Promoting investment in a business and raising funds for it can be a complex process that requires careful legalization. Organizing an investor’s contribution to a company can involve a number of legal papers.
Investment documents include a set of contracts signed between the company and the new investor(s). They usually contain standard information about the investment transaction: the identities of the parties; the amount of money invested; general terms (depending on the type of the investment); and of course any special conditions which are important to the parties. In particular, careful consideration should be given to the restrictive provisions.
The restrictive provisions are binding conditions that are written into an agreement between the investor and the company to determine what a party to the transaction can or cannot do under particular circumstances. Usually, restrictive provisions can be found in a company’s stockholders’ agreement (SRA), investors rights agreement (IRA), a certificate of incorporation or articles of association, depending on what is customary in the jurisdiction of the target company.
When entering into an investment transaction, both parties take certain risks. For the investor, the risks include how to protect the invested funds, or who ultimately retains control of the business. And for the company (namely, for its shareholders) the risks may relate to the receipt by outside parties of information about the company, its customers, employees, etc. The main purpose of an investment agreement is to find a compromise between the interests of both parties and clarify all important issues in writing.
The best way to create a strong partnership is to work out an agreement that will be legally binding and specify the conditions of compromise (i.e., spell out exactly what both parties need to allocate and properly share the risks involved).
Getting back to the restrictive provisions, let’s address the question of legality first. Of course, the parties may want to include in the agreement all the possible restrictions to protect their interests. But to be legally binding (and to survive a possible future legal challenge) the terms of any contract must comply with some basic common principles: there must be a valid interest to protect; the restriction must be no broader than it is reasonable to protect; and it must not be contrary to the public interest. If the principles are not met, there is always a risk of getting an unenforceable covenant. So, the investment agreement requires careful drafting of the commitments to provide fair and equal treatment of the parties.
So what can we call the common restrictive provisions for the investment contract?
The first and probably the most important common restriction in the investment agreement is the confidentiality clause. It protects the sensitive commercial information of the parties, including information about the investment or the investors.
For example, before providing investment funds, the investor may have access to some confidential information about the company, and this information must remain confidential, after the deal does is completed. The clause must define which information is confidential and which information was excluded from being confidential, and what are the consequences of inappropriate disclosure.
If there is a specific information that is considered confidential, or the parties want to protect it in case the investment transaction will not be completed, they may also want to sign a separate agreement, which is called a Non-Disclosure Agreement (NDA), and do so even before entering into the actual investment agreement. The NDA is used to protect the valuable trade secrets of a company so that they are not inappropriately disclosed to its competitors.
Aside from the confidentiality issues, there are some other common restrictions to consider.
A restriction that is not used very often (very rare and uncommon, actually), but still worth considering is a the non-compete covenant, which is used to prevent the parties to the investment agreement from competing with the company, both while they are a part of it, or after they leave it. If it is important to the parties, they can include it in their documents, but it requires very careful drafting – in some jurisdictions it may be unenforceable.
The same interest applies to employees. If the company wants to protect itself against losing its best or key employees to an investor’s competing business, it should include a non-solicitation restriction in the agreement. This may be also in the investor’s interest to prevent employees leaving with a shareholder that leaves the business after the investment has been made.
The restrictions may also apply to the exit from the enterprise (sale of a share by shareholders) or dismissal of management. For instance, an investor can be interested in maintaining the company in the same state as at the time of the transaction. For that, there may be a certain “lock-in” period when no shareholder can exit, or the director is not allowed to quit. Or vice versa, shareholders may insist that the staff may not be dismissed during that period. This is usually achieved by applying a “reverse vesting” (aka “repurchase provisions”) to shares granted to executives and directors, forcing them to vest their equity over time, and thus keeping them retained.
There are some other restrictions that the investors may be interested to include into the agreement. Those restrictions may concern the changing of different investors’ rights, privileges, or preferences that they have (not mentioned above). For instance, to the prevention of the dilution, also known as anti-dilution, triggered when the investor’s share is reduced because of issuing and selling of the additional securities by the company as a price per share lower than the price paid by the investor, or the prohibition from redeeming or repurchasing by the company of common shares, to avoid “indirect distribution” of dividends. You can read more about anti-dilution here.
Another restriction worth mentioning is the one related to so-called asset substitution. For example, the investor may require to include to the agreement the right to veto an assets sale under certain circumstances. The investors can also require to include some special restrictions in case of the company’s liquidation, or its acquisition: to protect their interests, the company may be obliged to guarantee the investors some preferences concerning the return of their investments and dividends.
These are the common restrictive covenants for the Investment Agreements. But it is very important to think about all the necessary provisions, when it comes to the real world investment deal. It must contain exactly what the parties need to protect their interests. That’s why the company should think about all the conditions in advance and negotiate it before the investment transaction is in process.
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