30 Jan 2023
11 Aug 2020
Raising capital to grow and transform your business is a core part of being a business owner. Capital raising is the process by which a business raises money, enabling it to fund an expansion of its operations. Raising capital is especially crucial for start-ups that tend to burn capital at a rate well beyond the financial capacity of their business owners, making self-funding unfeasible. To raise capital from third parties, however, owners need to negotiate by using capital raising documentation and/or investment agreements.
Here is your guide to the most used capital raising and investment agreement documents that you may need to use while raising capital for your start-up.
Capital raising enables start-ups to hire the people they need, develop new products and services, and conduct sufficient sales and marketing to promote their business. For these reasons start-ups must raise capital as they do not generate enough cash flow for growth expansion and require funding from external sources to support their business.
There are two major ways to acquire financial capital: debt capital and equity capital. Debt capital is generated by borrowing money, while equity capital is generated by selling ownership of the company.
We will be focusing on equity capital and what it entails. Should you need to find debt-related documents, please refer to this Corporate Loan Agreement.
The perk of this capital raising method is the lack of financial burden on the owners as they are not obligated to repay the investor. The investors will instead receive financial returns based on the market performance of the company, usually in the form of the payment of dividends and stock valuation.
However, the major setback is that ownership of the company is diluted, resulting in business decisions being undertaken by other shareholders. As such, owners have less scope to take risks and have lesser say while proposing risk-taking business development initiatives. Due to this, equity capital is generally more expensive than debt capital.
For successful start-ups, there are usually several rounds of findings:
Seed – this involves friends, family, or angel investors
Series A – this involves angel investors or venture capital funds
Series B – this involves venture capital funds or private equity investors
Series C – this involves cornerstone investors or private equity investors looking to cash out on a future Initial Public Offering (IPO)
Funding rounds provide investors with different investment needs with the opportunity to participate in different stages of the growth of the company through equity ownership.
Before raising capital, you will need to establish your company properly. You can refer to our guide for some help: Choosing the Best Structure for your Company.
If you are looking to directly begin raising capital, here are the top 3 documents you might need:
An investment agreement is a contract between founders and investors who are looking to purchase shares of an existing company. The incoming investor can be a new shareholder, an external investor, or an existing shareholder.
The investment agreement outlines the rights and responsibilities of the incoming shareholder(s) and the restrictions on their exercise of power. Terms and conditions are laid out clearly to the new company owners.
As we have discussed, it is crucial for business owners to raise capital through investment from angel investors and investment companies, and venture capitalists. This helps raise more capital, drastically accelerating business growth in turn.
Capital raising can be done through private or public equity transactions. A public capital raising is done for companies that have already achieved Initial Public Offering (IPO) on the stock market. Contrary to public capital raising, there are stricter requirements in place for take-private (public to private, P2P) transactions.
For instance, the certainty of funds must be secured when a firm offer for a public company is announced. The conditions that give rise to its effectiveness and rights to terminate it cannot be unconditional, to comply with the requirements of a take-private investment transaction. The investment agreement must be limited.
Since we are primarily focusing on start-ups, we will proceed under the assumption that investment will occur in a private setting.
If you want a template for an investment agreement, you can find it here: Investment Agreement.
So, what are the elements of an investment agreement? Here are some questions to guide you through the drafting process.
The main term of an investment agreement pertains to the payment of a sum of money to the company’s bank account at a subscription price, by a certain time, on the completion date. Most of the time, the amount of the share capital corresponds to the issuance of shares by the company.
This means that the more money you pay, the more shares you get. The issue of shares will then have to be recorded into a Company Record of Shares Transfer.
The use of an adherence clause ensures that obligations provided in the agreement adhere to future transferees under the investment agreement. In addition, if there is a Shareholders’ Agreement between the shareholders, it will be executed by requiring the new investors or the transferee to enter into a deed of adherence to the shareholders' agreement.
This means that the rights and obligations of shareholders would remain the same after a transfer of shares as if the new shareholder is an original investor bound by the Investment Agreement and/or Shareholders Agreement.
Sometimes, the clauses are incorporated by signing an additional deed, called the Deed of Adherence. No worries if you forgot to include the adherence clause in your Investment Agreement, you can sign the Deed of Adherence instead.
Investment trenches enable investors to pay their financial obligations through part payments. It is a form of “structured financing” which refers to the division of potentially risky financial products into loans. Under the investment agreement, funding can be given in instalments in stages over a period. Hence it is referred to as an investment trench.
After agreeing to a partial payment of investment funding, the important question arises: when should the investor pay the funding that remains? Common practice would be to pay in accordance with business milestones. Frequently used metrics include revenue, number of customers, product development, etc. This method of payment mitigates the risks undertaken by investors and motivates founders to achieve their business goals.
If the investor forgets to pay for the investment funding, you can send a Call Notice to Shareholders to require them to make the payment under the Investment Agreement.
They can do so through an investment warranty. An investment warranty is an explicit representation that statements made are true and accurate. The original owners of the company are required to warrant key information, such as:
The investment warranty serves as an official legal document that can give rise to liability when the information warranted is untrue. This offers security to the incoming investor and increases the likelihood that he/she would be willing to fund the business.
If the company encounters certain business problems, the original owners should notify the incoming investors by using a Risk Disclosure Statement. Even if there are no business problems, the founder(s) may still want to issue a statement to ensure the reliability and profitability of the investment.
Here are some common issues the founders should express clearly to investors:
Litigation – that the current shareholders are not convicted by a criminal court or found by a civil court, or in any litigation proceedings, particularly in violation of securities, commodities, and trade practices laws
Financial status - that the current shareholders are not subject to bankruptcy
Conflicting relationships - that the current shareholders have no confidentiality agreements or orders that prevent them from managing the business
Agreements - that there is no acquisition, deposition registration or voting of securities agreements
Warranties - that all company’s representations and warranties are true and accurate
In an investment agreement, the rights of the investors are usually detailed after negotiations between the founders and the investors to prevent future disputes. These prescribed rights often involve the rights to receive corporate reports, participate, and register as an initial public offering (IPO). Pre-emption rights may also be included; these enable current investors to have priority in purchasing shares before other future investors do.
Through restrictive covenants and/or confidentiality agreements. A restrictive covenant limits the shareholders’ ability to sell or transfer ownership of the company. Confidentiality agreements are also used and incorporated in the investment agreement to ensure corporate information remains private.
A shareholders agreement is an agreement concluded between the shareholders of the company before or at the time of the investment. The agreement defines their respective rights and responsibilities, organises the management of the company and protects the interests of the minority shareholders (usually the investors).
If there is already a shareholders agreement in place, the new investor can be bound by entering into a Deed of Adherence. You can view an example of one here: Shareholders Agreement between 4 Parties.
A Shareholders Agreement stipulates and protects the rights of all shareholders, whereas an investment agreement concerns the investment made by the incoming, new shareholder(s). For instance, an anti-dilution clause can be incorporated to ensure the same proportion of ownership after subsequent capital raise. The shareholders' agreement serves as an outline of the rights of shareholders over the company.
An Investment Agreement mainly governs the rights and obligations of incoming investor(s). It protects the incoming investor(s) from entering a dodgy start-up business and sets out the form of payment by the new investor(s). The investor(s) may choose not to invest in the company (or additional tranches) should the company fail to meet certain requirements. In its most basic sense, it is a contract between company owners and the investor(s) who want to purchase ownership of the company.
Despite their differences, both agreements serve as important documents for capital raising. They define the terms of the investment and set boundaries for the exercise and refrainment of power over the company.
With the Shareholders Agreement and the Investment Agreement in force, the capital raising process can be conducted seamlessly and in line with legal requirements. Together, they prevent disputes between shareholders as everything is written in black-and-white. Due to their similarity in this aspect, in some cases, the shareholders’ agreement and the investment agreement are combined into one document.
When drafting your Shareholders Agreement, you might want to consider the following questions:
How much of the company does each shareholder own?
How much does each shareholder have to pay to get his/her share?
What are the rights of each shareholder under the corporate structure?
Is there any protection for minority shareholders?
Are there any restrictions to prevent shareholders from competing against the company?
Are there any dividend policies?
How should the shareholders exit or terminate their interests in the company?
Do shareholders have the right to abandon or acquire shares?
Do Shareholders have the right to buy additional shares before a third party does?
What are the Accounting Policies in the Company?
What if the Shareholders come across a Deadlock Resolution or Dispute?
To know more about Shareholders Agreements, you can check out our blog post on the matter: What is and How to Prepare a Shareholders Agreement? (Free Templates).
Another way for investors to participate in the equity capital of the company is by buying shares from existing shareholders.
The main difference between this and investment in the company is that it is capital raising for the selling shareholders rather than the company. The existing shareholders would cash out but the company would not be getting the much-needed capital for expansion.
It is also possible for the selling shareholder to put some of the money back into the company or for the new investor(s) to inject more capital into the company after acquiring control.
A Sale and Purchase (S&P) Agreement is a legally binding contract between a buyer and a seller regarding a transaction. Here we are specifically referring to a Shares Sale and Purchase Agreement which governs the transfer of shares to a new investor at an agreed price. You can refer to our sample template here: Sale and Purchase Agreement regarding the Sale of Shares.
The seller shareholder may choose to sell all or part of his/her shares, albeit this is limited to the shares he/she owns. A shareholder cannot sell more than what he/she owns, i.e. the shares of other shareholders.
Under a Share Sale and Purchase Agreement, the company does not need to issue new shares to shareholders. This form of capital raising is therefore especially popular for:
Founders, who do not want to sell or dilute their current ownership of the company
Current investors, who would like to cash out their investments immediately by selling shares
After transferring shares, you should send a Company Record of Shares Transfer to the registration body in your country. Remember to do so, as if it is not sent, the validity of the investment may be hampered.
Share sale and purchase agreements are used when an existing shareholder wants to sell his/her ownership of the company to another party. On the contrary, share subscription agreements are used when a company issues initial shares to shareholders.
A share sale and purchase agreement may echo the adherence clause incorporated in the Investment Agreement. If an adherence clause is in force, obligations provided in the Investment Agreement would be attached to future transferees. To do so, the transferees are commonly required to enter into a Deed of Adherence with all other company owners.
An investment agreement is a contract defining the terms of investment in which a single investor invests in a company owned by managers/founders. The agreement is drafted in neutral form.
An investment agreement where a syndicate of private equity investors make loans and invest in a company. The form is drafted in neutral form with the appointment of a manager by the investor.
A Two-Party Shareholders Agreement to be entered into upon completion or establishment of the Joint Venture Company with standard clauses for minority protection. This agreement is drafted in neutral form.
A sale and purchase (S&P) agreement between a Buyer and a Seller with no warranties. This is suitable for the sale/transfer of shares. This agreement is drafted in favour of the Seller.
A sale and purchase (S&P) agreement between a Buyer and a Seller with no warranties. This is suitable for the sale/transfer of shares. This agreement is drafted in favour of the Buyer.
Please note that this is just a general summary on Capital Raising and Investment Agreements for Startups under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may want to speak to your local legal advisor.
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