Important Things To Look For In An Investment Contract

What are the important things to look for in an investment contract? What should entrepreneurs be looking at when reviewing investment contracts?

If you are launching a startup or are working on a growing business, you will eventually be looking to take on some form of capital.

Loans and their paperwork may be more commonly understood by the average individual. You know to look at typical factors such as finance charges, repayment amounts, and repayment dates. As well as prepayment penalties, and clauses that may come into effect in a default.

Investment contracts involving equity investors in your company can be substantially different. There can be many factors and clauses entrepreneurs have not had the experience of reviewing and evaluating.

Here are some of the key elements of an investment contract to pay special attention to.

What Is An Investment Contract?

An investment contract is a legal document governing the investment into a company.

Whenever you accept an investment of capital into your company, you want to have everything in writing. This applies regardless of whether it is a VC firm, an angel investor, or just friends and family that you have known your entire life.

This will save an immense amount of headaches, stress, confusion, legal battles, and financial loss.

An investment contract should lay out every aspect of the investment and agreement for both sides. Both the investor and the company receiving the funds. The more detailed, the better.

It is always wise to have a lawyer who specializes in investing and corporate law review your contracts. Even then, always read the fine print. Never be discouraged from asking questions, and ask them again until you are clear on what things mean.

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The Basics

The basics of any legal contract or agreement should include who the parties to the agreement are, and how they can be contacted.

In the case of an investor agreement, this will also include the amount being invested. What is being given of value in exchange for the investment, and the terms?

Be sure to check even these basics for accuracy. Otherwise, they can cost you dearly. And, that’s one of the first important things to look for in an investment contract.

Due Diligence

Startup investors are expected to conduct due diligence before completing an investment in a startup. Many first-time entrepreneurs are not prepared or expecting this.

Often the agreement will begin with an LOI (Letter of Intent), or term sheet. Which lays out the proposed initial terms of an investment. This document also lays out what needs to happen before the transaction is completed, what it is based upon, and includes drafting and signing the final documents or investor contract.

Investors have a responsibility to conduct due diligence and do their homework on a company before transferring any money. VCs, for example, are simply investing on behalf of many other investors whose money they have pooled together. If the investment does not perform as hoped, then you can bet those end investors will look for ways to hold the money manager accountable. Such as if they failed to do their due diligence.

What’s Included?

Your investment contract or preliminary documents should lay out what will be included in the due diligence phase of the transaction.

What will the investor need and be allowed to verify, and how, before they close the deal?

Will it include auditing all of your financials? Reviewing your bank account balance? Verifying your users are real? Speaking with your customers and vendors? Background checks on founders and key team members? Reviewing all of your legal agreements and contracts with employees, lenders, vendors, and other investors?

You should also have a time frame for how long this due diligence period will last.

What’s Excluded?

You may also be able to negotiate exclusions from due diligence. It is not very well known. Perhaps not even common. Yet, some founders have included this in their investor agreements. Helping to streamline the funding process, eliminating potential causes for delay, and avoiding anything that could derail the deal at the last minute.

Talk to your lawyers and fundraising advisors about anything that you may want to exclude from this process. It’s another one of the important things to look for in an investment contract.

When Will The Transaction Close & Funds Be Received?

While there are certainly some exceptions, it often takes a lot longer to close a round of funding than entrepreneurs estimate.

There can be a huge difference between getting a yes from an investor, them providing an LOI, and then getting through signing the closing paperwork, and seeing funds cleared in the bank.

As a new entrepreneur, with a young start, a very short runway, and looming payroll, even being a few weeks off can really destroy your company, or wind up with investors renegotiating because they know you have no choice.

Be clear about when the final documents should be signed. Then when the money should be clear in your account.

Even if you are using crowdfunding platforms, there can be a significant delay between when your campaign is funded, and you get the money.

Valuation

How much is your company being valued in this transaction?

There can be both pre-money valuations, and post-money valuations. That is how much your company is worth before and after the investment is made.

You may want to elaborate on the justification for the valuation, and what could change that during the process, and before the funding comes through.

Escrows

What, if any, money might be held back in escrow or withholdings?

Will any of the funds be spaced out over time? Or will they all be sent at once?

Are any funds set aside in escrow for pending taxes or other uncertainties?

Will there be requirements for shares to be put into a pool for employee options or other reasons?

Are there any reasons or situations in which the investor can claw back any of the funds?

Structure Of The Investment

How is this investment being structured?

Is this a lump sum cash injection? Or will it be provided in pieces over time, based upon certain terms?

Is this an equity investment? Meaning that you will be giving stock and shares in your company in exchange for the money?

If so, which types or classifications of shares are you promising to provide? What comes along with them?

If this is a debt investment, what are the terms? How much will the finance charges be? How much is the interest, and how is that calculated? Will there be penalties for prepayment? Be careful here. As commercial loans can have prepayment calculations that are pages long.

How much will repayments be? When will they be due? Will there be any security you need to provide as collateral? Will these be specific assets that are liened? Or will you have to sign a personal guarantee, and put your own personal assets and future income on the line?

Rights

What are the rights of each party to this investment contract?

What rights will you have? What rights will they have? How might this impact your operations and future fundraising and financing efforts?

Board Seats

Will your investors be awarded seats on your board as a right of their investment? If so, how many?

Who will be put in these board seats? The individual who is this involved in your business can be far more important than the brand name of any VC firm or institution. How well do you know this person? How well have you vetted them and built a relationship with them in advance?

What happens if something happens to that person? Who gets their seat?

How many board seats will the founders retain in return?

Voting Rights

What voting rights will investors be granted according to this investment contract?

What dictates those votes, and the power of those voting rights in the future? Who will ultimately have the controlling votes? Make sure you are thinking ahead through future rounds of funding and dilution.

Control & Decision Making

As a part of the above, who has the control, and has the ultimate say in making decisions about the business?

This can include big decisions, like taking on debt, allowing equity investors in the future, permitting the sale of assets or the company, and binding the company in partnerships.

It may also touch on things like the ability to hire and fire executive management, including you and your other cofounders. It can mean daily operational decisions, from layoffs to product design choices, pricing, M&A, and more. Be sure you know, and know who you are letting have this control in your company. Consider this to be one of the most important things to look for in an investment contract.

Ability To Cancel The Agreement Before Closing

What rights are there to cancel this investment contract before it is finalized?

What outs are there for the investors? What outs do you have? What are the specifics? How much notice will be given? What, if any, are the penalties or liabilities if one party cancels? Who will cover the costs of money expended on the process up until then?

Might there even be rights to claw back funds or cancel the agreement after closing under certain circumstances? What are those specifics?

Drawing up the investment contract is only one of the aspects of fundraising. Successful entrepreneurs must learn how to build relationships with investors for future pitching and series rounds. If you’re ready for more information about how to do that, check out this video I have created.

Liquidation Preferences

This is by far one of the most important clauses in an investment contract.

Liquidation preferences spell out who gets paid what, in what order, and any minimums involved in a liquidation event or exit.

If your investors get paid out their capital before anyone else gets a dollar, and they must receive a minimum of 4x the capital they put in, you will need to sell for a lot to see a penny yourself. It is quite possible for entrepreneurs to sell their company for a billion dollars and get nothing due to this clause.

What Happens When Things Go Wrong

One of the main purposes of having an investment contract in writing is not only to make it binding, but to spell out what happens in a default, disagreement, or when other things go wrong.

This includes if there are ‘bad actors’. If misinformation is provided, etc.

It will also include remedies and their boundaries. For example, which jurisdiction’s laws will be applied to managing these situations? If mediation will be mandatory. As well as who will pay the legal fees in a dispute.

Quick Contract Negotiation Strategy Tips

• Get more options and multiple term sheets on the table to pick from
• Always use a third-party buffer, i.e. fundraising consultant or lawyer
• Be prepared to give and take, so everyone feels they won something

Summary

Investment contracts are some of the most important and impactful documents you will encounter and deal with as you finance your startup. And, you should know what are the most important things to look for in an investment contract.

It is vital to understand the basics and most important lines and clauses for yourself. As well as getting professional help and representation to navigate and negotiate them.

The more informed you are, the better the deal you can drive, and the outlook for your company.

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