Guide to investing in a private company in Australia (2024)

The Process of Investing

Commercial Considerations

Ways to structure your Investment

Key Legal Documents

Terms Sheets and NBIOs

Due Diligence

Subscription Agreements

Share Sale Agreements

Shareholders Agreements

Shareholder Rights to Information

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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.

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.

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.

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).

The number and form of documents that you may be required to sign will depend on the structure of your investment and the type of private company that you are investing in. An investment in a small start-up owned by friends or relatives may involve fewer formalities than a large investment in a more established private company.

Terms Sheet

A terms sheet (also known as a ‘heads of agreement’ or ‘memorandum of understanding’) is normally used where the preparation and negotiation of a formal agreement cannot happen straight away but the parties wish to express their commitment to the deal. It will summarise the main commercial points that have been agreed between the parties without going into too much of the detail that would normally be found in a formal agreement. The document should specify which terms are binding, and which are not.

Subscription agreement/share purchase or sale agreement/convertible note/loan

You will need to sign a formal document that sets out the terms on which you agree to buy shares from a private company. The type of formal document will depend on the circ*mstances of your investment. We briefly explain some commonly used documents below.

Shareholders agreement/deed of accession

As a condition of you becoming a shareholder of the company you may be required to sign a new shareholders agreement with the other shareholders or a deed of accession to an existing shareholders agreement. This will be in addition to one or more of the formal documents above.

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 andexclusivity (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.

Terms sheet for investor

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.

Due Diligence Guide for Investors

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.

Read more about share subscription agreements

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