Investment Agreements in Start-Up Companies

February, 2022 / EKW

Introduction

An investment transaction in a start-up company is a complex transaction that anchors the terms and components of the commercial transaction. The transaction also anchors the relationship that has been created, due to the investment, between the investor and the target company (being the start-up company), as well as the relationship between the investor, as a future shareholder, and the current shareholders in the company (such as the company’s founders).

In the process of negotiations leading to an agreement, the parties try to reduce risks by mechanisms that will help them to optimally manage the company, as well as to maximize their interests as shareholders. Most of the agreed legal mechanisms concern the manner in which the company is managed, and some relates to rights and obligations that directly relate to shares that will be allotted to the investor, to the tradability of the shares, and so on.

Key documents in an Investment Transaction

In the vast majority of investment transactions, it is customary to summarize the details of the transaction in a (relatively) short document called a Term Sheet. The main purpose of the term sheet is to anchor the commercial terms of the investment (the amount of the investment, value of the company, etc.) as well as additional conditions such as setting an agreed period in which the investor conducts comprehensive due diligence about the target company, and granting time to the investor and/or the founders to complete the investment round through additional investors.

After the term sheet is signed and the terms conditions set out in it have been fulfilled, begins the preparation of the definitive agreements for making the investment, with the main one being the Share Purchase Agreement (SPA). All the legal mechanisms that are agreed upon in the term sheet will be extensively detailed in the SPA, and some also in a shareholders’ agreement and in the articles of association of the target company.

As part of the investment agreement, the parties sign additional documents, such as an investor’s rights agreement, revised articles of association for the company and sometimes also a shareholders’ agreement.

As stated, apart from the investment agreement, one of the material documents signed under the investment agreement is the company’s articles of association. The articles of association are in fact an agreement between the company and its shareholders, and between the shareholders and themselves. The company’s articles of association also regulate the agreements regarding the rights and obligations of the company’s various organs, such as the company’s board of directors and its general assembly.

Legal Mechanisms

Among the legal mechanisms that are discussed during the negotiations to reach an investment transaction, we shall elaborate below on the most central and common ones that are applied in investments in start-up companies:

Type of Shares – Usually a company is established with only one type of share, being “ordinary shares”, which give all their owners equal rights and obligations. In investment agreements, an investor, certainly if it is a venture capital fund, may require shares of a different type known as “Preferred Shares”, which provide their owners with benefits beyond those given to holders of ordinary shares. The benefits given to holders of preference shares are rights that provide benefits both in terms of how the company is managed, such as the right to veto certain decisions made by the company, and economic benefits such as preference upon liquidation, anti-dilution rights (explained below), and more.

Reverse Vesting Mechanism – One of the most common mechanisms to ensure the retention of key people in a company (mainly the founders) is to subject the founders’ share capital to a reverse repurchase mechanism known as reverse vesting. These mechanisms come alongside other mechanisms that are customary between the parties, such as: right of first refusal, bring-along right, tag-along right, etc. (as will be detailed below).

In the vast majority of cases, the limitation on the founder’s holdings is for a period of up to 48 months and it is incremental and decreased over time. This is a gradual vesting of the share capital over pre-determined periods, where shares that have not yet been “released” continue to be subject to a repurchase right without consideration by the investor(s) (according to their relative share in the company).

A linear mechanism can be set, i.e. quarterly or monthly vesting over two years, or a non-linear mechanism can be set, for example vesting over a period of two years where half of the shares are released only at the end of the first year (one-year cliff) and the rest of the shares are released equally at the end of each quarter of the second year.

In the reverse vesting mechanism, it is also customary to determine an acceleration of the shares that have not yet vested in certain cases. Thus, for example, in the event of an exit where the founders’ shares are subject to a reverse vesting mechanism, it is customary to determine that all the founders’ shares be deemed vested even though the vesting period has not ended.

Right of First Refusal – A right that gives a shareholder the opportunity to purchase shares of other shareholders who wish to sell their shares to third parties. There are exceptions to this right, including a transfer between related parties.

Pre-Emptive Right – A right that gives a shareholder the opportunity to participate in a future allotment of shares in order to maintain his holding in the company. There are a number of exceptions to this right, including the allocation of securities to the company’s employees, as well as an issue to a strategic investor.

Bring Along – The right of majority shareholders to oblige the minority shareholders to join the transaction for the acquisition of all the company’s shares. It is important to note that this right also exists, with certain reservations, in the Companies Law, both with regard to private companies and with regard to public companies.

Co-Sale / Tag-Along Right – The right of minority shareholders to join a transaction of the sale of a significant part of the company’s shares to a third party, under the same conditions. This is an interesting right that embodies a controlling interest premium even for minority shareholders.

Anti-Dilution – A dramatic right whereby a shareholder who has purchased shares in a company at a certain price will be entitled to receive additional shares in the company at no additional payment by him in the event that in the future the company allocates new shares at a lower price than that paid by the shareholder. This right has a number of variations, the main ones being Full Ratchet which does not take into account the investment amounts in each round, and a more moderate variation called Weighted Average Ratchet.

Restrictive Provisions – In a case where after the formation and completion of the transaction, the investor’s holdings constitute a minority in the company, this is, naturally, also reflected in the ability to influence resolutions by the company’s board of directors. In such cases, the investor may seek to determine that on fundamental issues the company’s board of directors will not be able to pass any resolutions unless the representative(s) of that investor on the board support the resolution (even though they constitute a minority on the board). Examples of such fundamental issues: a material change in the company’s field of business, a material deviation from an agreed business plan or budget, a material change in the company’s articles of association, and more.

Expiration of Rights

Before we finish, we will note that in most cases the above rights are not given to a particular shareholder indefinitely, and the company limits the period within which these rights will continue to apply. The main example for the expiration of these rights is a public offering of the company’s securities, along with other examples such as a substantial decrease in the rate of the specific shareholder’s holdings, the company’s reaching business milestones, etc.

Summary

As part of negotiations for an investment in a start-up company, it is important to understand the interests of each party in order to formulate a balanced deal that will allow each party to maximize its benefits.

Knowledge of the legal mechanisms is important for creating a fruitful relationship between the new shareholders joining the young technology company and the veteran shareholders, and at the same time for building a corporate structure in which the target company can conduct itself effectively and pertinently for the promotion of the company’s business, even though these may, at times, differ from the interests of the shareholders..