As a startup business, you are likely considering various capital-raising opportunities. You can do this through debt or equity. You should carefully consider which method is best for your business, including by looking at how much cash flow your business produces or how much equity you are willing to give up. If you choose to raise money by issuing new shares, you will be bringing on investors to your business. This article will explain what legal documents you need when you bring investors to your business.
Shareholders Agreement
A shareholders agreement is a contract between a company's shareholders that governs their relationship with the company. Its main purpose is to detail processes that should occur in certain situations.
A shareholders agreement is only required when your company is issuing shares. You do not need to put one in place when issuing SAFEs or convertible notes.
Common Shareholder Agreement Provisions
Preemptive Rights
A common clause in a shareholders agreement is a preemptive rights clause. Preemptive rights give existing shareholders the first right to buy shares if a fellow shareholder wants to sell them. They are included in shareholder agreements so that ownership of equity is kept within the control of existing shareholders.
Dissolution/Insolvency
A shareholders agreement will also include a dissolution clause. This clause will outline the process if the company is dissolved or goes insolvent. It might determine how your company should distribute assets or certain processes that you must follow.
Dispute Resolution Clause
A dispute resolution clause is another common clause in a shareholders agreement. This clause may outline a process that involves mediation to help parties resolve a dispute before escalating to court proceedings. Mediation is a dispute resolution process in which a third party facilitates discussion in order to come to a resolution between two disputing parties.
Deed of Accession
If you have a shareholders agreement in place, you might consider preparing a deed of accession for signing by your investors before they receive shares. This document ties your investors to the current shareholders agreement without having to get the shareholders agreement re-signed by all parties.
Your company can either prepare a shareholders agreement or deed of accession if a shareholders agreement is already in place.
Term Sheet
A term sheet is a document that outlines the key commercial terms of an agreement between the company and incoming investors when the company raises capital. It is used to document agreement on the important terms of the transaction. You might have heard it referred to as a heads of agreement.
Common Term Sheet Provisions
Type of Investment
Another important clause to include in your term sheet is what type of investment your investor is making. For example, whether the investment is in consideration for shares or whether it will be a SAFE or convertible note.
Business Valuation
A term sheet will usually include how much the business is worth before the investment, being the "pre-money valuation" if the company is undertaking an equity round (i.e. the issue of new shares).
It can be difficult to value a business when it is in the early stage of its growth cycle. Therefore, companies often use a SAFE or convertible note instrument to get around this issue (given neither needs a pre-money valuation to be agreed).
- SAFEs are an arrangement where investors provide money to a business but only receive equity when a future "priced" equity round occurs. This allows a business to be more accurately valued at that later date, and an investor will receive a number of shares that better reflect its investment amount.
- A convertible note is a hybrid debt and equity instrument. It operates similarly to the SAFE but with an interest-bearing element under which the investment made by the investor accrues interest between the date of investment and the date the investment converts into shares. Accordingly, convertible notes are a more investor-friendly instrument than a SAFE.
Investment Value
A term sheet should also include the quantum of the investment. An investor may invest in instalments or, more commonly, in a lump sum.
Key Takeaways
When you are bringing new investors, you must utilise the correct legal documents to protect your business. An important document to use is a shareholders agreement. This governs the relationship between your shareholders, outlines details of their shareholding and records the rights of each shareholder. Another important document is a term sheet, which includes capital raising details.
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