Investment Agreement vs Shareholders Agreement: What’s the Difference?
By Ching Hei Cheung
An investment agreement and a shareholders agreement are two commonly confused legal documents frequently used by corporations big and small. Distinguishing between the two will enable you to seamlessly integrate new shareholders’ fundraising investment efforts and consolidate ownership rights over your company.
Among the plethora of contracts and agreements available for companies of all sizes and stages of development, Investment Agreements and Shareholders’ Agreements remain two of the most useful contracts as they expedite the process of outlining the proper exercise or refrain of power by shareholders, and, more importantly, define the terms of investment to new partners. While an investment agreement sets forth a contract for individuals wanting to purchase ownership in a company, a shareholders agreement, conversely, outlines a new shareholder’s rights over the company.
In the case of investment agreements, the individual need not be a new shareholder but can be an existing shareholder or outside investor.
An Adherence Clause is one of the most commonly found provisions within investment agreements, which obligates any later transferees of the stock to be subject to the terms of the agreement. It is usual to have a provision requiring any transferee to enter into a deed of adherence which has the effect of treating the new shareholder as if he were an original party to the investment agreement and, therefore, bound by the provisions of the agreement.
There is often a discretion for the board to waive this requirement and an exclusion for those exercising options. By signing a deed of adherence, the new shareholder is bound by the same rules as the existing ones. It also ensures that the new shareholder receives the benefit of the rights given to the other shareholders under the shareholders’ agreement. This necessary provision is only binding on the people who sign it, as opposed to the company’s constitution, which applies to all shareholders by virtue of the Companies Act 2006.
Another unique component of investment agreements, which allow for the part-payment of investment to a business by investors over time is Investment Tranches. With “Tranche” retaining its French meaning for ‘slice’, this strategic mode of venture capital transfer falls under Structured Financing, which simply describes the myriad ways in which businesses can divide potentially risky financial products into loans. If the investor will not make the entire investment in the company at one time, the investment funds may be paid in specified amounts at specified periods of time. These payments are known as tranches.
It is very common in startup companies for investors to commit to capital investment at various company milestones. The tranches are generally tied to product development, revenue targets, or other operational metrics. Over the course of constructing an investment agreement, you may choose to utilise a Preference Shares Investment Agreement template in order to incorporate multiple tranches of completion, thus, giving way for greater investment earnings as the company progresses.
Following an investment tranche, an investment warranty may be made by the company as an explicit representation that statements made by the warrantor are true and accurate on the completion date. The representations and warranties generally list out company conditions that will be examined through due diligence. These may concern the financial position (accounting and tax representations), company assets (ownership and valuation), the ownership structure, the operational characteristics, and the legal situation of the company.
Examples of typical warranties include:
- Business plans;
- Shares of the company;
- Liabilities and contracts;
- Directors and employees;
Warranties work in conjunction with the concept of disclosure whereby the warrantor is liable where the warranty is untrue, except in cases where the problems were previously, expressly drawn to the attention of the purchaser via a “Disclosure Letter”. The following is a list of typical founders’ representations and warranties:
- Conflicting agreements — statement that the founder is not in violation of any confidential relationship, any agreement, or any judgment, decree, or order, and none of these conflict with the founder’s obligations to promote the company’s interests or with the venture capital agreement.
- Litigation — statement that there is no litigation or investigation against the founder.
- Stockholder agreements — statement that there are no agreements relating to the acquisition, disposition, registration, or voting of the company’s securities.
- Prior legal matters — statement that the founder has not been subject to petition under bankruptcy laws or the appointment of a receiver or similar, convicted in or subject to a criminal proceeding, or found by a civil court, the SEC, or the CFTC to have violated any securities, commodities, or unfair trade practices law.
- Company representations and warranties — statement that the company’s representations and warranties are true and complete.
An unique exception available strictly to investment agreements is the component of Investor Rights which can be expedited through the construction of an Investor Rights Agreement negotiated between a venture capitalist and members of a company.
The most common rights usually granted to investors by a company via an Investor Rights Agreement include:
- Liquidity of stock — The Venture Capitalist requires that the stock be registered with the LSE (London Stock Exchange) as part of an initial public offering, allowing the stock to be traded on the stock market.
- Right to receive corporate reports — financial and management reports, other periodic updates from the company
- Participation rights: rights of first refusal and pre-emption rights as per the Companies Act 2006 which provide assurance and protection over the investor’s percentage of ownership of the company.
Among the aforementioned components, which are unique to agreements allowing parties to purchase ownership over a company, investment agreements also include Restrictive Covenants which concern the individuals ability to sell or transfer shares or the restrictions placed on shareholders to the company, as well as Confidentiality Agreements which serve as assurances that the company will keep certain information confidential. You can use this template to securely construct your own NDA contract for investors. You can read more about restrictive covenants and Garden Leave here.
In contrast, a Shareholder Agreement protects the rights of existing shareholders as opposed to new parties wishing to purchase ownership of the company, as described by an investment agreement. Although the specific terms entailed within a shareholder agreement is dependant on the specific interests of the shareholders, typical provisions include:
- Voting provisions — requirement that the shareholder will vote shares in accordance with company restrictions.
- Minority Shareholder Protections — the ability for shareholders to make company proposals.
- Appointment Rights — the rights of the shareholders to appoint or remove specific shareholders.
It is therefore ideal for the company to keep their articles of association in mind when drafting a shareholder agreement in order to keep in force a secure and stringent safeguard on how shareholders should react in cases of unforeseen circumstances which may lead to potential acrimonious legal disputes between parties to the company.
In conjunction to a shareholders agreement, a Shareholders’ Resolution provides information on how to further enforce the actions of shareholders. Shareholder Resolutions are either passed as special or ordinary resolutions. Ordinary resolutions are usually for routine company businesses passed with a simple majority while special resolutions require a 75% majority and usually concern a company’s constitution. The default position is that an ordinary resolution is required unless statute or the articles state otherwise. The Companies Act 2006 provides that a written resolution can be signed by the same majority as a resolution passed at a meeting, which is a simple majority for an ordinary resolution and 75% for a special resolution, whereas under the 1985 Act unanimity was required.
Over the life cycle of each and every company, businesses inevitably enter into numerous ubiquitous agreements to take into fruition a developmental growth concept and further its likelihood of success within the business market. It is indispensable to fully understand which agreements and contracts to use in various negotiations, properly enforcing shareholder rights and, thus, propelling your business into success. With the proper articles, documents, and contract templates, you will be able to evolve your own company into greener pastures with the assurance that each contract is securely drafted to provide the greatest benefit to your company.
This article does not constitute legal advice.
The opinions expressed in the column above represent the author’s own.
Ensure that you are aware of the differences between both contracts and which contract is most appropriate for your business needs through Zegal’s ready-made custom templates supporting seamless and ever-developing client relationships.
Ching Hei Cheung is a first-year law student and aspiring solicitor studying at the University of Bristol. She is involved in a myriad of extra-curricular activities such as debating team where she has obtained first place in a national competition judged by a panel of legal professionals from Baker McKenzie, commercial awareness society and pro-bono society, in order to refine existing skills in public speaking and negotiations, as well as develop a greater understanding of the commercial market that encapsulates the everyday workings of the legal sector.