An investment contract is a legal contract used to formalize a transaction between an investor and company, where the investor will invest cash or something of value with the intent of return on that investment.
These agreements are regulated by the Securities Act of 1933 and other state and federal laws. At their core, they involve an investing party that will acquire an ownership interest in the company after investing. Some common investment contracts include a convertible note and a SAFE note.
To be considered a valid investment contract, the contract must contain the elements laid out by the Howey test, which include:
- Investments of money
- A common enterprise
- Profit expectation(s)
- Derived from the efforts of others
If your company needs capital by way of investors, you’ll likely enter into an investment contract. Let’s review at least 8 important things you should look for in an investment contract.
1. Structure of the Investment
The structure of the investment should aim to answer the following basic questions:
- Who is involved in the agreement?
- What is the investment?
- What is the purpose of the investment?
- What are the rights of the parties?
- What is the ROI for the Investing party?
- Who will handle reporting and control?
- What restrictions or obligations do the parties have?
Once these are answered, and both parties sign the document, it is executed.
Here is an article on 4 main investment types.
2. Length of the Investment
The length of the investment is not a random date agreed upon by both parties. Instead, it is the length of time it will take for the investor to reach their agreed-upon return on investment (ROI).
Also referred to as the term of the contract, this part of the contract also outlines how the agreement will end and what will happen if the parties want to terminate the contract early.
Here is an article on common types of investment contracts.
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3. Purpose of the Investment
The purpose of the investment should be made clear in the contract. In most cases, the investor’s purpose is to make a profit on their investment, and the company’s purpose is to raise capital.
Since the investor will become a new shareholder after the agreement is executed, the terms and conditions of the agreement must be explicitly outlined.
Here is an article on investment in the contract.
4. How Much the Investor Will Provide
Another key component of the investment contract is defining how much the investor, or party putting out the money or financial resources, will provide. Again, this could be tangible or intangible but usually involves transferring money.
Sometimes the investment agreement will require certain milestones to be reached by certain dates. Be sure to outline the details below clearly:
- Amounts
- Dates
- Forms of payment
Here is an article detailing investment contracts.
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5. Equity Share
On the other side, what the company is putting up in the form of equity shares should also be detailed. Consideration needs to be made for certain questions that may arise, including:
- What will the interest rate be? A flat rate or an agreed-upon rate based on the success of investment?
- What happens if the company goes bankrupt?
- What risks are there to the investment?
- Is there a need for an investment management agreement ?
Here is an article on why stocks are called equities.
6. Form of the Investment
The form of the investment, as it sounds, refers to how the investment will be received. This could include:
- Cash, either in a lump sum or over a period of time
- Check
- Wire transfer
The investment could be an exchange for tangible assets, like a yacht. Still, these situations are tricky for the exit plan. You don’t want to be left making a difficult decision if an investor changes their mind and wants that yacht back.
Here is an article to help determine what qualifies as an investment contract?
7. Return on the Investment
The return on investment is a key piece of information in an investment contract, and the contract should address it. In some cases, the contract may have conditional terms for the return on investment that depend on future events. Not detailing the return on investment could result in the investor asking that their investment be returned.
Since there are a few ways to calculate ROI, how it will be calculated must be outlined in the contract.
The most popular formulas to use are:
- ROI = Net Income / Cost of Investment
- ROI = Investment Gain / Investment Base
Here is an article that details ROI calculations.
8. Rights of the Parties
It is critical to define details on the rights of the parties involved, especially since the investor will be a shareholder. Any rights that would be included or, more importantly, excluded when the agreement is activated must be outlined first.
If needed, the rights of the investing party could be included in an investor rights agreement.
Entering into an investment contract offers no guarantees. However, given their pension for being complicated, a consultation with an experienced lawyer is recommended. They can walk you through the process and help you avoid potential pitfalls.
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