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.
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:
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.
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:
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.
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.
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:
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.
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.
Alongside the adoption of the revised articles of association and signing of the shareholders agreement, there are a number of other documents required to complete the seed round. Drafting of these documents should form part of the scope of works for your legal advisors.
A share certificate will be produced for each seed investor, setting out the number of shares they hold, the class of share (most likely ordinary shares for a seed round) and the nominal price per share (often a penny or a pound).
Each share certificate is signed by director of the company and witnessed.
A board minute will be prepared that will approve:
The board minute should also:
The board minute is signed by the Chairman of the board.
This ordinarily takes the form of one document with two resolutions:
The document is signed by the existing shareholders of the company.
If no warranties have been provided, then a disclosure letter is not required.
If warranties have been provided, then the warrantors and the company may wish to provide a disclosure letter, which sets out information relevant to the warranties.
For example, the founder (if one of the warrantors) may have provided a warranty that there is no outstanding litigation with any former employees. If there is any outstanding litigation, then this would be disclosed in the disclosure letter and referenced to that particular warranty. This ensures that the seed investors are aware of these issues and provides legal protection to the warrantor, as the investors would not be able to make a claim against the warrantor for breach of warranty in relation to that particular litigation. If the outstanding employee case was not disclosed and were to come to light after the transaction, then the seed investors may be able to claim for breach of warranty.
The disclosure letter is signed by the warrantors and the seed investors, to confirm receipt.
If there are any documents that are defined or referred to in the shareholders agreement, in particular, those referred to in the warranties, then these must be provided at completion, for example, a copy of the business plan, the investor presentation, the management accounts or any due diligence reports.
Alongside the adoption of the revised articles of association, signing of the shareholders agreement, there are a number of other documents and actions required to complete the round. Drafting of these documents will normally form part of the scope of works for the law firm representing the investor, who is also taking the lead on the investment documentation. It may be part of your law firm’s scope to review these documents and actions.
A share certificate will be produced for each investor in the round, setting out the number of shares they hold, the class of share and the nominal price per share (often a penny or a pound).
Each share certificate is signed by director of the company and witnessed.
A board minute will be prepared that will approve:
The board minute should also:
The board minute is signed by the Chairman of the board.
This ordinarily takes the form of one document with two resolutions:
The document is signed by the existing shareholders of the company.
A disclosure letter is usually drafted in response to certain individuals and the company agreeing to provide warranties.
The letter sets out any information that relates to the warranties.
For example, the CEO may have provided a warranty that there is no outstanding litigation with any former employees. If there is any outstanding litigation, then this would be disclosed in the disclosure letter and referenced to that particular warranty. This ensures that the new investors are aware of these matters and provides legal protection to the warrantor, as the investors would not be able to make a claim against the warrantor for breach of warranty in relation to that particular litigation. If the outstanding employee case was not disclosed and were to come to light after the transaction, then the new investors may be able to claim for breach of warranty.
The disclosure letter is signed by the warrantors and the new investor(s), to confirm receipt.
Any documents that are defined or referred to in the shareholders agreement, in particular, those referred to in the warranties, must be provided at completion, for example, a copy of the business plan, the investor presentation, the management accounts or any due diligence reports.
The investor’s legal counsel will carry out a number of specific pre-completion searches:
Make sure that you obtain power of attorney for any key individuals that are unable to attend the completion meeting and are unable to sign remotely. It is surprising how often completions are held up by availability.
If the company has restructured as part of the investment, ensure that a bank account has been set up for the entity that will receive the proceeds. It can take time to put a bank account in place and this can delay completion.
Following a successful presentation and early due diligence, an offer from a venture investor will come in the form of a term sheet (sometimes called a “heads of terms”).
A term sheet sets out the principal terms that will form the basis of the final transaction documentation, in particular, the articles of association and the shareholders agreement, that will be entered into on completion of the transaction. The term sheet is not intended to be legally binding (with the exception of the confidentiality clause) and serves to act as a guide.
While specific terms can be negotiated at the point of drafting the final investment documentation, the purpose of the term sheet is to ascertain alignment on the deal proposed, so this is the time to raise and discuss any proposed amendments.
In this section we summarise the terms you may come across in a venture term sheet, and what they mean.
Valuation
This will usually be presented as a certain amount invested for a certain equity percentage. From this, you can calculate the valuation that the investor has applied to the business (the post money equity value, pre money equity value and enterprise value).
For example, an investment of £2,000,000 for newly issued shares representing 25% of the business.
The value of the business is then:
Arrangement fee
Some funds charge an arrangement fee that becomes due when the deal completes and is usually based on a percentage of total funds raised. Fees vary significantly between funds – they are relatively uncommon among venture capital firms but more typical of later stage funds, such as growth capital or private equity funds. The transaction fee usually serves the purpose of covering the cost of the process for your investor and is also one of theirs sources of income. Some investors also charge an ongoing monitoring fee.
Ranking of Shares
The term sheet will set out how the newly issued shares will rank relative to the existing shares in issuance.
Institutional investors and funds will almost always seek a new class of share to be issued alongside the existing ordinary shares held by the founders and early seed investors.
This is so that specific rights can be attached to this new class of share – these rights may be economic and/or legal in scope.
Note that one of the eligibility criteria for a round to be EIS eligible is that newly issued shares are full-risk ordinary shares that are not redeemable or carry any preferential rights to the company’s assets on a winding up. This may impact the extent of rights attached to the new class of share.
Priority return or liquidation preference
Investors may ask that their investment is returned to them before the remaining proceeds are split pro-rata between the ordinary shareholders. A multiplier may be applied to this right, for example, a 2x liquidation preference means that the investor is entitled to twice their investment before remaining proceeds are divided up. The exit valuation at which this will apply may vary – it may only be relevant if you sell your business below a certain value, and hence is there to provide the investor with protection if things don't go to plan.
Liquidation preferences of 1.0x are relatively common. Up to 2.0x are occasional and above 2.0x are relatively rare.
The commercial terms of a deal need to be considered as a whole and not viewed in isolation, so consider this alongside the implied valuation, dilution and any other economic terms within the term sheet.
Some companies agree to higher liquidation preferences in return for giving away a lower equity stake in the business.
Participation
Investors that hold preferred shares may also ask for a portion of the proceeds owed to ordinary shareholders in the event of a sale, called “participating preferred shares”. There may be a cap applied to this participation, for example, the investor may receive a portion of the proceeds until they have received 2x their initial investment, and after that all proceeds will be divided among the remaining ordinary shareholders and the investor will not participate any further.
Dividend policy
Investors may request the right to participate in any dividends distributed to ordinary shareholders. In certain circumstances, they may also seek some form of preferred dividend, paid before any dividends to ordinary shareholders, provided that the company has sufficient reserves. They may also have the ability to veto any dividend policy.
Drag Along
A drag along right entitles a certain proportion of the shareholders (usually the majority) to force smaller shareholders into a sale of the company to a third party purchaser. This can be necessary to prevent smaller shareholders from refusing to sell their shares and preventing an exit event. Drag along rights are very common in venture term sheets as investors need to be confident of securing an eventual exit.
Tag Along
A tag along right entitles shareholders to participate if an offer is made for a majority of the issued shares, on the same terms as those offered to the majority shareholder(s).
Pay to Play
This clause requires that all investors contribute a certain amount to any future fundraising, and if they don’t they may lose certain rights, for example, be forced to convert their preferred shares into ordinary shares and thus lose their preferred rights. If you are raising money from multiple investors, those investors that are not well placed to provide further funding down the line may be put off by this clause as they may be faced with an inevitable loss of rights.
Information Rights
Investors may require certain information to be made available to them on a monthly, quarterly or annual basis, which could include:
Non Executive Director or Investor Director
Institutional investors may require the right to appoint a Non Executive Director to the Board – this may be an individual from their own firm or an individual they introduce from their network, or both. They may also have the right to make this person the Chairman.
If a number of funds are participating, this right is usually reserved for the lead investor to prevent the board becoming too crowded.
Warranties
The directors, founders and/or the Company will be required to provide warranties to the new investors. Warranties will vary in scope depending on the investor, from warranting the accuracy of the current share capital, to the reasonableness of assumptions underpinning the business plan, the status of the Company’s trading and any outstanding liabilities or litigation.
If you agree the term sheet and progress through due diligence to completion, you will produce a disclosure letter which can be used to disclose any relevant information against these warranties and protect yourself and the company from a claim being made in respect of those specific items. For example, you may be required to warrant that there are no current employment cases against the company – if there were to be one, this would be described in the disclosure letter.
Option Scheme
If you intend to put in place an option scheme, for example an EMI scheme, as part of the transaction or shortly thereafter, then this should be explicitly mentioned in the term sheet and should set out the maximum percentage of the issued share capital that the option scheme will represent.
Investors will take dilution from options into account when calculating their anticipated return. They may seek a higher equity percentage to compensate for a large option pool.
Up to 10% of equity is relatively common for an option pool to be allocated to key members of the team.
Transfer of Shares
These set out the rights of each shareholder to transfer their shares to another individual or entity. It is common to have in place permitted transfers, which allow shareholders to transfer all or a portion of their shareholdings to immediate family or family trusts. Otherwise, it may be drafted that any shares intended to be transferred are to be offered first to the existing shareholders pro-rata to their shareholding.
Investor Consents
Investor consents are often required by minority investors to provide them some protection and control over key decisions made by the directors, the company and/or the majority shareholders.
Investor consents usually require that a certain proportion of shareholders consent to a particular list of actions. Where this percentage is set depends on your current shareholder structure. If, say, following the fundraise two employee shareholders will hold 80% of the shares and the new investors will hold 20%, then there is no point in setting the threshold at 75% as this affords no protection to the new investors – the existing shareholders could vote together and ignore their consent. In this instance, the threshold may be set at 85%, say.
The list of consents usually comprises significant decisions, such as a winding up or sale of the company, issuance of new equity, significant capital expenditure, key hires or the disposal of assets.
Pre-emption
Pre-emption rights allow shareholders to participate in future share issuances or fundraises if they wish to, and thus reduce or prevent their equity shareholding from being diluted.
Leaver provisions
Leaver provisions set out what happens to the shares held by directors or employees that leave the company. They will usually define a “good leaver” and a “bad leaver”, for example, a bad leaver may be someone who is dismissed or who resigns, and a good leaver may be someone who becomes incapacitated through illness or dies. All of, or a portion of, their shares may be subject to repurchase by the company and any remaining shares are likely to lose their voting rights (be “disenfranchised”).
The purpose of leaver provisions is to discourage individuals from leaving, to ensure that those individuals that are no longer involved in the company are not able to vote on key decisions and that equity is returned to the company to incentivise a replacement, if necessary.
Swamping rights
Minority investors may define certain circumstances in which they will have the ability to take voting control, i.e. will hold 51% or more of the voting rights in the company. These rights may be invoked for any reason or could have specified triggers, for example, the company underperforming, a key director leaving the business or a breach of banking covenants.
Following a positive initial meeting, follow up queries and discussions on commercial terms, an offer from an investor will come in the form of a term sheet (sometimes called a “heads of terms”).
A term sheet sets out the principal terms that will form the basis of the final transaction documentation, in particular, the articles of association and the shareholders agreement, that will be entered into on completion of the transaction. The term sheet is not intended to be legally binding (with the exception of the confidentiality clause) and serves to act as a guide.
While specific terms can be negotiated at the point of drafting the final investment documentation, the purpose of the term sheet is to ascertain alignment on the deal proposed, so this is the time to raise and discuss any proposed amendments.
In this section we summarise the terms you may come across in a growth capital term sheet, and what they mean.
Valuation
This will usually be presented as a certain amount invested for a certain equity percentage. From this, you can calculate the valuation that the investor has applied to the business (the post money equity value, pre money equity value and enterprise value).
For example, an investment of £5,000,000 for newly issued shares representing 20% of the business.
The value of the business is then:
Arrangement fee
Some funds charge an arrangement fee that becomes due when the deal completes and is usually based on a percentage of total funds raised. The transaction fee usually serves the purpose of covering the cost of the process for your investor and is also one of theirs sources of income. Some investors also charge an ongoing monitoring fee to help cover the cost of their Non Executive, portfolio reporting requirements and portfolio company events.
Ranking of shares
The term sheet will set out how the newly issued shares will rank relative to the existing shares in issuance.
Institutional investors will almost always seek a new class of share to be issued alongside the ordinary shares held by the existing shareholders.
This is so that specific rights can be attached to this new class of share – these rights may be economic and/or legal in scope.
Debt-like instruments
A portion of the investment may be in the form of a loan note or similar instrument, which bears an interest rate and must be repaid at a certain future date. Incorporating an element of yield and downside protection for the investor may result in lower equity dilution, as the riskiness of the investment is reduced.
Priority return or liquidation preference
Investors may ask that their investment is returned to them before the remaining proceeds are split pro-rata between the ordinary shareholders. A multiplier may be applied to this right, for example, a 2x liquidation preference means that the investor is entitled to twice their investment before remaining proceeds are divided up. The exit valuation at which this will apply may vary – it may only be relevant if you sell your business below a certain value, and hence is there to provide the investor with protection if things don't go to plan.
Liquidation preferences of 1.0x are relatively common. Up to 2.0x are occasional and above 2.0x are relatively rare.
The commercial terms of a deal need to be considered as a whole and not viewed in isolation, so consider this alongside the implied valuation, dilution and any other economic terms within the term sheet.
Some companies agree to higher liquidation preferences in return for giving away a lower equity stake in the business.
Participation
Investors that hold preferred shares may also ask for a portion of the proceeds owed to ordinary shareholders in the event of a sale, called “participating preferred shares”. There may be a cap applied to this participation, for example, the investor may receive a portion of the proceeds until they have received 2x their initial investment, and after that all proceeds will be divided among the remaining ordinary shareholders and the investor will not participate any further.
Dividend policy
Investors may request the right to participate in any dividends distributed to ordinary shareholders. They may also seek some form of preferred dividend, paid before any dividends to ordinary shareholders, provided that the company has sufficient reserves. They may also have the ability to veto any dividend policy.
Drag along
A drag along right entitles a certain proportion of the shareholders (usually the majority) to force smaller shareholders into a sale of the company to a third party purchaser. This can be necessary to prevent smaller shareholders from refusing to sell their shares and preventing an exit event. Drag along rights are very common as investors need to be confident of securing an eventual exit.
Tag along
A tag along right entitles shareholders to participate if an offer is made for a majority of the issued shares, on the same terms as those offered to the majority shareholder(s).
Information rights
Investors will require certain information to be made available to them on a monthly, quarterly or annual basis, which could include:
Non Executive Director or Investor Director
Institutional investors may require the right to appoint a Non Executive Director to the Board – this may be an individual from their own firm or an individual they introduce from their network, or both. They may also have the right to make this person the Chairman.
Warranties
The company and certain members of the management team will be defined as “warrantors” and will be required to provide warranties, for example, they will confirm certain facts and provide certain information and agree that they will be liable for a certain sum if these facts turn out to be incorrect or untrue, or if certain information has been concealed.
Warranties are sometimes used as a means to minimise or reduce due diligence scopes – instead of spending lots of time reviewing the company’s contracts, an investor might ask you to warrant that there are no onerous clauses within any key contract. This requires you to have good knowledge of the company’s contracts and potentially carry out this review yourself.
Warranties will vary in scope depending on the investor, but typically include items such as warranting the accuracy of the current share capital, the reasonableness of assumptions underpinning the business plan, the status of the Company’s trading and any outstanding liabilities or litigation. The term sheet is unlikely to set out the full list of warranties, but if you would like to see this then ask the investor to provide the full list.
If you agree the term sheet and progress through due diligence to completion, you will produce a disclosure letter which can be used to disclose any relevant information against these warranties and protect yourself and the company from a claim being made in respect of those specific items. For example, you may be required to warrant that there are no current employment cases against the company – if there were to be one, this would be included in the disclosure letter.
Option scheme
If you intend to put in place an option scheme, for example an EMI scheme, as part of the transaction or shortly thereafter, then this should be discussed with an investor prior to issuance of a term sheet, as they will specify whether they are willing to accept dilution for this pot within the term sheet. It is common for offers to be a percentage of the fully diluted equity, post issuance of options.
Up to 10% of equity is relatively common for an option pool to be allocated to key members of the team.
Transfer of shares
These set out the rights of each shareholder to transfer their shares to another individual or entity. It is common to have in place permitted transfers, which allow shareholders to transfer all or a portion of their shareholdings to immediate family or family trusts. Otherwise, it may be drafted that any shares intended to be transferred are to be offered first to the existing shareholders pro-rata to their shareholding.
Investor consents
Investor consents are required by minority investors to provide them some protection and control over key decisions made by the directors, the company and/or the majority shareholders.
The list of consents usually comprises significant decisions, such as a winding up or sale of the company, issuance of new equity, significant capital expenditure, key hires or the disposal of assets.
Pre-emption
Pre-emption rights allow shareholders to participate in future share issuances or fundraises if they wish to, and thus reduce or prevent their equity shareholding from being diluted.
Leaver provisions
Leaver provisions set out what happens to the shares held by directors or employees that leave the company. They will usually define a “good leaver” and a “bad leaver”, for example, a bad leaver may be someone who is dismissed or who resigns, and a good leaver may be someone who becomes incapacitated through illness or dies. All of, or a portion of, their shares may be subject to repurchase by the company and any remaining shares are likely to lose their voting rights (i.e. they will be disenfranchised).
The purpose of leaver provisions is to discourage individuals from leaving, to ensure that those individuals that are no longer involved in the company are not able to vote on key decisions and that equity is returned to the company to incentivise a replacement, if necessary.
Swamping rights
Minority investors may define certain circumstances in which they will have the ability to take voting control, i.e. will hold 51% or more of the voting rights in the company. These rights may be invoked for any reason or could have specified triggers, for example, the company underperforming, a key director leaving the business or a breach of banking covenants.
Restrictive covenants
Restrictive covenants prevent certain individuals from doing certain things within a specific time period (usually their employment followed by a period after that, for example, one year). Individuals may agree to not disclose information, compete with the company or solicit business from the company.
Security
An investor may require that their investment is secured against certain assets. This would usually relate to a debt-like investment, for example, a loan note. An investor may be entitled to collect a certain asset belonging to the company or require personal security from the directors of the company in the event that the company goes into liquidation.
Equity or performance covenants
These covenants allow the investor certain rights in the instance that the company performs below a certain threshold (for example, the business plan). These rights may include the ability to take voting control of the company or to recall a loan note.
If you are not familiar with some of the terms used in this resource, we recommend taking a look at our Creating a term sheet for a seed round resource.
Part of the scope for your appointed law firm will be to update the company’s articles of association to reflect the terms proposed in the term sheet.
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.
The clauses of the articles are binding on the company and on all shareholders.
When raising investment from external investors, you will firstly need to ensure that your existing articles are fit for purpose – many companies adopt basic articles that are not sufficiently detailed for a growing company with shareholder-employees. Some early stage companies put in place a shareholders agreement when they are formed, containing terms which should in fact be included in the articles, but are not. This needs to be tidied up before, or as part of, a fundraise.
Secondly, the articles will need to reflect any specific rights associated with the new investment. As the term sheet is not legally binding, the revised articles and the new shareholders agreement will supersede the term sheet on completion of the transaction.
Each of the terms below are covered in our resource on creating a term sheet for a seed round.
Your appointed law firm will provide a mark-up or a new draft of the articles of association based on the term sheet provided and any existing agreements in place.
The BVCA provides model articles of association which are often used as a starting point across the industry. These can be accessed and downloaded here.
Alternatively, we have prepared an example set of articles in partnership with Charles Russell Speechlys, a leading private equity law firm, which can be downloaded above.
Once final terms are agreed with the seed investors, your appointed law firm will re-confirm that the draft-form articles reflect what has been agreed and what is drafted in the new shareholders agreement.
The articles will then be adopted by the company on completion via a shareholder resolution (they are not signed, like the other completion documents).
If you are not familiar with some of the terms used in this resource, we recommend taking a look at our Understanding venture capital term sheets resource.
Once a term sheet is agreed and during the course of due diligence, institutional investors will provide a first draft of the proposed articles of association (or, they may alternatively propose specific amendments to the company’s current 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.
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.
The clauses of the articles are binding on the company and on all shareholders.
We have prepared an example set of articles in partnership with Charles Russell Speechlys, a leading private equity law firm, which you may find helpful in understanding how these terms are typically drafted.
It is typical for several drafts of the articles of association to pass between both sets of lawyers before the final draft is agreed. We recommend staying relatively 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.
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:
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:
There is no definitive right or wrong way to set these provisions. The rationale for their inclusion is typically as follows:
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.
The articles will be adopted by the company on completion of the transaction via a shareholder resolution.
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.
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.
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.
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:
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:
There is no definitive right or wrong way to set these provisions. The rationale for their inclusion is typically as follows:
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.
The articles will be adopted by the company on completion of the transaction via a shareholder resolution.
If you are not familiar with some of the terms used in this resource, we recommend taking a look at our Creating a term sheet for a seed round resource.
Part of the scope for your appointed law firm will be to draft the shareholders agreement to reflect the terms proposed in the term sheet.
Also known as the subscription agreement or the investment agreement, the shareholders agreement sets out the commercial and legal terms of the seed 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.
Parties to the agreement will be the company, the new investors and most likely the management of the company, including key directors and employee-shareholders.
Each of the terms below are covered in our resource on creating a term sheet for a seed round.
Your appointed law firm will provide an initial draft of the shareholders agreement once the term sheet has been agreed. This should be shared with seed investors so that they can seek their own legal advice (should they wish to) and ensure that they agree with the detailed terms, as the term sheet is not exhaustive.
The BVCA provides a model shareholders agreement which is very detailed and often used as a starting point across the industry. It is used for institutional investors and therefore includes a number of clauses that may be unnecessary or not relevant for a seed round. The document can be accessed and downloaded here.
Alternatively, we have prepared an example shareholders agreement in partnership with Charles Russell Speechlys, a leading private equity law firm, which can be downloaded above.
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.
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 may be onerous to put in place such an agreement for a seed round unless a Series A is planned in quick succession and provided that the company has a good sense for what the Series A investor will expect.
