Investment Agreements

Simultaneously with the due diligence process, the parties' legal representatives conduct negotiations for the conclusive investment agreement. The investment agreement is an agreement for the sale of shares in the company to the investors in consideration for a certain amount of money (the investment). Although the transaction appears to be a simple one (ostensibly nothing more than the sale of an asset for money, a transaction commonly made for thousands of years), an agreement for an investment in a startup company is a complex legal document which regulates many issues concerning the investment itself, and the future relationship between the company and the investors and often also with other entities such as employees, directors, and previous investors. These agreements are packed with professional terms, most of which are unclear to anyone not proficient in legal language.

There are several approaches to drafting investment agreements. The customary method is to include in the investment agreement all the issues pertaining to the investment, including the rights attached to the investor's shares and the balance of power within the company, issues which are usually regulated also in the company's organizational documents (the certificate of incorporation or the bylaws). The supporters of this approach emphasize the importance of creating one document which embraces all the relevant arrangements, even at the cost of having these issues repeated in other documents. Another advantage is the independent course of action afforded to the parties to the contract, as opposed to the situation in which these issues are regulated only in the company's bylaws, which creates a doubt as to an individual shareholder's right to sue the company alone. According to another method, the investment agreement should not repeat issues which are already regulated in other documents or agreements. Another advantage in creating separate documents is that whenever an investor joins the company, the bylaws need not be changed and it is sufficient to join him in existing agreements.

There is no uniform structure for investment agreements, but a typical structure would include the following components:

• The transaction— The material terms of the transaction (the sale of securities in consideration for an investment) are discussed.

• The company's representations and warranties— This is usually the longest chapter in the investment agreement and the subject of lengthy discussions by the attorneys. "Reps and warranties" are designed to provide detailed information about the business and condition of the company and to enable the party relying on the representations to file a complaint if a representation is breached. However, where startups are concerned, as opposed to acquisition transactions involving giant companies, if a representation is breached and material damage is caused, the company will in any case not have the money required to compensate the investor. However, it is customary to require an opinion by the company's attorney with respect to certain legal representations, thus creating a "deep pocket" from which compensation can be sought in some cases, at least in theory. Over and above these representations, investors are protected against misrepresentations, fraud, or undue disclosure by standard provisions in the laws of contracts, torts, and securities. Section 10b-5 of the Securities Exchange Act of 1934 provides protection in most cases against the breach of a representation in an agreement to purchase securities. A contractual representation is, however, still legally superior since a complaint can be filed due to the breach of a contractual representation even without the presence of a state of mind (such as knowledge) or negligence by the party who made the representation.

  Another substantial advantage of reps and warranties is that they compel decision-makers to pay attention to and discuss all of the issues included in them. Bringing problematic issues to the surface enables the company to deal with them and enables investors to better quantify the risks involved in the transaction.

  It is customary to provide reps and warranties on many issues: the organization of the company and its organizational documents, the authority to sign the investment agreement, the company's share capital and undertakings to allot shares, its financial condition, property, intellectual property, material agreements, legal proceedings in which it is involved, taxation, employees, debts, and other issues that are unique to the company or have surfaced in the due diligence process. From the company's point of view, it is best to qualify the reps and warranties, so that only a breach having a Material Adverse Effect (MAE) on the company will entitle the investor to a remedy.

• The investor's representations and warranties— Except for the standard reps and warranties with respect to the investor's authority to invest and his or her financial ability to do so, it is customary to request representations pertaining to the investor's experience in venture capital investments and to his or her status as an "accredited investor," as well as additional representations supporting the classification of the transaction as a private sale which does not require the filing of a registration statement.

• The company's covenants— In contrast to representations and warranties which are a declaration of facts, a covenant is a promise to perform or refrain from performing certain acts in the future. There are two types of covenants: affirmative covenants such as an undertaking to provide financial information, and negative covenants such as an undertaking to refrain from performing certain acts without the investor's approval.

• Conditions precedent to closing— There are certain acts which the company undertakes to perform by the date of closing: usually obtaining approvals and adopting resolutions, changing the bylaws, having employees and entrepreneurs sign employment agreements, and other undertakings. If these acts can be performed relatively quickly, a shortcut may be taken by closing the transaction concurrently with the signing of the investment agreement, without holding a separate closing.

• Closing— In the closing, it is verified that all of the conditions precedent to closing have been met and that all of the documents which need to be delivered at the closing have been prepared. In some cases, there are several closing dates, either because the investment is made according to milestones or because additional investors are expected to join. In general, it is recommended that the transaction be closed as soon as possible without waiting for additional investors. Once the first investor is in, it is easier to attract more investors.

• Indemnification— It is customary for companies to undertake in the investment agreement to indemnify the investors for any damage they may suffer due to the breach of a representation or a covenant by the company. Although the parties and their attorneys dedicate much time to indemnification clauses, they are of little importance; legally, the investors are in any case entitled to a remedy under the laws of contracts or torts for the breach of a representation or a covenant. However, the company typically has no "deep pocket" from which the investors would be able to collect in case of such breach unless the company is about to make an IPO and has tangible assets and cash at its disposal. A partial solution is providing indemnification in the form of shares, not cash. From the company's point of view, it is best to try to limit, in the indemnification clause, the period of time in which a complaint can be filed for the breach of a representation. The statutes of limitation in most countries allow several years after the contract is signed, and in certain cases even after the breach is discovered, to file a contractual complaint. This exposes the company to a possible "retroactive complaint" by an investor who discovers after several years that his or her investment was unsuccessful and is looking for ways to collect his or her loss from the company. A possible solution is to limit the time frame for filing a complaint due to breaches in good faith.

• Schedules and exhibits— Two types of appendices are attached to investment agreements: disclosure schedules, which constitute part of the reps and warranties and provide information about the company; and additional exhibits, such as the organizational documents, employment agreements, and projected budget. Sometimes the company's legal counsel's opinion on legal matters is also attached to the agreement.