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Guide to investing in a private company in Australia

This guide explains how to minimise the risks of an investment into an Australian private company.  Although it is written specifically for private investors, it is relevant to any firm or company contemplating an investment in a privately owned company.

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1 Hour Workshop for Investors

Meet with a senior commercial lawyer to learn more about how to safely invest in a private company.

This workshop is designed to provide investors with preliminary insights and recommendations in relation to a specific investment opportunity.

  • Learn more about how and where to focus your due diligence
  • Understand more about the key legal documents
  • Gain insights into what is 'normal' (and what is not)
  • Discuss the key items for a terms sheet
GUIDE TO INVESTING IN A PRIVATE COMPANY

The Process of Investing

There is a relatively standard process for investing in a private company, at least where a material sum of money is involved.  It normally unfolds along the following lines:

  1. The parties sign an NDA.
  2. The company/seller provides an information memorandum or equivalent.
  3. High-level discussions occur in relation to the key terms and structure of the investment.
  4. Either the company/seller or the investor prepares a non-binding terms sheet (or 'heads of agreement' or 'non-binding indicative offer'/'NBIO'), which is signed once agreed.
  5. The buyer carries out due diligence investigations on the company.
  6. Final transaction documents are prepared, negotiated and signed. Normally (but not always) this involves a share sale agreement or share subscription agreement. There will also usually be a shareholders agreement where the investor is buying anything less than 100% of the company.
  7. The investor advances the funds and the investment is completed.

Commercial lawyers like us are normally involved from the very start of the process, to ensure the investor is asking the right questions and not binding themselves to anything they may regret later.

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Commercial Considerations

Investments into private companies are typically medium to long term investments. Quite apart from the terms of investment (including the purchase price), there are a number of commercial considerations for you to consider. For example:

  • Does the company have a clear strategic direction?
  • How realistic is the company’s business plan?
  • Who are the key managers? What experience do they have?
  • Who will be on the board of directors? What experience do they have?
  • Are there adequate incentives to ensure the key people remain committed? 
  • Who are the company’s shareholders? Are they likely to be able to contribute to the business’ success?
  • Is the company likely to need further capital? If so, when? How are you likely to be affected? 

At least for larger investments, investors will often go through a ‘due diligence’ period prior to investing. The purpose of investor due diligence is to allow investors to seek information from the company, to ensure the investor is fully informed before committing to an investment. Due diligence is discussed in more detail below.

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Ways to structure your Investment

There are different ways you can structure your investment.  The most common investment types involve shares, loans, convertible notes and/or options. Sometimes, a combination applies. The main features of these different options are summarised in the table below.

 

Requires agreed valuation?

Nature of Investment

Voting rights

Dividend rights

Nature of return

Shares

Yes

 

Equity

Yes

Yes

Variable (dividends plus capital)

Loan

No

Debt

No

No

Fixed (interest plus repayment)

Convertible Note

No

Debt unless converted to equity

Not unless converted

Not unless converted

Fixed or variable (if converted)

Option

Yes (for exercise price)

None unless exercised

None unless exercised

None unless exercised

None unless exercised

Shares

The most common form of investment in a private company is to buy shares. Normally, shares issued to investors are ordinary shares. Ordinary shares will normally give the holder voting rights, the right to receive dividends, and the right to receive any surplus capital if the company is wound up. If the company is sold, holders of ordinary shares would be entitled to share in the sale proceeds.

Although ordinary shares are the most common, different classes of shares are sometimes used where the parties agree for the investor to have different rights to other shareholders. Special rights are sometimes created in relation to dividends (e.g. fixed dividends), voting rights (e.g. limited or special rights) or capital entitlement (e.g. higher or lower ranking in the event the company is wound up).

If the investor is buying shares from an existing shareholder (or shareholders), the transaction will be documented in a share sale agreement. If new shares will be issued, the investor will subscribe for these shares through a share subscription agreement

One challenge with the use of shares is that both parties need to agree on a value. Where the share price is not agreed (for example, in the case of start-ups where the company’s prospects are inherently difficult to determine), or where the investor seeks priority over other shareholders, investors may seek to structure their investment by way of loan or convertible note.

Loan

Unlike an equity investment, a loan will have a fixed repayment date and provide the investor with a fixed return (by way of an agreed interest rate). Investors will sometimes place restrictions on the dividends that can be paid to shareholders while the loan is outstanding. If the company is sold or wound up, the loan would need to be repaid before any surplus proceeds are distributed to shareholders.

However, lenders’ rights are very different to shareholders’ rights. For example, lenders will not have voting rights and they will not stand to benefit from any growth in value of the company. For this reason, many investors will look to use a convertible note if they are unable to agree on a share price with the company upfront.

Convertible Note

A convertible note is a loan that may be converted into shares by the holder. Initially, a convertible note operates just like a loan. There will be a repayment date, and there may be entitlements to interest. However, the holder of the convertible note has the right to convert the loan into shares. The note will usually specify how and when the right needs to be exercised.

To avoid the parties having to agree on a valuation for the company at the time the note is created, the conversion price (being the price at which shares will be issued under the note) will usually be calculated by reference to a future event – such as the price used by the company in a future fundraising round.

Before the note is converted into shares, the holder will be in the same position as a lender (i.e. no entitlement to dividends, no voting rights and no stake in the company’s equity). The holder’s rights after conversion will depend on the type of shares issued under the note.

Option

Occasionally investors will seek an option, entitling them to buy shares at a specific price (being the ‘exercise price’). Usually options are provided as an additional incentive by the company, or as a protection for investors against future dilution. Options are mostly used in conjunction with shares, a loan or convertible note. They are not a form of investment on their own, as they are only exercised at the discretion of the investor (i.e. the investor is never required to exercise them).

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Terms Sheets and NBIOs

A terms sheet is a short form document that is intended to cover the key aspects of a deal, prior to the final transaction documents being prepared.

Most of the substantive parts of an initial terms sheet are usually non-binding, which is why some people refer to them as 'Non-Binding Indicative Offers' (or 'NBIOs').

Typically a terms sheet is prepared as soon as the parties have reached an 'in-principle' agreement on the key elements of the deal.

Once a terms sheet has been signed, the investor would normally commence any detailed due diligence investigations and the parties would start working on the formal  transaction documents.  One of the key purposes of a terms sheet is to ensure both parties are broadly in alignment on the key terms, before either of them starts committing significant time or costs to the transaction.

There is no definitive list of what should or should not be included in a terms sheet.  The contents and length of a terms sheet will depend entirely on the terms of the deal. 

As an example, a terms sheet for a share subscription would normally address items such as:

  • the parties,
  • the number and type of shares being purchased,
  • the purchase price and when it will need to be paid,
  • any key conditions of the subscription,
  • whether the investor will be entitled to a board seat,
  • any major issues that will need to be addressed in a shareholders agreement, 
  • confidentiality and exclusivity (if the negotiations are intended to be exclusive).

The lawyers will use the terms sheet as the basis for preparing the final transaction documents.  The more detail that is included in the terms sheet, the less scope there will be for the deal to fall apart later.  This is because in theory at least, there should be fewer issues  left for potential disagreement.

A terms sheet should clearly indicate which parts are binding and those that are non-binding. Typically the commercial terms (price, number of shares etc) are non-binding and terms relating to the parties' confidentiality obligations and any exclusivity arrangements are binding. 

A terms sheet would normally expressly state that any transaction will be subject to the outcomes of the due diligence process and final transaction documents being entered.

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Due Diligence

The best way to minimise your risk as an investor is to understand as much as possible about the company before you invest.  This is normally done through a formal due diligence process.

Usually performed after signing a non-binding terms sheet, due diligence involves a deeper investigation into the company's affairs. Due diligence inquiries typically cover a range of matters, including:

  • commercial (eg services/products, customers, suppliers, sales pipeline, market analysis, forecasts, opportunities etc)
  • operations, including human resources and IT,
  • financial and accounting,
  • tax, and
  • legal, including compliance.

Due diligence usually involves a range of conversations, meetings and written communications. This mix is important. Conversations and meetings will provide opportunities for you to assess the culture of the organisation and understand more about the key personalities involved.  Written communications will provide you with the data and other detail that you will need to undertake a well-rounded analysis of the company. 

A structured approach to due diligence is the best way to ensure you know as much about the company as possible. This knowledge will allow you to negotiate the best protections possible in the final transaction documents, and to also ensure you fully understand the opportunities and risks associated with your investment.  

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Subscription Agreements

A subscription agreement sets out the terms on which an investor agrees to buy shares from a company. At a minimum, a subscription agreement will identify:

  • the company issuing the shares,
  • the investor subscribing for the shares,
  • the number of shares to be issued,
  • the class of shares to be issued (e.g. ordinary shares, B class shares etc),
  • amounts to be paid by the investor (called the ‘subscription amount’), and
  • the time by which the amount is to be paid.

Sometimes all of the subscription amount is required to be paid upfront. In other cases, it is required to be paid in tranches over time (and some of these payments may be subject to the company achieving certain goals).

Beyond these bare minimum terms, the contents of a subscription agreement will vary depending on (1) the specific transaction concerned, (2) the level of sophistication of the parties (some investors will have more prescriptive agreements than others) and (3) whether there is a shareholders agreement (and if so, the contents of that agreement).

Subscription agreements will usually contain warranties in favour of the investor. The most common warranties sought by an investor relate to:

  • share capital – that the company’s share capital is as promised, 
  • accuracy of information – that the information given by the company to the investor is materially accurate, and
  • the company's accounts and tax - effectively - that the company's accounts have been prepared properly and all relevant tax obligations have been satisfied.

In addition to these basic warranties, some investors will seek more detailed warranties relating to the business itself – for example, around the company’s assets, intellectual property, employees and contractors, customers, key contracts, past claims or disputes, or any other matters of potential concern that could materially affect the value of the shares being sold.

Although it is normal (and advisable) for an investor to seek warranties and indemnities from the company, it is also normal (and advisable) for the company to seek to qualify those warranties where appropriate. 

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Share Sale Agreements

A share sale agreement sets out the terms on which shares in a company are to be sold. It will usually contain provisions that address the following:

  • price and payment,
  • conditions precedent to the sale (being conditions that must be satisfied before the sale can be finalised),
  • completion arrangements*,
  • warranties and indemnities, and
  • restraints and non-competes*.

The items marked with an asterisk (*) are more common where all of the shares in the company are being sold. 

Although a robust set of indemnities and warranties is a key part of your share sale agreement, relying on these provisions instead of carrying out proper due diligence is not guaranteed to provide you protection if things go wrong. Even if a warranty is breached there may be reasons why it can’t be enforced (for example, if the company does not have the funds to compensate you for your loss, or if you only become aware of the issue after the time for making claims has ended).

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Shareholders Agreements

The purpose of a shareholders agreement is to regulate the relationship between a company’s shareholders, and between the shareholders and the company. Shareholders adopt shareholders agreements to give them some certainty around how the company will be managed, and how particular situations will be dealt with.

A shareholders agreement should govern all of the key aspects of your relationship with the company and the other shareholders. Shareholders agreements usually contain a variety of provisions that regulate how and when shares can be sold.

  • Protection against dilution – understand the company’s plans for issuing shares and have these set out in your shareholders agreement.
  • Right to appoint a director – you won’t have a right to be (or appoint) a director unless you specifically negotiate one.
  • Rights to access information – your rights to receive company information will be limited if you are not a director.
  • Tag along and buy out rights – these provisions will allow the smaller shareholders to ‘tag along’ and participate in the sale of shares.
  • Pre-emptive rights – they give the shareholders the right to buy another person’s shares before they are sold to someone else.
  • Limit on the board’s control – a shareholders agreement will usually prescribe limits on what the board of directors can do without shareholder approval.
  • Protection against breach – shareholders agreements will often give shareholders express rights where another shareholder breaches the agreement.

Our checklist is intended to help you understand the types of issues that should be addressed in your shareholders agreement. You can download our checklist here.

Note that the checklist is intended as a starting point for discussion. As detailed as the questions may first appear, there may be other issues that will need to be considered and addressed. You may also wish to consult our detailed guide on shareholders agreements in conjunction with this checklist. You can download our shareholders agreement guide here

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GUIDE TO INVESTING IN A PRIVATE COMPANY

Shareholder Rights to Information

As a shareholder, your rights to information will be relatively limited.

This is because, in the eyes of the law, management of the business should be left to management and the board, and shareholders should not be given access to company information unless it somehow directly impacts their interests as shareholders.

Under the Corporations Act 2001 (Cth), a shareholder is entitled to copies of the company’s constitution and minutes of any shareholder meetings.  

If you require more information (as most shareholders will), you will need to negotiate this into your agreements with the other shareholders and/or the company.

Shareholders agreements will often require the company to provide more information to shareholders than is required at law, such as regular management accounts and annual accounts.  There will often be exceptions to any right to receive commercially sensitive information, such as where a shareholder is involved with a competitor, customer or key supplier.

Another way that investors will sometimes seek to access to further information is by negotiating a right to appoint a director or observer for as long as they are a shareholder.

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