If you are not familiar with some of the terms used in this resource, we recommend taking a look at our Understanding growth capital term sheets resource.

Once a term sheet is agreed and during the course of due diligence, investors will provide a first draft of the proposed shareholders agreement.

Part of the scope for your appointed law firm will be to review the proposed shareholders agreement and ensure that it reflects the terms agreed in the term sheet.

What is the shareholders agreement?

Also known as the subscription agreement or the investment agreement, the shareholders agreement sets out the commercial and legal terms of the round, including how the company and its investors will interact.

Unlike the articles of association, the shareholders agreement is not a constitutional document and therefore does not have to be made public. It may contain information and terms that you consider to be commercially sensitive and prefer to keep confidential.

Parties to the agreement will be:

• The company
• The new investors
• Key members of the management team, which may include key directors, employee-shareholders and the warrantors
• Newly appointed Non Executive Directors, that are joining the Board as part of the transaction.

Terms that are included in the shareholders agreement

• Sums invested
• Classes of share
• Commercial terms attached to classes of share
• Warranties
• Information rights
• Investor consents
• Restrictive covenants
• Option scheme
• Fees

Negotiation of the shareholders agreement

It is typical for several drafts of the shareholders agreement to pass between both sets of lawyers before the final draft is agreed. We recommend staying close to this process so that you are aware of any points of a commercial nature and can provide your position. The term sheet is used as a guide, but remember that it is not legally binding and therefore it is possible to propose changes.

In negotiating any equity investment, it is important not to lose sight of the fact that you are entering into a long term partnership with the new investor, and not selling the business, for example. As a result, alignment is important and protracted negotiation on minor points may be damaging and could impact the likelihood of completion or a successful partnership.

Points to be aware of

Here are a number of key points that are often discussed specifically during negotiation of the shareholders agreement:

Warranties and warranty liability caps

The company and certain members of the management team will be required to provide warranties. The list of warranties is included within the Shareholders Agreement. It may be that additional warranties are added by the investor through the course of due diligence – particularly if any concerns are raised. It is important to understand what each of the warranties means and if there are any that you are not prepared to give, then ask your lawyer to propose a caveat, carve out, or to disclose certain information against those specific warranties in the disclosure letter.

Warranty liability caps set out the maximum amount of money the company or individual is liable to pay in the event that the investor makes a claim under the warranties.

Where this cap is set depends on the investor and each individual warrantor, but they are often a subject of discussion as certain members of management may feel uncomfortable about their liability.
There are a few guiding principles that investors use when proposing liability caps:

• The cap should be sufficiently high to encourage the individual to consider the warranties carefully and make the appropriate disclosures
• It should take into account the shareholding that the individual holds and if they are receiving any cash out as part of the transaction. If they hold no, or a very small proportion of the equity and they are not selling any of their shares as part of the transaction, then their liability cap may be lower, or even nil.
• The company’s liability cap is ordinarily linked to the total size of the investment.

Investor consents

The shareholders agreement will set out any investor consent items, i.e. actions or matters for which investor consent must be sought.

This is necessary for minority investors who do not hold a controlling equity stake and therefore cannot exert this influence through their shareholding alone.

They require the ability to veto certain decisions in case they are excluded from them.

It is important to note that consent items are often those of key strategic importance to the company and its growth. The list is not intended to be an indication of the items that the investor wishes to veto, but instead the decisions that the investor would not want to be excluded from. They may be used as a guide as to decisions that should be discussed at board meetings.

The consents will likely include certain thresholds that should be set accordingly for your business.

Completion of the shareholders agreement

Once all terms are agreed, the shareholders agreement is signed by the relevant parties and dated on completion of the transaction, and from then on becomes legally binding on the parties to it.

Why do some companies have two shareholders agreements?

It is common practice in the US, and occasionally in the UK, for companies that undergo multiple successive funding rounds to have two agreements: a shareholders agreement and a subscription agreement.

The two documents essentially split the shareholders agreement in two – the shareholders agreement acts as an umbrella agreement while each subscription agreement governs a particular round.

This is designed to avoid the need to negotiate and draft an entirely new shareholders agreement each time a fundraise is undertaken.

The shareholders agreement contains the investor rights, such as information rights, warranties, investor consents and restrictive covenants.

The subscription agreement contains only the specific terms and mechanics of that particular round.
This approach can work well provided that the umbrella shareholders agreement is sufficiently sophisticated such that investors in subsequent rounds are happy to agree to their terms without significant amendments.

It is not uncommon for growth capital investments to comprise a loan note or similar debt-like instrument alongside equity.

In the instance that a loan note forms part of the investment, then a Loan Note Agreement will be entered into on completion.

This agreement sets out the terms of the loan note, specifically:

• Principal sum
• Interest rate
• Whether interest is rolled or paid in cash, and at what intervals if so
• Any security
• Repayment dates
• Early redemption and any associated penalties
• Events of default
• Default interest
• Additional drawdowns, if the debt is tranched
• Conversion terms, if the debt can be converted into equity upon certain triggers, for example, an exit event
• Redemption premium, if applicable

A first draft of the loan note agreement will be prepared by the investor’s legal counsel, and it will be part of your legal counsel’s scope to review and comment.

Terms to be aware of

The ability for the company to repay the loan note prior to maturity may be important, particularly if the interest rate is high or the interest is rolled up. Investors that have invested through a mix of equity and loan notes may not be comfortable with repayment of the loan notes too early in the investment cycle. It is advisable to check the process and consents involved, and if any penalties apply.

The events of default may be broader and more commercial in nature than those typically seen in banking documentation.

A redemption premium may be applied to the principal sum on repayment of the loan. This redemption premium could be payable in full even if the loan is repaid early - in which case, the cost of capital for the company would increase.

If you are not familiar with some of the terms used in this resource, we recommend taking a look at our Understanding growth capital term sheets resource.

Once a term sheet is agreed and during the course of due diligence, investors will provide a first draft of the proposed new articles of association.

Part of the scope for your appointed law firm will be to review the proposed articles of association and ensure that they reflect the terms agreed in the term sheet.

What are the articles of association?

The articles of association set out the rights of all shareholders and govern how the company, the board and the shareholders will interact.

All companies must have articles of association and most adopt the model articles upon incorporation. Unlike other transaction documentation, such as the shareholders agreement, the articles are a public document and therefore anyone can access and read the terms. As a result, investors may sometimes be sensitive to agreeing to significant deviations from their standard documentation, as other potential investee companies may read these documents and request the same.

Particularly commercially sensitive clauses are usually included within the shareholders agreement which is confidential, wherever possible.

The clauses of the articles are binding on the company and on all shareholders.

Key terms that appear in the articles of association

• Classes of share
• Consent rights
• Leaver provisions
• Drag along
• Tag along
• Transfer rights
• Pre-emption rights
• Liquidation or a return of capital
• Voting rights, including majority voting matters
• Dividends
• Board seats

Negotiation of the articles

It is typical for several drafts of the articles of association to pass between the lawyers before the final draft is agreed. We recommend staying close to this process so that you are aware of any points of a commercial nature and can provide your position. The term sheet is used as a guide, but remember that it is not legally binding and therefore it is possible to propose changes.

In negotiating any equity investment, it is important not to lose sight of the fact that you are entering into a long term partnership with the new investor, and not selling the business, for example. As a result, alignment is important and protracted negotiation on minor points may be damaging and could impact the likelihood of completion or a successful partnership.

Points to be aware of

Here are a number of key points that are often discussed specifically during negotiation of the articles:

Leaver provisions

The articles will define what happens to an employee’s shares if they leave the business. Ordinarily, a good leaver and a bad leaver is defined, for example:

• Good leaver: an employee who leaves due to illness, incapacity or death
• Bad leaver: an employee voluntarily resigns or is summarily dismissed

It may be that the Board can opt to treat a bad leaver as a good leaver, but this decision may also require investor consent.

Treatment may then be applied to the good or bad leaver’s shares, for example:

• In the case of a good leaver, X% of their shares may be subject to repurchase [by the company] at [market price]
• In the case of a bad leaver, X% of their shares may be subject to repurchase [by the company] at [cost].

There is no definitive right or wrong way to set these provisions. The rationale for their inclusion is typically as follows:

• Discourage key shareholder-employees, such as founders, from leaving the business
• Acquire a portion of leavers’ shares that can be used to incentivise a replacement
• Enable leavers to retain a portion of their shares.

Transfer rights

The ability of shareholders to transfer shares will be subject to limits. This is to provide investors with certainty around who they are invested alongside.

Ordinarily, a portion of shares may be transferred to certain people, for example, privileged relations. If you would like to transfer a significant portion of your shareholding, it is worth having this conversation with the investor prior to completion of the transaction.

Dividends

The articles may set out specific dividend rights attaching to certain class of share, for example, the investors may be entitled to a dividend that other shareholders are not. The articles also set out how dividends are declared, paid and divided.

It may be that the company can continue to pay dividends as it pleases, provided that it has sufficient distributable reserves, or it may be that restrictions are put in place, such as investor consent.
These protections are to ensure that the newly invested cash is not distributed as a dividend and is used to fund the growth of the company.

Priority return on exit

The articles may set out preferential rights attaching to the investor’s class of share that entitle them to proceeds in a sale before other classes of share participate.

It may be helpful to ask the investor to provide an example “waterfall”, which sets out the proceeds to each shareholder in the event of different exit prices. This will help clarify the exact nature of their preferential rights, for example, at what value they impact other shareholders.

Voting rights

The voting rights of members of the Board and shareholders are important to understand and it is worth asking your lawyer to set out exactly how these work.

Certain key decisions may be taken by the board, but may also be caveated and require investor consent. There may also be certain decisions that can be taken by a certain portion of the shareholders. This could result in smaller shareholders being excluded from certain decisions. This can be necessary to ensure the business can make key strategic decisions, such as a sale or fundraise.

Adoption of the articles

The articles will be adopted by the company on completion of the transaction via a shareholder resolution.