2021

A basic guide to the legal process:

Investment
Introduction

Investment appeals to businesses for a wide range of reasons. For investors, it

presents the opportunity to secure a return on capital in a tax efficient manner. For
investee companies, it is primarily a fundraising mechanism, and can also provide
access to external expertise and support.
“Investment” can encompass a broad range of activities. This guide focuses on
equity investment, meaning a subscription for or purchase of shares in a company.
It aims to address the following:
• advantages of investment;
• types of investor;
• stages of investment;
• key investment documentation;
• ancillary documentation and timeline; and
• key commercial terms.
This guide is intended to outline the main legal principles that any party entering
into an investment will need to consider. Specific advice should be taken when
structuring, documenting and implementing an investment to ensure that the
commercial, legal, regulatory and tax objectives of the relevant parties are met.

“
We use them for everything and think there is no
better alternative. They understand their clients
incredibly well.

- Client quote, Chambers UK, 2019

2 A basic guide to investment

1 Advantages of investment

2 Types of investor

3 Stages of investment

4 Key investment documents

5 Ancillary documentation

6 Timeline

7 Key commercial terms

8 Conclusions

9 Key contacts

10 Glossary

A basic guide to investment 3

1. Advantages of investment

Parties seek investment for a number of reasons:

For investees

Fundraising Access to external expertise

Companies typically seek Securing external
investment to raise cash to fund investment can give
working capital requirements companies access to the
and growth. Borrowing can be expertise, experience
problematic because of the and contacts of third-
accompanying requirement to party investors, whilst
make regular interest payments, incentivising those investors
putting pressure on a company’s to provide that support.
cashflow. By contrast, raising It can also enhance an
equity finance can give a investee company’s
company more freedom to credibility, helping it to build
reinvest excess cash in the a stronger network and
business or pay dividends to secure future investment.
shareholders.

For investors

Generation of returns Tax planning

Investors generally invest to Investment can, in some
achieve a return on capital. circumstances, enable
Different types of investors will investors to take advantage of
seek different types of return (and certain tax reliefs, such as EIS
accordingly, make different types and/or SEIS. The availability of
of investment). For example, a these will vary depending on
private individual may seek to the particular circumstances
invest in a diverse portfolio of of an investor and investment,
assets to generate long term and investors will need to
retirement income. A private equity take specific tax advice to
fund, on the other hand, may invest ensure their investments are
with a five-year exit strategy, in structured in a tax efficient
the interests of generating shorter manner.
term returns for its shareholders.

4 A basic guide to investment

2. Types of investor

1. Friends and family 5. Private equity funds

Initial investors are often individuals with a close personal These are investment management companies which
connection to a founder / investee. They will typically make large investments in companies through a variety of
provide the founder with their first capital through relatively investment strategies including leveraged buyouts.
small investments in exchange for small portions of equity.

2. Angel investors
Whilst this guide focuses on equity investment,
These are high net worth individuals or small investment- a brief comparison between equity and debt is
focused entities with experience in investing in early- set out below.
stage companies which have already built a product.
Equity: An equity investment is a subscription for,
3. Venture capital trusts or acquisition of shares in a company. An equity
These are publicly traded companies listed on the London investor provides the investee company with cash
Stock Exchange which invest in early stage unquoted and receives an ownership stake in return.
companies through pooled investor money.
Debt: A debt investment involves the lending
4. Venture capital funds of funds to an investee company at an agreed
These invest pooled investor money to provide financial rate of interest, usually repayable in instalments
and operational expertise for early stage, innovative during a specified period.
businesses with strong growth potential.

3. Stages of investment

The stages of equity investment into a company typically follow the following:

Private equity
Private equity funds
Series B typically acquire
stakes in much later
While seed and Series
stage companies. As
A funding is used by
Series A these funds’ returns
companies to meet initial
are generally based
Once it has a more set up costs and support
on their ability to
Seed established track record early stage growth,
improve a business’s
This is the first round of and business model, Series B funding is
performance and sell
external funding that a a company may opt typically sought to fund
it on for a profit, they
business seeks, to help for Series A funding to further expansion. Again,
tend to take controlling
meet its initial start-up continue to grow its series B fundraisings
stakes in a company
costs. The investor base business. Angel investors tend to involve minority
and leave founders with
tends to comprise angel and venture capital firms investments. The terms
minority shareholdings
investors (high net worth typically dominate these of the investment
(if anything).
private individuals) and rounds, taking minority documentation may
venture capital funds, and stakes and seeking be varied at this stage
may also include founders’ certain investor to include additional
family members and protections in minority protections,
friends. Founders tend to the investment depending on the
retain majority stakes at documentation. requirements of any new
this stage, and third party investors coming in.
investors typically take
minority shareholdings.

5
4. Key investment documents

The following key documents are typically involved in the implementation of an investment:

Confidentiality agreement Subscription/investment agreement

Before any substantial negotiations take place, the parties This is the mechanical agreement by which an investor
will enter into a confidentiality agreement. This prohibits agrees to subscribe for shares in a company for a
them from sharing the information they provide to one particular subscription price, and the company agrees to
another relating to the investment with third parties. issue those shares to it. It also usually contains warranties
given by the company and its founders or managers to
Information memorandum investors about the state of the business and the potential
Investee companies will typically prepare a presentation investment.
for investors about the company, containing material
information about the company’s business, operations, Disclosure letter
finances, capital structure and future plans. Companies will If the company and/or its managers have given warranties
need to seek specialist regulatory advice before sharing to investors in the investment documentation, they
any information with investors to ensure that they do so in may wish to provide a disclosure letter to investors to
compliance with all applicable regulatory obligations. accompany these. This letter gives the warrantors the
opportunity to disclose any matter which might render
Term sheet any warranty untrue (and thereby avoid liability for claims
As a first step, the parties will agree the main terms and for breach of warranty in respect of such matters after the
conditions of the investment in a term sheet. This will investment completes).
serve as a basis for the subsequent negotiation of full form
documentation and tends not to be legally binding. It may, W&I insurance policy
however, contain some legally binding provisions, such Investors and / or warrantors may wish to insure the
as an obligation for the investee company to negotiate warranties under a warranty and indemnity insurance
exclusively with the investor for a certain period. policy, to protect one or both parties in the event of a
breach of warranty. The appropriateness of such a policy
Articles of association will need to be considered on a case by case basis. A
These govern the internal affairs of a company and function warranty and indemnity insurance broker will typically
as a contract between the company and its shareholders. assist with this aspect of an investment transaction,
They are publicly available at Companies House and set liaising with lawyers and insurers to negotiate an
out details of the rights attaching to shares issued by the appropriate policy for the deal.
company and related governance information.

Shareholders’ agreement
This is an agreement between the shareholders of a
company regulating the relationship between them. The
company is usually also a party. Unlike a company’s Articles,
it is a private document and does not need to be publicly
filed. It is therefore typically used to record personal,
confidential or sensitive agreements reached between
shareholders. Shareholders’ agreements often deal with
matters such as investor decision-making, shareholder
consent rights and the protection of minority shareholders.

6 A basic guide to investment

5. Ancillary documentation

In addition to the key documents listed, a suite of supporting documents will be required to implement the investment:

Shareholder approvals
Certain approvals may be required from the target company’s existing shareholders. For example,
existing shareholders may need to give the directors of the company authority to issue new shares to
investors, or to waive their pre-emption rights in respect of the proposed share issue, or to approve the
company’s adoption of new articles of association. Certain other shareholder consents may also be
required under the company’s existing investment documentation.

Board approvals
The directors of an investee company will generally need to approve and authorise the company’s entry
into the investment documentation and issuance of shares pursuant to it, among other matters. This is
typically done by a board meeting or directors’ written resolutions. The company’s existing articles of
association should be checked to ensure the right approach is adopted. If the investor is a company, it
may also need to secure certain approvals to enter into the relevant documentation and subscribe for
shares under it. This will need to be checked and confirmed on a case by case basis.

Service agreements
Investors may ask founders and senior management team members who do not already have service
agreements with the company to enter into these on or before the investment completes. Service
agreements help to ensure that key members of the company’s management team continue to
contribute to the success of the company. They also tie into the good leaver / bad leaver provisions in
the investment documentation (as discussed below).

Administrative filings
Once the investment has been completed, the company will need to update its register of members,
issue share certificates to the new investors and make any appropriate filings at Companies House.
These include, among other items, any special resolutions passed by shareholders in connection with the
investment, a copy of the new articles of association of the company (if adopted) and a form SH01 which
indicates that shares have been allotted in the company.

“Excellent market knowledge, very commercial,

pragmatic and practical advice.
- Corporate M&A, Legal 500 2020

A basic guide to investment 7

6. Timeline

Investments can be implemented in a very short timeframe or take months to complete. This will
depend on the number of investors involved, the complexity of their interests and the terms on which
they are seeking to invest, and the willingness of all parties to work cooperatively to achieve their goals.

A typical investment might take eight weeks from the start of discussions to completion. An indicative
timeline is as follows:

Identify investee company

Enter into a
confidentiality agreement
1 week

Information memorandum
provided to investor

Draw up a
non-binding term sheet

Due diligence on
the investee company

Negotiate investment agreement /

6 – 7 weeks

shareholders’ agreement

Obtain board and

shareholder approvals

Update shareholder register

and complete filings

8 A basic guide to investment

7. Key commercial terms

Investment documentation will typically cover the following key terms:

Board composition Tag provisions

The board of directors of an investee company will These provide that, if a certain percentage of a company’s
normally comprise senior executives including the shareholders agree to a sale, the remaining shareholders
CEO and CFO. Investors may seek the right to appoint can tag along with them and sell their shares on the same
a director to the board. Whilst larger shareholders terms and conditions. The threshold at which tag rights will
typically can successfully negotiate this right, minority be triggered is negotiated between the shareholders, but is
shareholders may instead be given a right to appoint usually set at a level which represents a change of control of
an observer to the board (or nothing at all). It is also not the company. Tagging shareholders may be given the right
uncommon to see investors being given rights to appoint to transfer all or a pro rata proportion of their shares to the
a director or observer for as long as they hold a certain relevant buyer.
percentage of the company.
Transfer restrictions
Investor consent rights Investors and companies will generally seek to restrict
Investors will be keen to negotiate rights which prevent shareholders’ rights to transfer shares to third parties.
managers and/or other shareholders making key decisions Often, share transfers will be subject to investor
about future fundraisings and/or the operation of the consent, or to pre-emption rights in respect of existing
business without their consent. Investors may seek veto shareholders. Certain limited transfers to, for example,
rights, whereby their consent is required for certain members of a shareholders’ family or corporate group,
key decisions. Alternatively, they may seek to include may be permitted without restriction.
a requirement that the company does not take certain
actions without the consent of a specified majority of Leaver provisions
investors. A company will generally want to retain as much These generally provide that, if an employee shareholder
decision-making flexibility as possible, and be conscious of leaves the company, the company (or its shareholders) can
the administrative burden of having to obtain shareholder acquire their shares back from them at a pre-agreed price.
consents for decisions. This aspect of investment If the employee shareholder leaves for a “good” reason
documentation is therefore often heavily negotiated to (e.g., death, incapacity or redundancy) they will usually be
ensure the balance of interests is properly addressed. entitled to sell their shares for the higher of cost price and
fair market value. If, however, the employee shareholder
Pre-emption rights leaves for a “bad” reason (e.g., resignation or misconduct),
When companies issue new shares to incoming investors, they will be required to sell their shares for the lower of
the holdings of existing shareholders are diluted and as cost price and fair market value. An employees’ shares may
a result become less valuable. Shareholders therefore also be subject to vesting provisions, whereby his or her
typically seek a right to subscribe for new shares pro rata shares only become valuable after completion of a certain
to their existing shareholdings before the company offers period of employment.
them to new investors. Although these rights do exist
under the Companies Act 2006, the statutorily prescribed
procedures can be burdensome to comply with, so parties
will often seek to disapply them and replace them with
bespoke provisions in the investee company’s articles.

Drag provisions
These provide that, if a certain percentage of a company’s
shareholders agree to a sale, the remaining shareholders
can be dragged into the sale and forced to sell their shares
on the same terms and conditions. The threshold at which
drag rights will be triggered is negotiated between the
shareholders, but is usually set at a level which represents
a change of control of the company.

A basic guide to investment 9

8. Conclusions

This guide is only a summary of the key steps involved in implementing an investment. Making or receiving
an investment can be relatively straightforward, but there are many potential pitfalls which parties will need
to be aware of as they progress through the process.

Specific legal, tax, accounting, financial and regulatory input should all be sought at an early stage, to
ensure that all parties are appropriately advised and protected.

Farrer & Co’s Corporate team regularly acts for private investors, venture capital funds, private equity firms,
family investment offices and investee companies on all aspects of investment. We would welcome the
opportunity to discuss any aspect of this guide with you.

9. Key contacts

Clementine Dowley Jonathan Haley

Associate Partner, Key Contact for Corporate
+44 (0)20 3375 7489 +44 (0)20 3375 7552
[email protected] [email protected]

Co-author Adam Phillips, Farrer & Co

10 A basic guide to investment

10. Glossary
Ancillaries an umbrella term for supporting documentation such as board minutes, shareholder resolutions,
stock transfer forms and Companies House filings that are required to effect a transaction

Articles of a document governing the internal affairs of a company

association

Confidentiality a legally binding contract between parties to an agreement preventing either party from
agreement sharing the information they provide to one another with third parties

Disclosure letter a letter given by the investee company / managers disclosing matters that would make any
warranties untrue

Drag-along a provision enabling a majority shareholder to force a minority shareholder to join in the
provisions sale of a company

Good and bad provisions incentivising key executives to stay with the company and deterring them from
leaver provisions leaving the company and/or to protect shareholder value from non-performers

Pre-emption rights provide existing shareholders with the right to buy newly issued or transferred shares in
the company before the shares are offered to the general public

Seed first official equity funding stage used to help companies finance market research and
product development

Series A first external (other than friends and family of the founder) equity funding stage used to
help companies develop their product and hire employees

Series B second external equity funding stage used to help companies to scale their operations and
move towards generating a profit

Shareholders’ a private agreement entered into between all or some of the shareholders in a company
agreement regulating the relationship between them

Subscription/ an agreement dealing with the subscription for shares by the investors in return for the
investment investment monies
agreement
Tag-along a provision enabling a minority shareholder to have his shares bought on the same terms
provisions as majority shareholders

Term sheet a (largely non-binding) document setting out the key terms of the proposed transaction

Warranty & an insurance policy providing cover for losses arising from a breach of warranty
indemnity
insurance policy
A basic guide to investment 11
Farrer & Co LLP
66 Lincoln’s Inn Fields
London WC2A 3LH
+44 (0) 20 3375 7552
[email protected]
www.farrer.co.uk