When investors put their money into a business, they want to make sure their investment is safe and that they have some say in how their funds are used. Investment agreements usually include different protections to help keep investors’ interests secure and reduce risks. These protections are important for both the investor and the business because they set clear expectations and help avoid future conflicts.
In this article, we’ll go over the common protections that we typically see in an investment agreement.
Equity Ownership and Dilution Protection
One of the primary concerns for investors is the protection of their equity ownership. As businesses grow and raise additional funding, new shares may be issued, potentially diluting the investor's ownership percentage. To address this, investors often require anti-dilution clauses in the investment agreement for share.
There are a number of different approaches to these clauses such as:
- Full-ratchet anti-dilution clauses: These adjust the investor’s share numbers as if the new shares were issued at the price of the subsequent lower round. For example, if a company raises additional capital by issuing new shares at a lower price than which a previous investors paid, the full ratchet clause allows those earlier investors to have their shares re-priced as if they had originally paid the lower price. This effectively increases the number of shares they own, ensuring that their ownership percentage is not diluted by the lower-priced share issuance.
- Weighted average anti-dilution: Adjusts the investor’s shares based on a weighted average of the price paid by the investor and the price of the new shares. When a company issues new shares at a lower price, the weighted average anti-dilution clause adjusts the conversion price of the investor’s shares based on a formula that considers the total number of shares outstanding before and after the new issuance, as well as the prices at which both the old and new shares were sold.
These clauses ensure that the investor’s ownership percentage is protected or adjusted in case of future fundraising rounds at lower valuations.
Board Representation and Voting Rights
Investors often seek a say in the strategic direction of the company by securing a seat on the board of directors or obtaining special voting rights. This ensures that they have influence over key decisions, such as major financial commitments, mergers, acquisitions, or changes in company policy.
Common Protections Include:
- Board Seats: Allowing the investor to appoint one or more members to the board.
- Veto Rights: Giving the investor the power to block certain decisions that could negatively impact their investment.
- Supermajority Voting: Requiring a higher-than-normal percentage of votes for certain decisions, ensuring that investors have a say.
These protections help investors monitor their investment and contribute to the company’s governance.
Liquidation Preferences
Liquidation preferences are a critical protection for investors, particularly in scenarios where the company is sold, merged, or liquidated. This clause determines the order and amount of payments to investors before the founders or other shareholders receive any proceeds.
Types of Liquidation Preferences:
1x Liquidation Preference
The investor receives their original investment amount back before other shareholders are paid.
Participating Liquidation Preference
The investor receives their original investment amount and then shares in the remaining proceeds with other shareholders.
Non-Participating Liquidation Preference
The investor chooses either to take the liquidation preference amount or to convert their shares and participate with other shareholders.
These preferences ensure that investors recoup their investment before others in case of an exit event.
Pre-emptive Rights
Pre-emptive rights allow investors to maintain their ownership percentage by participating in future funding rounds. When the company issues new shares, investors with pre-emptive rights have the opportunity to purchase additional shares before they are offered to outside investors.
Key Benefits:
- Protection Against Dilution: Ensures that the investor’s ownership percentage remains stable.
- Opportunity to Increase Investment: Allows the investor to increase their stake in the company during future rounds.
Pre-emptive rights are essential for investors who want to protect their equity stake as the company grows.
Drag-Along and Tag-Along Rights
Drag-along and tag-along rights are protections that address the sale of the company or shares.
Drag-Along Rights
These allow majority shareholders to force minority shareholders to join in the sale of the company. This ensures that a potential buyer can acquire 100% of the company, making it easier to complete a sale.
Tag-Along Rights
These give minority shareholders the right to join a sale if the majority shareholder is selling their stake. This ensures that minority shareholders can sell their shares on the same terms as the majority shareholder.
These rights protect investors from being left out of a sale or being forced into unfavourable terms.
Information Rights
Investors want to stay informed about the company’s performance and operations. Information rights require the company to provide investors with regular updates, including financial statements, business plans, and other relevant reports.
Typical Information Rights Include:
- Quarterly and Annual Financial Statements: Regular updates on the company’s financial health.
- Business Updates: Periodic reports on business operations, strategy, and market conditions.
- Access to Records: The right to inspect company records and books.
These rights ensure that investors are kept in the loop and can make informed decisions about their investment.
Right of First Refusal (ROFR)
The Right of First Refusal gives investors the first opportunity to buy additional shares if the company or other shareholders decide to sell. This protection ensures that investors can increase their stake in the company or prevent unwanted parties from acquiring shares.
Key Aspects:
- Right of First Offer (ROFO): The company or shareholders must offer the shares to existing investors before seeking outside buyers.
- Right of First Refusal: If the company or shareholders receive an outside offer, existing investors have the right to match the offer.
This protection allows investors to maintain control over who becomes a shareholder and how much equity is held by new investors.
Exit Rights
Exit rights provide investors with the ability to sell their shares and realise a return on their investment, typically within a specified timeframe. This can include put options, which allow investors to sell their shares back to the company or to other shareholders, or mandatory redemption rights, where the company is required to buy back shares after a certain period.
Key Considerations:
- Timeline: Exit rights usually kick in after a specific number of years.
- Valuation Method: The method used to determine the share price at the time of exit.
These rights give investors a way to exit the investment and recover their funds, especially if the company is not moving toward an IPO or sale.
Investor protections in an investment agreement are essential for safeguarding the interests of those who provide capital to a business. These protections, ranging from equity ownership safeguards to exit rights, help balance the risks involved in investing and provide a clear framework for how the investment will be managed. For both investors and entrepreneurs, understanding and negotiating these protections is crucial to building a successful and mutually beneficial partnership.
Wright Hassall are experienced legal advisors in relation to all types of investments, if you are considering raising capital, we would love to hear from you to discuss your options in detail.
The information provided in this article is provided for general information purposes only, and does not provide definitive advice. It does not amount to legal or other professional advice and so you should not rely on any information contained here as if it were such advice.
Wright Hassall does not accept any responsibility for any loss which may arise from reliance on any information published here. Definitive advice can only be given with full knowledge of all relevant facts. If you need such advice please contact a member of our professional staff.
The information published across our Knowledge Base is correct at the time of going to press.
