Understanding Investment Agreement Terms before Pitching to Investors

In today’s corporate environment, growth of any business depends upon various factor one of the most critical being the availability of adequate funding.

It is essential for every business to meet its working capital requirements on a timely basis. Companies operating with adequate and well-planned funding are better positioned to sustain operations, capitalize on growth opportunities, and withstand market uncertainties. In contrast, businesses facing funding constraints often encounter significant challenges that adversely affect their growth and long-term survival. Accordingly, access to sufficient and timely funding remains a fundamental element in the success of any business.

A company may raise funds through various sources like Loan from Bank, Loan from Member, Director or Relatives, External Commercial Borrowing etc. However, when such funding options are not feasible or sufficient, businesses may consider private equity and venture capital investments to facilitate growth and ensure business survival.

While private equity (PE) and venture capital (VC) funding can be an effective growth option, it requires careful execution, as inadequately structured documentation may lead to significant challenges for the business. Certain key documents, such as the Term Sheet, Share Subscription Agreement, Shareholders’ Agreement, and Investment Agreement, are required to be executed when dealing with a venture capital investor.

Further, it is important for the business owner to have clarity on the key issues that must be considered as detailed below:

1. Right of First Refusal: It is also known as ROFR Clause, under the Right of First Refusal Clause, if the Company/ Businessman intends to sell or transfer its share to any other person, then in such a case, a Private Equity/ Venture Capital Investor having the Right of First Refusal may urge the Businessman / Company to buy the shares of the Company at the same terms and conditions and at the same price as those offered to the third party.

For Example: Mr. A has purchased shares of a Company ABC Limited with the Right of First Refusal, now suppose Mr. B (existing shareholder of the Company ABC Limited) intends to sell his shares to Mr. C at a price of 150 Per share. Since Mr. A is having Right of First Refusal, Mr. B first has to offer the shares to Mr. A for purchasing it at same price and terms and condition as those proposed Mr. C. and Mr. A reserve the right to purchase it at same terms and condition from Mr. B. Further here Mr. B can only sell his share to Mr. C once the same is being refused by Mr. A to Mr. B.

2. Ratched Clause (Anti-Dilution Clause):It is also known as Anti Dilution Clause or price protection, under the Ratched Clause, interest of PE/ VE Investor is protected against the significant dilution in its shareholding.

For Example: At the initial stage of funding, Mr. A purchased 5% Equity shares in ABC Limited at a price of 15/- Per share, later on, in the second stage of funding, ABC Limited has offered the shares to Mr. B at a price 10/- per shares, Now Mr. A having Anti Dilution, may force ABC Limited to convert his share at a price Rs. 8/- per share thereby increasing in number of shares.

Example No. 2: Suppose Mr. A intends to purchase share of ABC Limited, it was agreed between both the Parties, i.e. ABC Limited and Mr. A, that Mr. A will only hold upto 5% of the Equity shares of ABC Limited, now in future ABC Limited again come up with issue of share and increased its paid up share capital from Rs. 1,00,000/- Rs. to 2,00,000/- Rupees, due to such increase in share, holding of Mr. A had been reduced, now Mr. A having Anti Dilution right, may urge ABC Limited to let him participate in the further issue of share so that his shareholding of 5% remain intact.

3. Tag-Along Right: Through Tag along Right, significant interest of PE/ VC Investor is being protected. Under this if the majority of the shareholders sell their shareholding in the company, then in that scenario, PE/ VC Investor having Tag Along right, may elect to participate in such sale and sell its shares at the same term and conditions as those applicable to the majority shareholders.

For Example: ABC Limited at the very initial stage of its funding had offered 5% Equity share to Mr. A with Tag Along Right. Later on, after 5 years of its business, ABC Limited and it shareholders are intending to sell entire of its business and found the buyer Mr. B, now as Mr. A is having the Tag Along Right, he can also participate in the transaction and sell his 5% shares to Mr. B at the same price and term and conditions at which ABC Limited and its shareholders has agreed with Mr. B.

4. Drag-Along Right (Bring Along):Also known as Bring Along Clause, this type of clause is structured in such a manner that if the majority shareholders are ready to sell their shareholding or stake in the company to the third person then it would become obligatory on the part of the remaining shareholders to sell their share also.

Further this drag-along right or Bring Along can be enforced only when the consent of majority shareholders of the Company is taken.

For Example: ABC Limited at the very first stage of funding has issued 10% Equity shares to Mr. A at a price of 20/- per share by holding Drag Along Right, now suppose after 5 years of its business, ABC Limited and its shareholders intends to sell entire of its business and found a buyer B, now since ABC Limited is having Drag Along Right, it may compel Mr. A to sell his stake or shareholding in the Company to Mr. B at the same price and term and condition upon which ABC Limited has agreed with Mr. B.

5. Pre-emptive right on new share: Under this Clause if the Company is intending to issue new shares, then in such a scenario the Company has to first offer the shares to the Investor having pre-emptive right, to buy the shares of the Company, before offering the same to third person, at the same price and with same terms and conditions at which the Company is offering such shares to the third person.

For Example: Suppose Mr. A had purchased the shares of the Company ABC Limited with pre-emptive right, now in case ABC Limited proposed to issue new shares to Mr. B then by virtue of pre-emptive clause, ABC Limited had to offer such new shares to Mr. A and only thereafter Company can offer the same to Mr. B.

The right as mentioned above are also specifically mentioned in the Companies Act, 2013 wherein same right is provided to the investor. As per the section 62 of the Companies Act, 2013 under which if the Company is intending to issue new shares to someone, other then Private Placement, then in that case the company would be required to first offer such shares to its existing shareholders.

6. Management Control: Under this Clause, the PE/ VC investor shall be eligible to appoint any person from his side as a Director of the Company i.e. at the Board Level of the Company. Further under this clause, what would be the criteria for appointment of such person as Director be decided like whether he/she would be required to hold shares and how and in what manner he/she would have control over the management etc needs to be mentioned specifically.

7. Conversion Right: Suppose if the PE/ VC Investor has purchased the preference shares in the investee Company with the conversion right, now the Investor reserve the right to choose or force the Investee Company to convert their preference shares into the equity shares of the Company before liquidation of the Company or after expiry of certain time period as decided at early stage of investment.

 Practically conversation of preference shares into equity shares are delayed till the time Investee Exit from the Company so that he/ she can easily enjoy rights of having preference over the Dividend on the preferences shares of the Company.

8. Veto Right/ Power: It is also known as Protective Provisions, Veto Right or Veto Power etc, normally every investor while investing his capital in any company insist the company to grant them veto right on certain reserved matter on which the company cannot take any decision without affirmative vote of the Investor.

For Example: Suppose Mr. A has invested Rs. 1 crore into a Company ABC Limited with Veto Power over the alteration of any clause under Memorandum of Association and Article of Association. Now if ABC Limited intends to increase its Authorized share capital resulting in Alteration of Memorandum of Association. Now in this situation the Company can’t amend its charter documents without the prior permission of Mr. A (having Veto Right).

9. Information Right: Every investor when invest its capital into any company he expects that the funds are used for their intended and legitimate purposes and are neither underutilized nor misused. To assess this, investors typically require the right to periodically review the company’s financial position, budgets, and other relevant documents, and to inspect the books and records of the company.

10. Liquidation Preference: It is the contractual right of the Investor to get preference in receiving amount of proceeding in case the company goes into liquidation. Practically as the Private Equity or Venture capitalist are investing their hard-earned money at very early stage of business of any company, so in case Company goes into liquidation or Company sell their entire business to someone, then such VC shall get the preference, over the common stock holder, in receiving a certain amount of proceeding.

There is also a concept of “Multiple” (2X, 3X or 4X) in case of Liquidation preference, it is advisable to pay extra care while inserting these types of clauses. Under this type of Clauses Investor are entitled to get multiple of his original investment (double or triple etc) before common stockholder get anything in return.

11. Materiel Adverse Changes: Also known as MAC Clause or Material Adverse Effect. This clause typically grants the investor the right to refuse to consummate the transaction or to renegotiate the terms if any unforeseen event or circumstance occurs between the execution of the transaction documents and the closing, which materially and adversely affects the business, operations, financial condition, or prospects of the company.

 It allows the businessman to disclose and qualify certain representations and warranties prior to closing, so that disclosed matters are not treated as breaches at the time of closing.

12. Put Option: As per this clause the Investor reserves the right to sell their shares to the Company where an exit opportunity is not provided to the Investor in the form of IPO/ Buy Back.

It is pertinent to note down here that it is an option on the part of Investor and investor is not under an obligation to sell their shares to the company. However, if the investor exercises their put option right then the Company would be under an obligation to purchase the shares from the Investor at a pre-determined price.

13. Call Option: It gives the right to the Investor to buy the underlying shares at the exercise price, at or within the specified time period. Further it is the right of the Investor and do not create obligation on the part of Investor.

14. Confidentiality: At an early stage of investment process, it is normally agreed between the Investor and the Company that until the completion of the transaction, content and existence of the agreement will be treated as confidential and shall not be revealed by the investor, Company or founders to any third person.

Further this also contain that the above said things can only be revealed after execution of proper agreement or in order to comply with any statutory or other regulatory requirements.

Conclusion: A careful review of the above-mentioned clauses clearly demonstrates that investing in, or raising funds for, a startup is far from a simple exercise. Both parties i.e. Investor and Founder must exercise due diligence and maintain a clear and balanced understanding of these critical provisions at every stage of the transaction. Therefore, a well-structured investment framework, supported by balanced documentation and informed decision-making, is essential to ensure smooth operations and sustainable growth for all stakeholders involved.