Legal documents associated with investing in private companies can be complicated. It is imperative that you show your solicitor every document so they can explain complex concepts to ensure you understand all issues, and minimise risks where possible, even if they are not an immediate concern to you at the time of the investment. Highlighted below are some of the things you should be looking out for;
Pre-emption rights: this is a right of first refusal on the issue of new shares by the company and is necessary to prevent dilution of your shareholding without your prior consent. You may also want a right of pre-emption on the transfer of shares to ensure that other shareholders cannot simply transfer to an unknown third party without offering those shares to you first.
Drag and Tag: it is unusual to find a buyer for part of a shareholding and therefore if you are a minority shareholder, you will want the option to be able to “piggyback” onto a deal procured for majority shareholders and equally as a majority shareholder you may want to be able to drag minority shareholders so that a deal for the entire shareholding is not scuppered by a shareholder with a minor interest.
Roles of founders: clearly define the role of the founders with lack of fulfilment being punished by way of a compulsory transfer of the breaching shareholder’s shares. This will ensure that the management team you bought into is delivering as promised.
Restrictions: it will be important to protect your business interests from being replicated by the founders/management team elsewhere if the agreement is no longer lucrative for them. Some founders may be of the opinion that they can market their idea, or use their contacts elsewhere so it is important to clearly restrict their action during and after they cease to be a shareholder. Recently the courts have been more willing to enforce wider restrictions in shareholders’ agreements than employment contracts creating added protection for investors, although this still requires careful judgement.
Minority shareholder protection: under company law, shareholder decisions can be passed by a majority or by at least 75% of shareholders, therefore minority shareholders may be overlooked. For example as a minority shareholder, you will have no right to management information, so a right to see budgets, management accounts etc. should be included as a contractual right. This can also be a right to veto any specific or major decisions.
Warranties: it is important to get at the very least basic warranties e.g. assurances that the business plan and budget are accurate. The agreement should also deal with enforcement of a claim under the warranties, for example, is each warrantor liable for the total amount of the claim.