By William Robins, Keystone Law Angel Investment Team
So, you have weighed up the pros and cons and decided to seek business angel investment. How are you going to get investment? What perils await you? This article looks at the process and the key legal issues in securing angel investment.
Business angels are wealthy individuals who invest in high growth businesses in return for equity. Some angels invest on their own, whereas others do so as part of a network. In addition to money, angels often make their own skills, experience and contacts available to the company. Angels typically invest in companies which need between £10,000 and £500,000 where funding from traditional sources, such as banks and venture capitalists, is not available. Banks generally require security and most venture capital firms are only interested in financing much larger amounts.
Before finding your angel investor
There are plenty of things that you could be doing before beginning your search for angel investors to make your company more attractive and avoid obstacles further down the road. Angel investors will almost certainly have made similar investments in the past and will usually engage lawyers and accountants to review your books and records as part of their due diligence investigations of your company. Your company needs to be ‘investment-ready’ before due diligence begins. As a result, your company will appear well run and the investor will have more confidence in you and your company. Here are some common issues that can be addressed prior to due diligence:
- Shareholding structure - is your company set up in such a way as to enable investors to receive the tax benefits of the Enterprise Investment Scheme? This is often an important consideration for angel investors and can make or break their decision to invest, or lead to a lower valuation of your company. Are employee share options in place? Putting them in place at the same time as a proposed investment might have adverse tax consequences for the holders of those options.
- Customer contracts – do you have appropriate written contracts in place? Investors will want to see that the key customers and suppliers are legally tied in to a contract from which they cannot choose to walk away.
- Intellectual property - investors will want to be absolutely certain that any IP you claim to own is actually owned by your company, is defensible and secure. For example, key pieces of technology or software might have been worked on by a third party. If there is no written agreement with that person agreeing to transfer the relevant IP then it will be arguable that the third party owns it, not your company. Another common issue is that domain names are often registered incorrectly in the name of the person who had the credit card handy when the domain name was being paid for – that is often an employee (or former employee!) or the person who developed your website.
- Employee contracts - leaving aside the fact that employees are entitled to written information regarding the terms of their employment, investors will often want to ensure that key employees are properly tied in to your company and will expect to see enforceable notice and non-compete provisions. Asking employees to enter into formal contracts after they have learned about a possible investment often gives them the edge in negotiating with you.
- Business plan – angel investors will want to see that you have a clearly articulated strategy for the business over the next five years (with achievable milestones and a potential exit) and that management have a strong understanding of products and markets. You will need to prepare this carefully, as it essentially becomes your sales document and investors are likely to require that you warrant (i.e. promise contractually) that this has been prepared honestly and that you have prepared it based on reasonable assumptions.
The list could go on but the important point to note is that failing to put in place appropriate structures and document properly the company’s internal and external relationships is likely to make the company less attractive to investors. One advantage of approaching a business angel through an angel network is that the network manager can (for a fee) help get your company investor-ready.
Usually, the first step is for you to send a potential investor a brief summary of the investment opportunity (some angel networks will have a standard application form). You will need to be careful about who the document is sent to as there are strict rules about marketing the shares of any company – your angel network should be able to help you navigate that process. The summary document may or may not contain confidential information, depending upon the nature of your business. If the investor expresses interest there will probably be a number of meetings at which you will provide further detail or a presentation to the relevant angel network. In certain circumstances it may be appropriate to require the potential investor to sign a non-disclosure agreement to protect your company’s confidential information from being exploited. (We have made available a precedent NDA at www.keystonelaw.co.uk/publications_NDA.php)
Once the investor has sufficient information about your business, then either you or the investor will draft the heads of agreement (sometimes called a memorandum of understanding, letter of intent or term sheet) which sets out the key terms of the investment. There is no rule as to who prepares the first draft of the heads of agreement. The party with more bargaining power will normally decide, and would therefore choose to prepare the heads of agreement as it is advantageous to set the starting point for negotiations. The heads of agreement are usually expressed as not being legally binding – both parties should be able to back out of the transaction until the investment agreement is signed.
Due diligence takes many forms and can be done to different levels of intensity. Investors might be willing to invest based simply on their trust in the management team (and their warranties in the investment agreement – see below). However, that is often unlikely and usually investors will ask the management team a number of detailed questions concerning its management, accounts, customers, suppliers and prospects.
Dealing properly with the due diligence is likely to be time consuming. Having all the company’s records organised and ready and contracts in place before the process begins should speed up the investment process and allow you to focus better on running your business.
Investment agreement (aka ‘Subscription and Shareholders’ Agreement’)
Drafting and negotiating the investment agreement is the main area of input by lawyers and is where they can add the most value. Investors will often have their own preferred set of investment documentation and the convention is that the investors’ lawyers will produce the first draft of the investment agreement; but that is by no means a hard and fast rule.
Investors will typically be looking for an exit from the company in three to five years and the investment agreement will govern how your company must be run during the period of the investment and form the backdrop to your relationship with your investor(s). The investment agreement is not there simply to cover what happens when something goes wrong. It will typically deal with the following issues:
Shareholdings - investors will usually take a minority stake in your company but often take a class of share that gives them enhanced rights in relation to other shareholders. Shares have three main characteristics: rights to dividends, rights to capital and rights to vote, all of which can be apportioned differently between different types of shareholder. For example, the investor may take a class of share that gives them a right to take dividends before the management team and a right to an enhanced capital return.
Management control - investors will usually not want to be involved in every decision taken by the company but are likely to want a seat on the board and a right to veto a number of key operational matters. There will typically be a list of 20 – 30 ‘reserved matters’ that the board of the company must refer back to the investors before the company can take the proposed action. Typical reserved matters include taking out loans, incurring large capital expenditure and hiring or firing senior employees. The investors are also likely to require the company to adhere to a business plan and budget which is agreed each year. The important point here is that the reserved matters should only restrict key operational matters, leaving the management to take day-to-day decisions in the ordinary course.
Protecting the investors’ shareholding - the investors may want to include specific protections to prevent their shareholding from being diluted by the company issuing new shares to other shareholders. Investors will always require some kind of pre-emption right (a right of first refusal to participate in any new issue of shares) but some may go further and require specific anti-dilution protections. Giving too many protections to investors may stifle future equity investment or lead to the investors’ shareholding increasing to the detriment of the management team. This can be a complex area.
Warranties – you and your company’s management and/or the founders will be asked to provide a number of warranties to the investors representing that certain matters in relation to your company’s business are true. If those warranties turn out to be untrue, then the investors may be able to sue those who gave the warranties for breach. Your lawyer’s job will be to reduce and limit your potential personal liability by negotiating the nature and scope of the warranties, by introducing certain contractual provisions to limit your liability and by agreeing, in a document known as a ‘disclosure letter,’ a number of exceptions and qualifications to the warranties.
Incentivising management - investors will want to tie in management to the company for as long as possible and, for that reason, will usually want ‘good leaver/bad leaver’ clauses in the agreement. A good leaver/bad leaver clause works in such a way that if an employee-shareholder leaves the company for a ‘good’ reason (e.g. illness) then the employee is either permitted to retain his/her shares or to sell them for a fair price to the other shareholders. If the employee leaves for a ‘bad’ reason (e.g. to work for a competitor), then his/her shares are sold for less than fair value, often for just £1. There are many possible variations to what constitutes a good or bad leaver and the respective consequences. You should pay careful attention to any such provisions.
The investment agreement is not just for the protection of the investors. There are other aspects to it which the management team should be looking for. For example, where you and the founders retain a majority shareholding, then you should insist on ‘drag-along’ rights. Drag-along rights give the majority shareholders a right to force the minority shareholders to sell their shares, if the majority have accepted an offer from a third party to sell the whole of the company’s share capital. Without such a right, just one small shareholder might be able to prevent the sale from going ahead because most buyers will want to buy 100% of the company and nothing less. On the other hand, if you and the other founders hold a minority shareholding then you will want ‘tag-along’ rights. This is the opposite of drag-along and is designed to allow the minority to be treated in the same way as the majority if the majority were to sell its shares.
Completing/closing the deal
In addition to the investment agreement there will inevitably be other documents to negotiate, prepare and sign. This might include IP licences, employment contracts, keyman insurance, the disclosure letter, new articles of association, board minutes, share certificates and Companies House forms.
If all goes to plan then most deals can be completed without you and the investors having to be in the same room, although it is not uncommon for there to be a completion meeting where all the documents are signed by the parties in person.
Making best use of your lawyer
Angel investment transactions often involve complex issues and documentation. Broadly speaking the legal work involved in a £250,000 investment follows the same course and documentation as a £25m venture capital investment. You are going to need your own lawyer and the investors will certainly be using their customary lawyer and you cannot take advice from him/her. Once you have found the right lawyer, it is important (for both client and lawyer) to be open and efficient. Here are just a few suggestions to maximise your lawyer’s efficiency so they can add the most value:
- involve your lawyer at an early stage – it may save you money! Lawyers understand that their clients often see them as a necessary evil; someone who is there to draw up the paperwork of a deal that is all but done. But, involving your lawyer earlier in the negotiations can avoid problems later in the day. Just a few minutes talking through a proposed transaction with your lawyer at the start might reveal a problem with the proposed structure – something which would take much longer to renegotiate if it was spotted later in the day.
- agree clearly the scope of the work - if you know there are areas where you do not want your lawyer involved, then address that in advance with your lawyer.
- structure completion meetings - try not to use them as an opportunity to finalise unresolved issues. Sometimes this cannot be helped, but this will mean you are wasting money.
Taking on an angel investor will change the dynamic of your company. It is a major decision to seek angel investment. Once taken, and before you approach investors, you should consider what steps you need to take to become investment-ready. Once you have found a potential investor, take care with your confidential information and in negotiating the heads of agreement. You will need your own lawyer to smooth the path to investment and help create a framework within which both you and the investor are happy to work.
Keystone Law has 15 lawyers who are all experts in angel investment. Their backgrounds and areas of specialism vary, but without exception they have acted for large investors (including VCs and large public quoted companies) in respect of major investments. At Keystone Law, angel investment is a key part of our service to clients. We also have extensive expertise with all the issues that can happen during a company’s journey, including mergers and acquisitions, exits and floats.
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