If you’re a business owner looking to raise money for your company, you might think about bringing on an investor like a venture capital or private equity firm. If so, you’ll probably encounter legal paperwork as part of the fundraising transaction, including an investment agreement. This might be now or in the future and in return for cash, labor, an asset, and more.
What exactly is an investment contract?
An investment contract is a legal instrument in which one party invests money in exchange for a return. The Securities Act of 1933 governs investment contracts. To fit in this category, a contract must have the following four elements of the so called Howey test:
- An investment of money
- In a joint enterprise
- With the hope of profiting
- From the efforts of others
Although the Howey Test is not the only testing technique available, it is the most often used to ensure that an investment contract fulfills the security criterion.
Some common types of investors agreements are:
- Stock Purchase Agreement
- Statutory Stock Option Agreement
- Nonstatutory Stock Option Agreement
- Restricted Stock Agreement
- Royalty, Commission, or Percent of Revenue
- Nonstatutory Stock Option Agreement
- Convertible Debt Agreement
- Simple Agreement for Future Equity
Stock Purchase Agreement
Purchasing shares outright is the most basic form of investing in a company. Following share purchase, you become a shareholder of the company. That’s why, in addition to the stock purchase agreement, you need to investigate the company’s articles of incorporation, bylaws, founders agreement and any other documents by which they issue shares and related rights (like voting, preference of distribution, etc.). Bylaws deal with how the corporation will be operated, how many shares will be issued, kinds of stock, shareholder powers, death and incapacity, and more.
Statutory Stock Option Agreement
A stock option grants you the “option” to purchase the company’s shares at a price specified when the options were given. The goal of a stock option is to provide a person with the ability to acquire business shares at a set price in the future.
If the value of the company’s shares rises, you may exercise your options and acquire common shares at a discount to their market value. Stock option agreements can be nonqualified or qualified.
Statutory stock options are sometimes known as Incentive Stock Options (ISOs) or Qualified Stock Options (QSOs).The Internal Revenue Code governs these specific sorts of stock options. There are tax benefits to statutory stock options, but some of them have strict requirements that cost the company more up front.
ISOs (incentive stock options) are common forms of employee remuneration that are granted as rights to company stock. ISO is a form of employee stock purchase plan designed to retain key workers or managers. ISOs are often taxed more favorably than other forms of employee stock purchase plans.
Key Characteristics of ISOs
Schedule: ISOs are granted on a start date known as the grant date, and the employee exercises their right to purchase the options on the exercise day. When the options are exercised, the employee has the option to sell the stock immediately or wait a certain amount of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which the options expire.
Vesting: Most ISOs have a vesting schedule that must be met before the employee may exercise the options. In certain circumstances, the usual three-year cliff schedule is followed, when the employee becomes fully vested in all options awarded to them at that time. Other firms adopt a graduated vesting schedule, which enables workers to invest in one-fifth of the options issued each year beginning in the second year after the award. In the sixth year after the grant, the employee is fully vested in all options.
Exercise Method: Incentive stock options, like non-statutory options, may be exercised in a variety of ways. To exercise them, the employee may pay cash up front, or they can be exercised in a cashless transaction or via a stock exchange.
Clawback: These are situations that enable the employer to recall the options, such as if the employee quits the firm for reasons other than death, incapacity, or retirement, or if the company itself becomes financially unable to pay the options’ obligations.
Bargain Element: ISOs may frequently be exercised at a price lower than the current market price, providing the employee with an instant profit.
Discrimination: Unlike most other forms of employee stock purchase programs, ISOs are often exclusively available to executives and/or key workers of a firm who fulfill certain basic qualifications. ISOs are similar to non-qualified retirement plans in that they are often tailored for individuals at the top of the business hierarchy, as opposed to qualified plans, which must be given to all workers.
ISOs are eligible for preferential tax treatment over other types of employee stock purchase plans. This distinguishes these options from the majority of other types of share-based remuneration. However, in order to earn the tax advantage, the employee must fulfill certain duties.
There are two types of dispositions for ISOs:
1) Qualifying Disposition: A sale of ISO stock that occurs at least two years after the grant date and at least one year after the options are exercised. Both requirements must be satisfied for a stock transaction to be categorised in this way.
2) Disqualifying Disposition: A sale of ISO stock that does not fulfill the required holding period.
Nonstatutory Stock Option Agreement
Nonstatutory stock options are sometimes called Nonqualified Stock Options. An NSO, or non-statutory stock option, is a form of compensatory stock that is not an ISO, or incentive stock option, as defined by the Internal Revenue Code. These are unrestricted stock options. These stock options can be granted to workers, as well as suppliers, the board of directors, contractors, and anybody else to whom the firm grants them. While NSOs are quicker to produce and do not need as much legal red tape, they must still follow all SEC requirements. This is why you should consult with a corporate securities attorney before using them.
NQOs are among the most frequent types of employee stock options. You may acquire a stock at a fixed price for a certain length of time while the market value grows. Once the stock vests, the aim is to earn a profit on the shares.
Profit may be conferred to NSOs immediately. There are no waiting period limits, and you may sell the shares as soon as they vest for an infinite profit. This sort of stock option does not have a minimum price. The exercise price may be determined by the corporation as it deems appropriate. Furthermore, there is no cap on how much money workers may gain from exercised NSOs.
NSOs and Tax Implications
The following are tax implications for non-profit organizations:
– NSOs are regarded as a kind of typical revenue received from a corporation.
– For tax purposes, NSOs are analogous to a cash bonus or other payment.
– The recipient is taxed on the difference between the stock’s market value and the grant price on the day the stock options are exercised.
– This, like other kinds of remuneration, will be reported on a W-2.
– Once sold, the receiver is taxed in the same manner as if they were selling any other stock, for either short-term or long-term capital gains. This is determined by how long you have owned the stock.
The Benefits of Non-Statutory Stock Options
NSOs provide three key advantages to both workers and businesses:
1. It will enhance the employee’s income without increasing the employer’s costs. As the stock price increases, an employee’s earnings increase. The cost is borne by the free market rather than the employer.
2. It will boost staff morale and engagement. Benefits normally enhance morale, but NSOs are unique in that they allow workers to earn a greater salary while also giving them the impression that their overall behaviors would have a favorable influence on their remuneration.
3. It offers for taxation flexibility. Employees may reduce the effect of taxes by postponing the exercise and selling of options until the moment is ripe to make it financially worthwhile. From the company’s perspective, they will also have deductions for the amount of spread that workers report as income.
1. They impose a higher tax burden. Because NSOs are considered ordinary income, exercising the options is a significant tax action that may position workers in a higher tax rate.
2. There is some danger. There is never a certainty that stock prices will rise. This suggests that the options may be ineffective. This will reduce staff productivity and morale, not to mention the financial effect.
3. Problems with exercise If the cash necessary to exercise the options is required upfront, some workers may be unable to pay it. Exercises that do not need cash might also be troublesome for lower-income workers since they may lose out on big profits if they have to sell exercised shares right away.
Restricted Stock Agreement
This form of stock agreement has clauses that restrict the investor’s ability to assume ownership of the equity interest (or enable the firm to claim ownership) depending on a specified occurrence or events.
As an example, consider an employee who gets restricted stock options in exchange for putting in time and effort for the firm. If they fail to complete their tasks in accordance with the time and effort criteria specified in this sort of agreement, the person will lose the right to possess that stock. This sort of stock agreement may be used for stocks or LLC ownership interests and can work with direct equity, stock options, or the different methods to issue LLC ownership interest.
Commission, Royalty, or Percent of Revenue
In many cases, investors just wish the rights to the portion of the company’s income, without owning any shares. A royalty agreement, also known as Commission Agreement or Revenue Sharing Agreement, may be drafted to provide an investor the right to such dividends.
In this sort of arrangement, an investor gives up money in return for a percentage or cash amount that vests over time.
Convertible Debt Agreement
If an investor lends your firm money that can be converted into shares later, your company will give them a convertible loan note.
A convertible debt arrangement is made when a person or corporation agrees to lend money to a firm but has the option of converting the loan into a stake in the company.
The convertible debt arrangement will specify who has the right to convert debt into equity.
Some convertible debt arrangements enable the lender to either demand repayment of the loan or convert the loan into shares.
Simple Agreement for Future Equity
A simple agreement for future equity (SAFE) is a contract between an investor and a corporation that grants the investor rights to future equity in the company, similar to a warrant, but without establishing a set price per share at the time of the original investment. When a pricing round of investment or a liquidity event happens, the SAFE investor gets the future shares. SAFEs are designed to make it easier for entrepreneurs to get early funding other than convertible notes.
A SAFE’s exact conditions vary. The core mechanics, however, are that the investor pays a particular amount of funding to the firm at the time of signing. In exchange, the investor obtains stock in the firm at a later period, in response to particular, contractually agreed-upon liquidity events. The major trigger is often the company’s selling of preferred shares, typically as part of a future priced fund-raising transaction. Shares are not valued at the moment the SAFE is signed, unlike a pure acquisition of equity. Instead, investors and the corporation agree the process for issuing future shares while deferring real valuation. These requirements often include a cap on the company’s valuation and/or a markdown to the share valuation at the time of the trigger event. As a result, the SAFE investor shares in the company’s upside between the time the SAFE is signed (and funding is supplied) and the trigger event.
Safes are supposed to function similarly to convertible notes, but with less complexities. A SAFE, unlike a convertible note, is not a loan; rather, it is more akin to a warrant. Because there is no interest paid and no maturity date, SAFEs are not subject to the rules that debt is in many countries. The key incentive for a SAFE is its simplicity.
What are some common elements of various investment agreement types?
Certain key terms are often found in different types of investment agreements:
Due Diligence. Investors may request that specific measures be undertaken before the initial portion of the investment is finished: submitting a business plan and accounting; obtaining the relevant tax clearances; having the power to offer additional shares to investors in the venture; and adopting new articles of organization are some of these activities. Also the distribution of stock or stock options to the founders and senior management members; transfer of the required intellectual property rights of the founders or others to the corporation; and obtaining necessary insurance, such as management liability insurance.
Investment Tranches. Payments for investments in enterprises are often paid in tranches, each of which is measured by the completion of agreed-upon milestones. These milestones are often assessed by, for example, the different phases of development of one or more products or a company’s commitment to new advancements.
Warranties. In addition, investment contracts should provide some assurances that the company’s key economic metrics are true. The following are typical warranties: Absence of pending lawsuits; Commitments and contracts; Directors and workers.
Restrictive Covenants. Restrictive covenants, often known as non-competition agreements, are intended to restrict founders from competing with the firm’s operations both during and after their involvement in the company.
Investors Rights. The company’s founders or management directors must promise certain things in exchange for their financial investment. E.g., the distribution of the funding amount and the investor’s co-voting rights. Audit rights. Reporting responsibilities to notify investors about business operations, including a list of turnover, gross profit, problems, events, and the next planned actions.
What is the difference between investment and shareholder agreement?
Even though both investors agreements and shareholders agreements are contracts between investors and a company, the shareholders agreement goes into more detail about how the company will be run and how decisions will be made than the investors agreement. It may include, among other things:
Who has authority to nominate directors?
When, how, and to whom are additional shares issued?
How may shareholders sell or transfer their shares?
What information must the company provide to its shareholders?
When and how shareholders may have a voice in how the company is operated
Because the shareholders agreement will effect investors’ rights as co-owners of the company, they will be interested in its contents and will demand involvement when it is drafted. There are, nevertheless, significant variations between shareholder agreements and investment agreements.