, an investor may be frustrated when a particular technology cannot be fully utilized or marketed in certain ways, thereby reducing the worth of the company. Although the investor may have agreed to the terms of the contract, the company still may end up in a lawsuit, which can be avoided by using an intellectual property lawyer who can catch such particularities in advance.
Examples and Case Studies in Investment Agreements
Presenting a few real-life examples or case studies can help readers understand how investment agreement contracts function in practical situations.
For instance, consider case study one. Company A, looking for a new investor, agrees to pay back Company B’s loan of $60,000 along with an interest rate of 10% over five years. In addition to this, A will allow B to convert from a creditor to an equity holder through their agreement to purchase 6% of the company’s stock when the stock becomes public. Although this arrangement is mutually beneficial to the two companies, it can be detrimental to Company A if it cannot pay back the loan. If it fails to make payment, it will end up losing a chunk of its equity.
In this next example, Company C is searching for a new investor, too. Like Company A, it offers to pay back Company D’s $60,000 loan at a 10% interest over five years. But Company D also wants to take equity inside Company C, but it asks for 12% of the company’s shares. In contrast to the first example, Company C’s offer is not likely to entice Company D to agree to the investment since it will be giving away more in equity than it could get back in the form of repayment.
Of course , there are many other factors to consider when agreeing to an investment. Some investors may request a preferred return of 10%, others may ask for 20%. It all depends on how much equity a company can afford to give away while maintaining its business.
In this case, Company E needs a new investor. It agrees to pay in dividend form a preferred return of 8%. Investing in Company E may seem like a good fit for a potential investor. They would receive their return in dividends, not stock in the company. This makes sense since Company E has no desire to dilute its equity. Investors who want stock would be better off investing in Company A or C.
Company F, however, is probably not cut out for an investor. The company cannot afford to pay back Company B’s $60,000 loan at 10% over five years. It is also not interested in giving equity away to investors. Seeking out an investor might be good for Company F, aside from the fact that the business cannot pay back a loan or provide shares.
All investment agreement contracts are different. Equity holders are, of course, willing to accept more risk with their investment, so it’s important to consider an entire portfolio of options.