What is a Subscription Agreement?

One of the most widely utilised methods by companies to raise funds is through an Initial Public Offering (IPO), where the company sells the shares to the general public. However, entities such as startups or bootstrapped companies that are not in the position to attract public investors look toward private investors for funding. When such private investors are included in the funding, the deal is done through a Subscription Agreement.

What is a Subscription Agreement?

A subscription agreement is a legal agreement between a company and a private investor to sell a specific number of privately owned shares of the company to the private investor. In return for the shares, the private investors invest a prespecified capital amount which the company uses for specified business operations.

The subscription agreement presents a private investor’s candidacy to join a limited partnership in a company. A limited partnership is when private investors or partners own the company. Under the subscription agreement, the terms are set for the company to sell a certain number of shares in return for a predetermined amount from the private investor.

Understanding a Subscription Agreement

A company that is not listed on the stock exchanges is privately owned by the current partners of the company. Such a company may be registered as a limited partnership firm, startup or small company. When such companies want to raise capital without listing on the stock exchanges, they approach or are approached by private investors.

These private investors utilise the subscription agreement to present their application to be a limited partner in the company. The general partner in the company, who manages the partnership entity, brings in limited partners (private investors) using the subscription agreement. Once a private investor is approved to be a limited partner, the company gets a certain amount of capital, and the investor is termed a silent partner.

Silent partners are expected to invest a one-time amount and have no material participation in the business’ operations. They usually are not involved in the decision making of the company and hence, are exposed to lower risk than the general partners. The liability of private investors under the subscription agreement is limited to the investor capital amount, unlike the unlimited liability of the general partners.

Most share subscription agreements contain a specific rate of guaranteed returns for the private investors on the invested amount. However, some subscription agreements provide a percentage of the company’s profits as a reward for investing the specified amount. Furthermore, the silent patterns have the right to hold the stocks and sell them at the time of the IPO.

Advantages of a Subscription Agreement

A subscription agreement becomes an effective tool for the general partners to ensure that the company receives adequate funds while the private investor can realise profits on the invested amount. Here are the advantages of a share subscription agreement:

• Limited Liability: Under the subscription agreement, the private investors who become the silent partners have limited liability. In the case of the company becoming bankrupt, the limited partners can not be held liable to repay the lenders or any other entity from their wealth. Their liability is limited to the invested amount.

• One time-Investment: Silent partners are required to invest a prespecified amount as a one-time investment and not offer payments over time as venture capital contributions. Under the subscription agreement, this makes up for a great way to invest a lump sum amount and realise returns.

• Investment Growth: The subscription agreement allows investors to invest in companies at the early stage of their growth. As businesses may grow to be worth billions, the amount invested by the private investors can multiply by a huge margin with time, allowing them to get high returns on the investment.

• Easier Funding: Not every company wants to list on the stock exchange for raising funds as the issue may be unsuccessful based on the company’s present condition. Hence, general partners of the company utilise subscription agreements to raise funds without having to offer the shares to the general public.

Disadvantages of a Subscription Agreement

Although a subscription agreement has numerous advantages for both the general and the silent partners, it isn’t without its disadvantages. Here are the some of the disadvantages of a subscription agreement:

• Lack of Rights: The silent partners do not get internal rights such as voting rights and are not allowed to be involved in the day-to-day activities or the company's decision-making process. This restricts the silent partners from having a say and can result in them losing their invested amount.

• Huge Amount: Under the subscription agreement, the private partners are required to invest a huge lump–sum amount without the option of stretching the investment over multiple tranches. Hence, some investors prefer buying equities from the secondary market.

• No Liquidity: Once the private investor invests in the company and becomes a silent partner through the subscription agreement, the funds are held by the company. The only way the silent partners can realise cash for the shares is to have someone else buy them out, which can be a huge hassle.

• Lack of regulation: Since the deal that happens through the subscription agreement is not regulated by a governing body such as SEBI, it may result in a lack of transparency or other legal issues.

Final Word

A subscription agreement is a vital legal document that a company which is not looking to list on the stock exchange can utilise to raise funds and add silent partners to its company structure. Furthermore, private investors can also utilise the subscription agreement to invest in a company before anyone else and see their investment grow over time.