Investment agreements: key clauses that every entrepreneur should be aware of
Investment agreements are fundamental documents in the entrepreneurial ecosystem, as they regulate the relationship between investors and startups. For entrepreneurs, knowing the key clauses in these agreements is essential to protect their business vision and ensure a fair collaboration with investors.
Below, we analyse the most important clauses in an investment agreement.
1. Condition precedent clause
This clause sets out prerequisites that must be met before the investment becomes effective. These may include obtaining regulatory approvals, verifying financial statements or the startup meeting certain targets.
2. Representations and warranties (R&W)
Representations and warranties seek to assure investors that the company is in a stable financial position and that there are no hidden risks that could affect its value. They include statements about intellectual property, absence of litigation and legal compliance.
3. Non-compete and permanence clause
Investors often require that the founders remain with the company for a certain period of time, ensuring their commitment to the growth of the business. In addition, competition restrictions may be included to prevent founders from creating rival businesses after their exit.
4. Investor rights
This clause regulates the participation of investors in decision-making. It may include:
- Veto rights: these allow investors to block certain strategic decisions, such as the issuance of new shares or the sale of the company.
- Composition of the board of directors: defines how the members of the board of directors are elected and the participation of investors in the management.
5. Anti-dilution clauses
These protect investors against future financing rounds in which the price per share is lower than initially paid. There are two main types:
- Full ratchet: adjusts the conversion price of preference shares to the lower price of a new issue.
- Weighted average: calculates a weighted average price between the original valuation and the new valuation.
6. Restrictions on the transferability of units
Rules on the sale of start-up shares are established to maintain the balance in the shareholder structure. These include the following:
- Tag along: this allows minority shareholders to sell their shares if a majority shareholder decides to sell his or her shares.
- Drag along right: this obliges minority partners to sell their shares if a majority partner receives an offer to buy them out.
7. Preferential liquidation clause
Determines the order in which proceeds are distributed in the event of liquidation of the company. Investors can receive their initial investment before the founding partners receive profits.
Typically, investors have priority to recover their investment before the founding partners receive profits. Depending on the negotiation, this preference may be:
- Participating: the investor receives its initial investment and also participates in the distribution of the remaining funds.
- Non-participating: the investor only receives the amount of its initial investment without participating in the further distribution.
8. Exit clauses
Investment agreements often include provisions on how and when investors can exit the company and recover their investment. The most common options are:
- Sale of the company: if an attractive offer is received, investors can demand a full sale of the business.
- IPO: in case the company grows significantly, an initial public offering can be planned as an exit route.
- Sale of shares: investors can sell their shares to third parties under pre-established conditions.
Understanding these clauses is essential for entrepreneurs to negotiate investment agreements in an informed manner and protect the growth of their startup. Expert legal advice can make a difference in structuring a fair deal for all parties involved.
