Dear Reader,

We hope you had a very enjoyable Easter break.

With bank interest rates low and public equity markets volatile, some of you may be considering investing in a private company. Or you may be looking for vital equity to shore up the balance sheet of your company or expand into new markets. In this month's issue of ‘EveryMonth' we demystify the key legal documents used in private equity investments.

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Best wishes

James Hunt and the team at Everyman

Raising Private Equity? What to Look Out For in the Legal Documents.

If you want to raise finance for your business, external funding will basically either be debt or equity. Debt funding, eg a bank loan, is the most straightforward method, but, especially in the current economic climate, may be unappealing or unavailable. So you may consider raising money by issuing shares - equity - to a new investor.

Depending on the size of your company and the amount of funding you need, potential investors can range from business angels to established private equity providers. But regardless of the type of equity funder, the key investment documents will be the Investment Agreement and the Articles of Association.

The Investment Agreement

The Investment Agreement has two main purposes:

• It sets out the mechanics of the transaction: the number of shares to be issued, the price they are subscribed for and the parties they are issued to.
• It describes the contractual relationship between the investor and your company.

The Investment Agreement is subject to several pre-conditions, such as satisfactory completion of due diligence, reorganisation of share capital, and taking out key man insurance for certain directors.

You will be expected to give certain warranties to the investor: for the company, a maximum liability usually equal to the amount of the investment, and for managers, a liability usually limited to a multiple of their salaries.

The Investment Agreement sets out the expected financial information - generally more comprehensive than the information the company is required to produce by law. The Agreement also addresses representation on the board of directors, and lists matters requiring the investor's consent, ranging from operational matters such as entering into contracts above a certain value to more fundamental matters such as issuing new shares. Make sure these don't unduly hamstring the business's day to day running and that the procedure for getting consent is as efficient as possible.

The investor will require managers to enter into covenants not to compete with the company once they leave; try to negotiate covenants which are no more onerous than those you may already have in your service agreements.

An investment agreement may also contain provisions relating to the investor's (and the company managers') eventual exit from the company. Though the agreement cannot sensibly commit the parties to sell the company at an agreed point in the future, it may set out a general timeframe for exit, and perhaps stipulate the appointment of a corporate finance adviser to market the company. It will also include a ‘Drag Along Article' so that once the holders of an agreed percentage of the equity (often 75%) agree, then all shareholders must sell.

The Articles of Association

An investor usually holds a different class of share from those held by management; the various rights of the different classes of shares are set out in the articles of association.

Shares held by the investor may carry the right to a fixed dividend (a percentage of the amount subscribed), a participating dividend (a percentage of the profits of the company), or a combination of the two. The investor's dividends are always paid before any dividends on managers' shares, and often some of their shares will be redeemable at a set point in the future, guaranteeing the investor at least a partial exit after a fixed time.

The liquidation preference sets out the rights of each class of share to receive capital on liquidation of the company or following the sale of the business. The investor is entitled to be paid before managers, receiving the subscription amount for both preference and ordinary shares, together with any unpaid dividends. Only after all these amounts have been paid will managers be entitled to any payment.

‘Ratchets', which must be carefully drafted, allow managers to increase their percentage shareholding in the company, as an incentive to them to maximise the investor's return. The ‘ratchet' is triggered by the investor achieving a pre-agreed rate of return on investment within a certain timeframe or by an exit being achieved above an agreed price.

Investors will be backing the management team as much as the company, so they try to ensure managers' commitment to the company by restricting their ability to transfer shares other than to certain permitted transferees, generally family trusts or close family members. Any manager leaving the company must also sell his shares. The price he receives will depend on whether, according to the Articles, he is a ‘good leaver', who may offer his shares for sale at their market value, or a ‘bad leaver', who has to sell his shares at their nominal value!

Would you like some more information or advice on this topic? Download a more detailed fact sheet from our website, or call us for some initial advice about your situation. Contact James Hunt on 0845 868 0962 or email james.hunt@everymanlegal.com.

Legal updates and news

• Companies and their advisers are still struggling to cope with Companies House filings on share issues. Changes are promised soon so that the issue price of historic share subscriptions need not be shown.
• The new simplified form of Model Articles of Association for private companies is now available: now may be a good time for a legal review of your Articles and statutory books.