Can You Accept Investment Before Your Shareholders Agreement Is Ready?

An investor is ready to wire the money, but your Shareholder Agreement is still being finalized. Rather than delaying the investment - and potentially slowing down funding your business could really use - you might be tempted to accept the money now and finish the documents afterwards.

Can you do that?

Potentially, yes. A Shareholder Agreement does not always need to be finalized before an investment can move forward. However, that does not mean you should accept investor money without properly documenting what the investment is and what the investor receives in return.

The documents you need will depend on how the investment is structured, whether the investor is receiving stock immediately or investing through something like a SAFE or convertible note, and the corporate and securities laws that apply.

This article focuses on corporations issuing stock. Investment into an LLC works differently and will generally involve membership interests and an Operating Agreement rather than shareholders and stock.

What Actually Needs To Be Agreed Before You Take The Money?

Not every investor becomes a shareholder as soon as they invest.

An investor buying stock may become a shareholder when the investment closes and the shares are properly issued. By contrast, someone investing through a SAFE or convertible note may provide money now without receiving stock immediately.

That distinction matters because a Shareholder Agreement is only one part of documenting an investment.

Before investor money changes hands, the company and investor should be clear about the key terms of the deal. Depending on the investment, this could include how much is being invested, what the investor receives in return, the price or valuation, the number and class of shares, when the investment closes and any conditions that need to happen first.

For an investment that may convert into stock later, the parties will also need to agree on the relevant conversion mechanics. Depending on the instrument, this could include matters such as a valuation cap, discount, conversion events and what happens if the expected financing never occurs.

These terms will not necessarily all sit in a Shareholder Agreement. They may instead be recorded in a stock purchase agreement, SAFE Agreement, Convertible Note or another agreement designed for the particular financing.

Getting this clear before accepting the money can help avoid a much harder question later: what exactly did the investor pay for?

A Term Sheet Is Not The Same As The Final Investment Documents

Perhaps you already have a Term Sheet setting out the proposed investment. Does that mean you are ready to accept the funds?

Not necessarily.

A term sheet is commonly used to record the main commercial points of a proposed investment before the definitive documents are prepared. Depending on the deal, it might cover valuation, the amount being raised, the type of security being issued, investor rights, board representation and other important terms.

However, a term sheet does not automatically replace the documents needed to complete the investment.

Many investment term sheets are intended to be largely non-binding, apart from particular provisions such as confidentiality, exclusivity or expenses. Whether a particular provision is legally binding will depend on how the document has been drafted and the circumstances surrounding the agreement.

So, while a signed term sheet can be an important step towards an investment, it should not automatically be treated as permission to wire the money and figure out the details later.

What If The Investor Is Receiving Stock Immediately?

If the investor is buying stock now, the investment itself should be properly documented even if the final Shareholder Agreement or other ongoing investor documents are still being negotiated.

For a relatively straightforward investment, this might involve a stock purchase or subscription agreement setting out the number and class of shares being purchased, the purchase price, representations made by the parties and what needs to happen at closing.

For a larger priced financing, however, the paperwork can be broader.

US venture rounds may use several coordinated documents dealing separately with the purchase of stock and the investor’s ongoing rights. For example, these can include a Stock Purchase Agreement, Investor Rights Agreement, Voting Agreement, Right of First Refusal and Co-Sale Agreement and amendments to the company’s Certificate of Incorporation.

This is an important distinction.

The document that gets the investor into the company does not necessarily have to be the same document that governs everyone’s ongoing rights afterwards.

Does The Company Actually Have The Stock Available To Issue?

Before promising an investor a particular number or class of shares, the company should check its existing corporate documents and cap table.

Corporate law in the US is primarily state-based, so the exact requirements will depend on the company’s state of incorporation.

The company should generally check whether it has enough authorized but unissued shares, whether the proposed class or series of stock already exists, which corporate approvals are required and whether any existing shareholder or investor rights affect the issue.

For example, under Delaware law, the board generally authorizes the issuance of stock and determines the consideration and other terms of the issuance, subject to the corporation’s Certificate of Incorporation and applicable law.

The Certificate of Incorporation also sets out the classes and number of shares the corporation is authorized to issue, along with relevant rights and preferences.

This means that if a company wants to issue more shares than it currently has authorized, or create a new class of preferred stock that its existing Certificate does not accommodate, additional corporate steps may be required before the financing can close.

An investor saying “I’m ready to wire the money” is therefore not necessarily the same thing as the company being legally ready to issue the stock.

What About Existing Shareholders And Investors?

Bringing in a new investor can dilute existing shareholders and may affect rights that have already been granted to earlier investors.

Whether shareholders have statutory preemptive rights depends on the relevant state law and the corporation’s governing documents.

For example, Delaware shareholders do not automatically have preemptive rights to subscribe for new stock. Those rights generally need to be expressly provided for in the corporation’s Certificate of Incorporation.

Existing investors may still have contractual rights, though.

An Investor Rights Agreement, Shareholder Agreement or earlier financing document might give certain investors pro rata participation rights, approval rights or other protections relating to future stock issuances.

Before promising a new investor a particular percentage of the company, the company should therefore check both its governing documents and any existing investor agreements.

What Corporate Approvals Are Needed?

A financing also needs to be properly approved under the corporate law of the company’s state of incorporation and its governing documents.

For a corporation, this will commonly involve board approval of the financing and the securities being issued. Depending on the transaction, shareholder approval or amendments to the Certificate of Incorporation may also be required.

A Board Consent can be used in appropriate circumstances to formally document the board’s approval of an equity issuance and related financing documents.

Directors approving a financing also need to exercise their authority consistently with the fiduciary duties that apply under the company’s state of incorporation. This can become particularly important where a transaction will significantly dilute existing shareholders, affect control of the corporation or create different economic rights between shareholders.

The company should also make sure its stock ledger and cap table accurately reflect the securities that have actually been issued.

Good corporate records become particularly important when the company raises another round, goes through due diligence or is eventually acquired. Trying to reconstruct several years of informal equity arrangements at that point can be much harder than documenting the investment properly when it happens.

Do Federal Securities Laws Apply?

Yes.

Stock, SAFEs, convertible notes and other startup investment instruments can involve the offer and sale of securities. At the federal level, every offer and sale of securities generally needs to be registered with the Securities and Exchange Commission unless an exemption from registration is available.

Private companies commonly raise capital using an exemption rather than conducting a registered securities offering.

One frequently used framework is Regulation D.

For example, Rule 506(b) can be used for qualifying private offerings without general solicitation. Rule 506(c), on the other hand, permits general solicitation where all purchasers are accredited investors, the company takes reasonable steps to verify their accredited investor status and the other requirements of the rule are satisfied.

Which exemption is appropriate depends on factors such as how the raise is being conducted, who is investing and how the investment opportunity has been marketed.

If a company relies on Regulation D, it must generally file a Form D notice with the SEC within 15 calendar days after the first sale.

Importantly, for Form D purposes, the “first sale” is when the first investor becomes irrevocably contractually committed to invest. That may occur before the funds are actually transferred.

This is another reason securities compliance should be considered as part of the investment process rather than something to clean up once the money has arrived.

What About State Securities Laws?

Federal securities law is not the end of the analysis.

States also have their own securities laws, commonly referred to as “blue sky” laws.

Depending on the exemption being used and where investors are located, the company may have state notice filings, fees or other compliance requirements.

For Rule 506 offerings, federal law preempts substantive state registration and qualification requirements, but states can still require notice filings and fees and continue to enforce their anti-fraud laws.

So, even where a company has identified an appropriate federal exemption, it should not assume there is nothing further to consider at state level.

What If The Investor Isn’t Becoming A Shareholder Yet?

This is particularly common in early-stage US fundraising.

Instead of completing a priced equity round immediately, a startup may raise funds through a SAFE Agreement or Convertible Note.

A SAFE - short for Simple Agreement for Future Equity - is an agreement where the company promises an investor a future ownership interest if specified triggering events occur, such as a later equity financing or acquisition.

Importantly, holding a SAFE does not itself give the investor an ownership interest in the company. The investor receives that ownership interest if and when the SAFE converts into equity in accordance with its terms.

A convertible note works differently. It generally begins as debt and can later convert into equity under the terms of the note.

Because stock is not necessarily issued immediately, SAFEs and convertible notes can allow startups to raise capital before completing a priced equity financing.

However, that does not mean the investment can remain informal.

A SAFE should clearly deal with matters such as the investment amount, relevant valuation cap or discount, conversion events and what happens in circumstances such as a sale or dissolution.

A convertible note may also need to deal with interest, maturity, repayment and the circumstances in which the debt converts into stock.

And importantly, using a SAFE or convertible note does not remove securities-law considerations. The company still needs to consider the federal and state rules that apply to the offering.

You may be able to postpone issuing the stock. You should not postpone documenting the investment.

Can You Make The Investment Conditional On The Final Documents?

Another option is to agree to the investment but delay closing until the remaining documents are ready.

For example, a definitive investment agreement can provide that closing only happens once certain conditions have been satisfied.

Depending on the deal, those conditions might include obtaining board approval, getting required shareholder consents, amending the Certificate of Incorporation, dealing with existing investor rights or executing the final Shareholder Agreement and other financing documents.

This can give both the company and investor certainty around the proposed transaction without putting the company in a position where the money arrives before it is legally ready to complete the financing.

If the documents are nearly finished, coordinating the wire transfer with the formal closing can often be much cleaner than taking the funds early and trying to complete the remaining legal steps afterwards.

What If The Investor Has Already Wired The Money?

Sometimes the money arrives before the paperwork catches up.

Perhaps the investor transferred it after a handshake agreement. Maybe everyone signed a term sheet and assumed that was enough. Or perhaps the company intended to issue stock but never completed the board approvals or final investment documents.

If this happens, the first step is to establish exactly what occurred.

Was the payment intended to purchase stock, a SAFE, a convertible note or something else? Has anything actually been issued? What do the emails and existing documents say? Was the transaction approved by the board? Has the cap table been updated? Was an appropriate securities exemption identified and were any required filings made?

Avoid simply backdating documents or changing the cap table to make the records look as though everything happened correctly at the time.

Depending on the issue and the company’s state of incorporation, there may be procedures for ratifying or validating defective corporate actions. However, the solution should be based on what actually happened rather than trying to recreate the transaction retrospectively.

Getting the position reviewed early can be much easier than discovering an equity problem when a future investor starts due diligence.

Why Not Just Finish The Shareholder Agreement Later?

Sometimes you can.

But if the investor has already become a shareholder, negotiating their ongoing contractual rights afterwards can become much harder.

A Shareholder Agreement might cover matters such as voting, management, share transfers, future fundraising and what happens if a shareholder wants to exit.

In a US venture financing, some investor rights may instead sit in separate documents such as an Investor Rights Agreement, Voting Agreement or Right of First Refusal and Co-Sale Agreement.

The important point is that these contractual rights do not automatically appear simply because someone invested.

Becoming a shareholder also does not automatically make the investor a party to a Shareholder Agreement. The relevant parties generally need to execute the agreement, or an appropriate joinder, before they are contractually bound by it.

That is why it is worth deciding which ongoing investor and shareholder rights need to be agreed before closing rather than assuming the company can sort them out afterwards.

So, Can You Accept Investment Before The Shareholder Agreement Is Ready?

Potentially, yes.

A pending Shareholder Agreement does not necessarily mean the entire investment needs to stop. What matters is whether the investment itself has been properly structured, approved and documented.

If the investor is buying stock immediately, that might involve a stock purchase or subscription agreement, the necessary Board Consent and other corporate approvals, sufficient authorized stock and any other investor documents required for the round.

If the investor is providing money now for equity later, a SAFE Agreement or Convertible Note may allow the company to raise the funds without issuing stock immediately.

In either case, federal and state securities requirements still need to be considered.

Alternatively, the parties can agree on the investment but make closing conditional on the remaining documents being signed.

What you generally want to avoid is accepting the investor’s money first and leaving everyone to work out what they actually bought afterwards.

Getting Your Investment Documents In Place

There is no single document that covers every US investment.

A Shareholder Agreement can deal with the ongoing relationship between shareholders. A SAFE Agreement or Convertible Note can document an investment that may result in equity later.

A stock purchase agreement can document a direct investment in shares, while an Investor Rights Agreement and other financing documents may deal with additional investor rights. If you are still agreeing on the main commercial terms of the raise, a Term Sheet can also help record those terms before the definitive documents are prepared.

The right document suite depends on the type of raise, your state of incorporation, your existing cap table and governing documents, and the rights being negotiated with the investor.

Getting legal support before the funds are wired can help make sure the investment documents, corporate approvals, securities requirements and ownership records all line up properly - rather than trying to fill in the gaps once the investor is already on board.

If you would like a consultation on getting the right legal agreements sorted before accepting investments, you can reach us at (888) 449-8437 or team@sprintlaw.com for a free, no-obligations chat.