Shareholding Agreements for Start-ups: Key Clauses and Pitfalls in Investor Term Sheets
For many start-ups, funding rounds form part of their growth strategy. Even at an early stage, so-called term sheets or investment agreements are often negotiated.
It is precisely here that important economic and legal decisions are being made.
What is a term sheet?
A term sheet sets out the key terms of a proposed investment.
Typical content:
- Business valuation
- Level of participation
- Right to be consulted
- Exit regulations
Even though many provisions may initially appear to be non-binding, they often have a significant influence on the subsequent drafting of contracts.
Why clear ownership structures are crucial for future funding rounds
Arrangements made at an early stage often have implications that extend far beyond the initial round of funding. Complex ownership structures or unbalanced investor rights can deter subsequent investors and make future rounds of funding more difficult.
A complex shareholder structure can quickly emerge, particularly where there are several rounds of investment. A lack of clarity regarding approval rights, anti-dilution mechanisms or exit arrangements often leads to delays in negotiations.
Many investors therefore ensure, at an early stage, that the company has a professional corporate structure and transparent decision-making processes.
Key clauses in practice
Liquidation Preference
Governing the distribution of proceeds in the event of an exit. This can have significant financial implications for founders.
Vesting
The founders’ shares are often subject to specific time frames or conditions.
Dilution protection
Investors often take steps to protect themselves against future losses in the value of their investment.
Right to be consulted
Decision-making processes and authorisation rights should be clearly defined.
Common pitfalls
Particularly in the early stages of financing, terms are often negotiated under considerable time pressure. This carries the risk that the long-term implications of individual clauses may be underestimated. What initially appears to be a purely technical contractual provision may later have a significant impact on control, exit structures or further rounds of financing.
Many start-ups initially focus heavily on the funding itself – rather than on the long-term implications of individual clauses.
The following are particularly problematic:
- unbalanced control rights
- unclear exit arrangements
- complex dilution clauses
Practical tip: Plan ahead
Having a clear structure in place from an early stage makes subsequent funding rounds considerably easier.
These are important:
- clear cap tables
- tailored shareholder structures
- transparent decision-making processes
It is also crucial that the investment agreement, the shareholders’ agreement and the articles of association are consistent with one another. Contradictory or unclear provisions often lead to uncertainty and conflicts between investors and founders at a later stage.
Conclusion
Investment agreements are far more than mere financing documents. They have a long-term impact on a start-up’s control structure, growth and exit options.
If you have any questions on this or other topics, please contact us - we will be happy to advise you.
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