Investment contract – part 2

In the previous blog post we looked at the term sheet document as a list of basic arrangements between the parties of the investment transaction, which are then transferred into the contract and specified further. Now let’s check what clauses appear in such a contract and what purpose they serve.

The construction of the investment agreement is not regulated by any standard. It is usually proposed by the investor and refined through negotiations. However, some clauses are typical and occur universally.

First of all, the venture capital fund invests mainly in the team. VC fund does not buy shares in a business idea, but in an enterprise run by specific people in whom the fund believes. Therefore, the investor is afraid of the situation when the team loses interest in the project, starts to take part in other activities and finally abandons the project before its completion. These concerns are addressed in: vesting, operational exclusivity and lock-up clauses.

1. Vesting clause causes the members of the startup team to commit themselves to be active in the company for a certain period of time. In exchange, they are entitled to shares in the company. These shares may be owned by team members from the beginning or acquired successively as they work for the company. In the first case, if any of the founders voluntarily abandons the company, he will be obliged to sell the to fund a part of his shares at a predetermined price or his shares in the company will be liquidated. The sooner a founder abandons the project, the more shares he will lose. In the second case, the team members successively receive shares in the company after a fixed period of work for the company (eg every 6 months), obtaining a target number of shares after a certain period (eg 3 years).
2. The investor tries to avoid the situation, when he learns unexpectedly, that the project in which he invested is only one of the founder’s many projects, to which the founder can devote only a small fraction of his time. That is why the investor usually wants to know about the scope of professional obligations of key team members and does not want this scope to expand in an uncontrolled manner while the project is underway. Hence the exclusivity clause, in which the founders undertake that they will not conduct other professional activities (including, naturally, competitive ones) during the term of the contract without the consent of the supervisory board.
3. The lock-up clause prevents the contracting party from selling its shares in a specific time period (for example during the term of the contract), which also aims to prevent the project from being abandoned, and is also relevant to the planning of the IPO (initial public offering).

Secondly – the fund believes in the competences of originators and does not want to impede their management of the company, however, it cannot afford to lose control over spending funds and achieving objectives Preventing this are contractual provisions regarding the composition and powers of the company’s governing bodies and the right to information.

1. Clauses regarding the governance of the company define the procedures of appointing governing bodies and the scope of their rights. Typically, the fund (for as long as it is a so-called leading investor) reserves the right to control, for example, appointing members of the company’s supervisory board with a decisive vote. It may also reserve for itself the right to appoint a member of the management board if the fund considers the founders unable to implement the project or other “emergency” situation occurs.
2. The investor’s right to information is guaranteed by appropriate clauses regarding reporting and controlling. There are defined types of reports to be submitted cyclically by the company’s management, audit mechanisms are defined along with the sanctions for failure to comply with information obligations. Often, the fund also reserves the right to choose the company that will be keeping the company’s books.

Thirdly – the fund is aware that the process of financing the development of a startup does not necessarily end with the current investment round and that the share structure will be subject to changes. It is therefore trying to secure its interests in relation to future share issues and changes in the ownership structure of the company by means of appropriate anti-dilution, priority, tag along, drag along clause as well as rights related to the company’s sale.

1. The anti-dilution clause states that if future share issues will occur at a price lower than the one at which the fund acquired shares, the investor’s share package will be proportionally supplemented with compensatory issues. This will secure their share packet value against diminishment.
2. If any of the parties to the agreement will sell shares in the future, then, by virtue of the right of first refusal clause, the other partners will be entitled to purchase these shares on the same terms on which they were to be sold to a third party. Only if they do not take advantage of this right, the shares can be sold to a third party. The seller must therefore inform the remaining shareholders on what terms he intends to sell the shares and give them an appropriate (specified in the contract) time to raise funds for the purchase of those shares.
3. If the contracting party will sell its shares in the future, the second (privileged) party has, on the basis of the tag along clause, the option of joining this transaction. This means that the buyer who intends to purchase a stake of shares will not purchase it from one shareholder, but from all partners who decide to join the transaction, on the same terms. This clause is primarily intended to protect financial investors from the possibility that they remain in a company while the founders are not a part of this company anymore.
4. In addition to the option of joining the share sale transactions, the privileged partner also has the right to require other shareholders to take part in the transaction on the basis of the drag along clause. Thus, if he finds a buyer for his shares, he can demand that the other partners sell their shares, on the same terms on which he sells his. (Shareholders involved in transactions may usually, according to the first refusal clause, buy back the offered shares themselves and thus prevent their sale to a third party). This clause applies if the prospective buyer is interested in purchasing the entire company (or majority stake).
5. Financial investors usually purchase shares for cash, and founders get their shares for non-cash contributions. These contributions are often “overvalued”, i.e. their valuation assumes that the originators will achieve the company’s development goals. Therefore, it would be difficult for investors to accept a situation in which, when the company is liquidated, the founders have a share in funds obtained from liquidation, in a situation where investors did not fully recover the invested funds. Thus, if in the case of the company (or a significant part of it) being sold to a third party, for example by liquidation, merger or takeover, the fund would not get back the money invested, it has the right, by virtue of the liquidation clause, to get priority in the distribution of money obtained from the sale of the company or its assets.

Therefore, the investment agreement (like a loan agreement) has mechanisms protecting the interests of the financing party. However, unlike a loan agreement, these are the only protections – there is no collateral, nor promissory notes. In addition, by negotiating a term sheet, you can build balanced contract terms that, while protecting the interests of the investor, will be satisfactory for the founders of the startup.