Subscription Agreement: Everything to Know
A subscription agreement is between a company and a private investor to sell a specific number of shares at a specific price, documenting suitability.8 min read
Updated June 25, 2020:
What Is a Subscription Agreement?
A subscription agreement is between a company and a private investor to sell a specific number of shares at a specific price. This investor fills out a form documenting his or her suitability for investing in the partnership. A subscription agreement can also be used to sell stock in a privately owned business.
Subscription Agreement: What Is It?
The subscription agreement is used to keep track of how many shares have been sold and at what price the shares sold at for a privately held company. The subscription agreement details all the information about the transaction, such as the number of shares and price, and confidentiality provisions.
Some agreements include a specified rate of return that investors are guaranteed to receive. That might be a percentage of the company's net income, or it could be a specific amount in lump sums that are to be paid out on specific days.
Subscription agreements are most common with startups and smaller companies. They're used when business owners don't have the resources to work with venture capitalists or to take the company public.
Why Are Subscription Agreements Important?
For companies that need more funding, it's a way to do it without taking a company public or finding venture capitalists to invest. Investors enter into a limited partnership, which basically means they are silent partners. These investors are only obligated or expected to make a one-time investment. It limits the risk significantly, but it also limits the say investors have in company decisions.
Subscription agreements rely on SEC Rule 506(b) and 506(c) of Regulation D. The stipulations within those rules include:
- How companies can or cannot solicit investors.
- What information is shared with investors
- Who is allowed to invest.
When to Use a Subscription Agreement
Private companies tend to use subscription agreements if they want to raise capital from investors that are private. This can be done by selling either shares or the company's ownership without needing to register with the SEC. Companies that have a private placement memorandum might also want to include a subscription agreement to attract possible investors. Whether you're a company that wants to invest in another company or a private investor, a subscription agreement defines all the transaction details, such as the agreed upon number and price for the shares.
Investors can protect themselves against companies by amending the terms of the deal. As a company selling stocks or shares, this prevents an investor from changing his or her mind right before the investor gets into the deal. Having a subscription agreement will help solidify a promise into a fixed transaction.
Investing With Subscription Agreements: Advantages and Disadvantages
When it comes to investing, there are definitely some good and some bad in choosing to do so using subscription agreements.
- Subscription agreements provide a way to sell stock without registering securities with the Securities and Exchange Commission (SEC). Creating the prospectus needed for registering with the SEC is time-consuming and expensive.
- It's a one-time investment, unlike venture capitalist investing, which requires much more time and typically multiple investments.
- It's not a huge time commitment since you're a silent partner in the investment.
- It's a limited partnership, so there's no worry about being liable.
- There are no voting rights and no way to help the business be successful. You have to trust that the leaders of the business know what they're doing.
- Once you've invested your money, there's no way to get the money back if you change your mind.
Not Using Subscription Agreements: Advantages and Disadvantages
What if you decide to invest in other ways? Here are some pros and cons to investing but not using subscription agreements.
- Although the private placement memorandum has ample information about the investment, a prospectus that the SEC prepares and approves is more thorough. Therefore, it might be more helpful in deciding whether it's a strong investment.
- Investing with a company through a subscription agreement requires a large sum of money. However, investing in a public company allows you to use a smaller sum if you're unsure of whether it's a good investment.
- Investing in a private company allows you to get in on the "ground floor." You're able to invest before it goes public. If and when the company goes public, assuming it's successful enough to get there, it's likely the stock you own will be worth a lot more.
- Investing in a company with a subscription agreement means you'll have access to the general partner to ask questions and to get to know the management team. You don't always get that with other types of investing.
Making the Agreement Too Complicated
While all the necessary legal information should be covered in this agreement, try to keep it as simple as possible. For example, you can include mention that the investor has read the private placement memorandum rather than repeating the information disclosed in the memo. This avoids potential confusion if the disclosures are paraphrased.
Not Getting Legal Counsel
Being a legal document, it's important to have a legal expert that specializes in finance to help you. A lawyer can explain to you all the legalese used in the contract and ensure you agree with what's there.
For example, as an investor, you would want to know whether the money you invest will be kept in escrow. Then, once a specific amount of funds is raised, it's released to the seller. This ensures that if the funds aren't raised, the money is sent back to the investors.
Common Subscription Agreement Terms You Need to Know
An accredited investor is someone who fits one of the following:
- Has a net worth over at least $1 million, excluding the value of a primary residence.
- Has an income of at least $200,000 a year for the last two years (or a combined income of $300,000 a year if married) and a reasonable expectation of earning that much or more in the current year.
- An entity that has combined assets of more than $5 million.
Limited (Liability) Partnership
Limited partnerships, or limited liability partnerships, have less say in a company's management. A general partner manages the business and has a hand in its direction. The general partner also has personal liability for debts and obligations. The limited partner, however, has limited liability, protecting them from debts the company incurs.
A partnership is a business agreement between two or more people who own a company together. All partners are legally liable for the actions of any of the partners. Therefore, there's a financial risk when entering into a business partnership.
Sale of stock to a limited number of investors. These investors must be accredited, including proof of investment experience, number of assets, and net worth.
Private Placement Memorandum
The subscription agreement is included as part of the private placement memorandum. Companies provide these memos to investors. It takes the place of a prospectus.
Frequently Asked Questions
What information is typically included in a subscription agreement?
The information in each agreement varies, but generally, the following information is included in a subscription agreement:
- Company information
- Expectations of both parties
- Agreement to subscribe (this includes the number of shares and price)
- Rights attached to the subscription
- Voting preferences
- Liquidation and redemption preferences
- Terms for termination before completion
- Nomination onto board
- Confidentiality provisions
- How the returns will be paid out
Can I solicit investors?
In the past, to find investors to take part in the sale of stock by privately held companies, you could not solicit investors generally. However, in 2013 the SEC lifted the ban on general solicitation. This means you can advertise that you're looking for investors, such as online advertising through websites and social media. Note though that the investors still have to be vetted to ensure they are accredited investors. Only verified and accredited investors can be accepted as investors for your company.
However, there is an exception made for equity crowdfunding. Those are considered different and have different requirements.
What are Private Placements?
When a company wants to raise capital, it will often do it by giving out shares of stock that are for purchase by the public or with a private placement. The main disclosure form for possible general public investors is called a prospectus. This is a disclosure document that states information about the company and any underlying security. The private placement consists of a sale of stock that's limited to a certain number of investors who are accredited and meet certain criteria.
The criteria for this accredited status involve having a specific level of:
- Investment assets
- Net worth.
Investors will get a private placement memorandum as another option to the prospectus. The memorandum has a less detailed description of the investment. As is often the case, the memorandum and subscription agreement accompany each other.
Some agreements will have a certain rate of return outlined that will be paid to the investor, such as a specific percentage of the company's net income. The agreement will also list what the payment dates are for the return. This type of structure gives the investor priority, since he or she will earn a rate of return on his or her investment before the founders of the company or the minority owners do.
How Can Private Companies Raise Money?
Private companies who want to raise money to sell their shares of stock to specific individuals or organizations can use these agreements without needing to register with the U.S. Securities and Exchange Commission. A common occurrence of this is venture capital funding, where a business sells its stock shares to investors of venture capital and in return exchange capital that helps the business begin or expand. Before the stock sale is complete, both parties must sign a sales contract that's legally binding. This is called a corporate stock agreement or corporate subscription agreement.
What Is a Corporate Subscription Agreement?
A corporate subscription agreement is similar to a standard purchase agreement in that they function the same way. It's a promise that a private company makes to sell a certain number of shares at a specific price to the subscriber, or private investor. This is also a promise the subscriber makes to buy shares of the stock at the price that's been previously agreed upon. While this is between two private parties, every share that's sold makes the subscriber one of the owners in the company just as a traditional investor would.
Corporate Subscription Agreement: Terms and Conditions
Many agreements have conditions and clauses that protect any private company. Subscribers are required to stick to them in order for the agreement to stay enforceable. Having an indemnity clause means subscribers must repay or indemnify the company if any monetary damages are suffered because of subscriber misrepresentation. Many subscriber agreements also have a confidentiality clause and a non-compete agreement. They may also have clauses that make it mandatory for subscribers not to solicit current customers away from the company or to impair the reputation or name in any way.
What Are the Financial Disclosure Requirements in a Corporate Subscription Agreement?
Private companies have similar obligations that public ones do when it comes to disclosing their finances fully, as well as other information about the company before the agreement gets signed. Full disclosure is defined as the company being required to provide financial documents in addition to other specific information about the current projects it has going on. This also includes any business plans for the future.
The main difference is the name disclosure document. It's known as a Private Placement Memorandum with a private company and a prospectus with a public company. Once this is signed, it gets attached to the subscription agreement.
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