Breaking Down The Share Subscription Agreement: Key Clauses Explained

Understanding how to draw up a share subscription agreement is one of the essential steps when raising funding. As the founder of a company, you’ll work with your legal counsel to create a formal agreement. You can rely on this document to provide an extra layer of security for your new company.

As you continue to scale the fledgling company and attract more investors, the agreement sets up an underlying framework. It defines the terms and conditions under which initial investors provide capital and the returns you’ll offer.

Essentially, you’ll draw up share subscription agreements (SSA) when raising funding from private investors. These entities are primarily informal, such as angels, family, friends, colleagues, as well as, venture capitalists, at times.

Participants in the investment deal typically sign the agreement before the actual shareholders’ agreement is finalized. Read ahead for the detailed information included in this document.

Understanding What a Share Subscription Agreement Is

The share subscription agreement outlines the relationship between the company and potential investors. The document is the investor’s commitment to purchasing a specific number of shares at a pre-determined price. It also includes the process by which your company will issue the shares.

Keep in mind that all agreements–with investors, consumers, and other third parties–must comply with the Securities and Exchange Commission (SEC). You’ll use the share subscription agreement (SSA) to maintain a record of the outstanding shares in the market and their ownership.

For instance, to keep track of the entities owning the shares, the number of shares they own, and their terms. You’ll also mention the price per share at which they purchased the stock. Other information includes the specific class of shares, confidentiality clauses, voting rights, and additional provisions.

A detailed record helps mitigate any potential legal disputes regarding the returns investors can expect. It eliminates ambiguity and clarifies expectations from the investment deal since it details the rights and obligations of the partners.

Understand that the share subscription agreement is distinct from the term sheet. But both papers ensure that company founders and their investors align their respective interests with the funding.

How Share Subscription Agreements Work

Founders raising capital for their early-stage startups typically use share subscription agreements (SSA). At this stage, they are not ready for venture capital and may also consider private placement deals. Not all agreements are the same, and clauses may vary according to the company.

Your fundraising advisors will draw up well-structured and organized, legally binding documents. One of the most crucial details is the expected rate of return on the original investment that investors anticipate. You’ll also include the framework for calculating and delivering the returns.

For instance, a percentage of the corporate profits to be paid out quarterly, biannually, or annually. Or, the returns payable when the company achieves certain financial milestones. Returns can also be contingent on the company liquidating certain assets or being acquired.

Share subscription agreements must comply with Regulation D of the SEC guidelines, which govern private placements. Since your company is a private entity and you’re seeking investors without general solicitation or advertising, Rule 506(b) applies.

If you engage in general solicitation, you’ll comply with Rule 506(c); however, you must verify the investors’ accredited status. Furthermore, you needn’t complete the entire registration process under the Securities Act of 1933, since this is a private placement.

However, know that any securities you issue in exchange for funding are considered restricted. This means that investors cannot freely sell them in the open market without registering as accredited entities or getting exemptions.

Understanding Share Agreements and Share Purchase Agreements

Don’t confuse an SSA with a shareholder agreement. SSAs focus on the initial investment transaction, but a shareholder agreement outlines the ongoing relationship shareholders have with the company. The latter includes additional clauses, like board seats, voting rights, and share transfer restrictions.

Shareholder agreements are with accredited investors who have conducted thorough due diligence before providing capital. SSAs are agreements with informal investors, such as family and friends. It is not unusual for founders to enter into both types of agreements concurrently.

Also, understand the difference between SSAs and share purchase agreements. When investors purchase shares from a current shareholder, instead of the company issuing the shares, they typically sign share purchase agreements.

Subscription Agreement Governance: SEC Regulation D – Rule 506(b) and 506(c)

Rule 506(b) of Regulation D is considered a “safe harbor” under Section 4(a)(2). It provides objective standards that a company can rely on to meet the requirements of the Section 4(a)(2) exemption.

Who can Invest in the Company?

• “No general solicitation or advertising to market the securities.”
• “Securities may not be sold to more than 35 non-accredited investors (all non-accredited investors, either alone or with a purchaser representative, must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment)”

What Information is Shared with Investors?

• “Must give any non-accredited investors disclosure documents that generally contain the same type of information as provided in Regulation A offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well)”
• “Must give any non-accredited investors disclosure documents that generally contain the same type of information as provided in registered offerings.”
• “Should be available to answer questions from prospective purchasers who are non-accredited investors.”

Information Included in the Share Subscription Agreement

Even though you’re raising funding from informal sources, it’s crucial to have the paperwork in order. Remember, you’ll also include information about your informal investors in the cap table. Here’s a quick look at the essential information that share subscription agreements (SSA) carry.

• Investor Information: Name, address, contact information, and designation of each investor
• Investment Information: Number of shares they will own, price per share, the total investment amount, and the type or category of shares, such as common stock, preferred stock, or any others.
• Conditions and restrictions to which the shares will be subject
• Timeline for which the shares are issued
• Conditions for Completion: Any conditions that the founder and investor must meet before they finalize the investment deal. These conditions may include regulatory compliance and closing criteria.
• Process by which the investor provides capital, such as in a single tranche or increments, as in capital calls.
• Risk Disclosure: This clause outlines the risks associated with the investment, so that investors are aware of the potential downsides. It ensures complete transparency.
• Dispute Resolution: The procedures and steps participants can take to resolve disputes if they arise.
• Entire Agreement: This section states that the share subscription agreement and all related agreements constitute the complete understanding between the parties to the deal.
• Termination: The agreement outlines the conditions under which either party can terminate the deal. For instance, if the company undergoes significant changes or fails to meet certain pre-determined conditions.
• Commitments and Covenants: This section describes the obligations that both parties must fulfill. The investor commits to providing a certain amount of capital under specific conditions, while the founder commits to issuing shares.
• Severability: The agreement specifies that even if any clause or section is deemed invalid, it will not affect the investment deal.

Representations and Warranties

Representations and warranties in the share subscription agreement are assurances or promises the company and investors make. They assure that the information they have provided is accurate, and they have the authority and capacity to act.

As the founder, you’ll assure investors that the company has the legal right to issue shares. You’ll also provide details of any ongoing legal disputes regarding share issues. On their part, investors assure that they have an accredited status, if necessary.

Under SEC regulations, such investors earn a specific income or have a particular net worth. Even if they are not accredited investors, they must provide assurances that they have the legal authority to invest.

Indemnification Clause

This section in the share subscription agreement protects the participants in the investment deal. If either party fails to fulfill their obligations, this clause assigns responsibility for the setbacks or damages. It specifies who will cover the losses.

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Advantages Outlined in a Share Subscription Agreement

For Founders:

• You can access capital from non-accredited investors without worrying about offering them board seats and voting rights. Investors have no controlling rights over the company, allowing you complete autonomy over the decision making. These factors eliminate some of the complexities of drafting the agreement. There are fewer clauses.
• You can get a one-time investment tranche to keep the startup running until the seed stage. Once the company is stable and ready to scale, you can approach accredited investors for capital.
• You don’t need to comply with complex regulatory requirements.

For Investors:

• Investors are not liable for any losses the company might incur. In this respect, they are limited partners and their liability is restricted to the money they’ve invested in the company.
• Investors can commit to a one-time capital contribution.
• They need not participate in the company’s day-to-day operations.
• They can invest in the initial stages of the company and earn significant returns as it scales and earns revenues.
• Even entities who don’t have much knowledge about startups or how they operate can invest money and watch it grow.
• Investor rights, obligations, and returns are clearly stated in the share subscription agreement.

Disadvantages Outlined in a Share Subscription Agreement

For Founders:

• Since you’re accessing capital from informal sources and non-accredited investors, you’ll get only capital. Such deals don’t include industry-specific guidance and access to networks.
• The risks of legal issues is higher and in case of disputes, you’ll have to engage in complex negotiations. To avoid this situation, you’ll draft the share subscription agreement with the assistance of expert legal counsel.
• Sourcing capital from friends, family, and colleagues can result in relationships souring if things go wrong.

For Investors:

• Non-accredited and informal investors may find it difficult to understand the legal jargon in SSAs.
• They don’t get any voting rights or a say in the company’s operations, but must invest in good faith. This factor can be downside and raise their risks.
• Any shares investors receive through the share subscription agreement are restricted. This means they cannot sell them in the open market and must sell them back to the company.
• Any capital they invest in the company is illiquid. The lack of liquidity can be a downside.
• Investors must commit to providing a certain amount of capital and accept unfavorable terms, not to mention higher risks.
• They are investing in the very early stages of the company and the risks of losing the capital is high.

Drafting legally-binding investment contracts is only one of the next steps. Are you looking for detailed information about the things to take care of post startup funding? Check out this video I’ve created explaining what you need to do.

Drafting the Share Subscription Agreement – Tips to Remember

Here’s what you need to remember when drafting the agreement with informal investors:

• When drafting the SSA, include language and terms that are easy to understand by informal investors. Be aware of the entities who will be reading and understanding the document. For instance, accredited investors are experienced in how the funding ecosystem works. Here, you’re working with friends and family.
• Clearly explain all the terms and conditions in simple and plain language. Avoid confusing and complex words. Ensure you explain how investors can withdraw their investment, the terms, and termination clauses.
• List all the possible risks carefully and make sure readers can understand what can happen. For instance, the company being unable to deliver returns on schedule or the investment failing entirely.
• Even though you’re raising capital from informal sources, your startup is subject to regulatory compliance. Ensure you understand the relevant rules and take steps to follow them. Don’t overlook changes in regulations and stay updated with the latest amendments.

The Takeaway!

A share subscription agreement formalizes your informal relationship with early investors. You’ll use this document to define expectations and obligations and provide a legal framework for the capital raise. The key is to explain all the relevant terms and conditions in easy-to-understand words.

At the same time, ensure you include all the information and eliminate the possibility of disputes. Always retain the services of expert legal counsel to guide you through the process and stay compliant with the law. You’ll secure not only the startup, but also your relationships with investors.

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