Finance & Legal
The Most Common Contract Clauses : What You Need to Know
Written by
Lineke Kruisinga
Published on
July 29, 2024
Written by
Published on
You've pitched your idea to investors, and a few have shown interest. Now, before diving into detailed negotiations, it's crucial to understand everything about the clause contract and its commonly used clauses.
The clause contract is one of the most significant documents you'll ever sign. It outlines the key terms of your deal with investors and can greatly influence your experience as your startup grows. However, there's a catch: when you receive your clause contract, it may be your first time, while the investors across the table have already seen hundreds.
A term sheet is a written document that lays out the important terms and conditions of a deal. It summarizes the key points agreed upon by both parties before getting into the detailed legal agreements and the time-consuming due diligence. Think of it as a guide for the legal teams to draft the final agreement. However, it's non-binding and only highlights the main points of the deal.
Learn more on Termsheet Tactics
A clause contract is a formal, legally binding document that lays out the important terms and conditions of a deal. It captures the key points agreed upon by both parties during negotiations and serves as the definitive agreement governing the relationship. Think of it as the final blueprint for how your partnership with investors will work. Unlike a term sheet, a clause contract is binding and contains the detailed legal language necessary for enforcement.
Most people will tell you that an investment is all about valuation and capital. But investors are looking to minimize risk while maximizing returns, so they'll add a range of clauses to protect their interests. These clauses can significantly impact the deal. A deal with a lower valuation but better terms in the clause contract can often be more favorable.
The key clauses in a clause contract can be grouped into four categories: deal economics, investor rights and protection, governance and control, and exits and liquidity.
Taking outside investment usually means you prefer having a smaller piece of a bigger pie rather than a big piece of a small pie. To protect this piece of the potentially big pie, you need to watch the deal economics closely. Beyond valuation, investors use specific clauses to limit their downside and guarantee a return, such as liquidation preference, participating preferred, and dividends. Be careful with these terms, as your current clause contract will influence your next round of financing.
One of the first and most important items in the clause contract is the investment amount, specifying the amounts per investor (lead, non-lead).
Valuation is the next big item. The start of any negotiation is ensuring both parties are talking about the same thing. This isn't always straightforward with pre- and post-money valuations.
The key difference is timing. Pre-money is the value of your company excluding the funding you're raising, while post-money is the value right after the investment. For example, if you're looking for a €500,000 investment and your company is worth €1,000,000 pre-money, you'll hold two-thirds of the shares post-investment. If it's post-money, you'll only hold half.
Preferred stock is more valuable than common stock as it grants certain rights, including conversion rights, allowing conversion of preferred stock into common stock. Conversion can be optional or mandatory.
Optional conversion rights allow the holder to convert shares of preferred stock into common stock. For instance, an investor with a €1 million non-participating 2x liquidation preference representing 25% of your company’s shares would get €2 million if the company is sold for €50 million. If the investor converts their shares, they would receive €12.5 million.
Mandatory conversion rights require the holder to convert shares into common stock at pre-defined events, like an IPO.
The option pool size is directly linked to valuation. Sharing equity with employees is a key tool in the startup world. Investors often ask for a sizeable option pool before their investment, which dilutes the founder’s shareholding but not the investors'.
Learn more about Option Pool
Liquidation preference determines who gets paid first and how much in events like liquidation, bankruptcy, or sale. For example, an investor with €500,000 in preferred shares and a 2x liquidation preference will get €1,000,000 if the company is sold for €2,000,000, leaving the remaining €1,000,000 for common shareholders.
Learn more about Convertible Note
With regular preferred equity, the preferred holder gets paid first, then common shareholders. If the preferred is "participating," they also get a pro-rata share of the remaining proceeds. For instance, if your company has €10m of participating preferred equity and €40m of common equity, and it's sold for €60m, participating preferred shareholders first get €10m, then 20% of the remaining €50m, totaling €20m.
Investors might ask for dividends to guarantee a return. For startups, dividends are often not paid regularly but accumulate over time, growing the preferred in size and benefiting the investor at the end of the investment (sale/IPO).
Learn more about Equity Crowdfunding
When we dive into deal economics, we've seen how investors maximize their upside. Now, let's explore clauses in the clause contract designed to protect their investments.
Anti-dilution rights are crucial in safeguarding investors from dilution when a company issues more shares, decreasing existing shareholders' ownership. There are two main types: weighted average anti-dilution and ratchet-based anti-dilution.
Learn more about Anti-Dilution
In a Series A round, full-ratchet anti-dilution ensures that if new shares are issued at a price lower than the Series A price, the original price adjusts to match the lower price. For instance, if a company initially has 100,000 shares at €10 each, and issues another 100,000 shares at the same price, the investor holds 50% of the company. If new shares are later issued at €9, the original investment remains €1,000,000 but now represents 111,111 shares, reducing ownership to 47%.
More common among contract clauses is the weighted average anti-dilution, which factors in the number of new shares issued at the reduced price to calculate the new Series A price. This method is more founder-friendly, accounting for the total shares issued in the new round. It comes in two flavors: broad-based and narrow-based, with the former considering fully diluted capitalization and the latter only counting common stock.
When crafting the clause contract, it's vital to clarify control. Key aspects include voting rights, board rights, information rights, and founder vesting.
Voting rights let shareholders vote on corporate policies. The clause contract outlines how these rights are split among share classes (A, B, Preferred) and what actions need a voting majority, like:
Preferred shareholders often get veto power over these actions, while sometimes a "common" majority gives control to common shareholders.
The board’s composition and mandate are crucial. The board represents shareholders and oversees major decisions, such as:
Investors might adjust the board structure for more control. A 2-1 board (two founders, one investor) is founder-friendly, while a 2-2-1 structure (two founders, two investors, one independent) risks losing control. Specific provisions might require investor board member approval for key actions.
Learn more about Board of Directors
Information rights require sharing the company’s financial and business status regularly. Typically, this involves quarterly management reports and detailed annual financials to keep investors informed.
Founder vesting ensures founders stay committed by risking their shares if they leave early. This helps retain key personnel and attracts replacements. Negotiate a fair vesting program, possibly excluding part of your holdings for past efforts.
Vesting details matter during a sale. "Single trigger" means all shares vest upon sale, while "double trigger" requires staying for a period post-sale (e.g., 12 months). While single trigger benefits founders, double trigger can assure buyers of your commitment during integration, smoothing the deal process.
Pre-emptive or pro-rata rights let investors maintain their ownership percentage in future financing rounds by participating proportionally in new stock issues. Though attractive to investors, these rights can complicate later rounds when new investors want larger equity stakes.
ROFR and co-sale rights protect investors in secondary offerings. ROFR allows investors to buy stock before it’s sold to a third party. Co-sale rights enable investors to join in secondary transactions, selling their shares under the same terms as larger shareholders.
A no-shop clause prevents the company from seeking other investment proposals, giving the investor leverage. Monitor the timing of this clause to avoid prolonged periods without alternatives during due diligence.
So, you've built your company, raised some cash, and now it's time to sell. But what if your minority shareholders aren’t on the same page? Enter drag-along and tag-along rights—your solution to potential roadblocks.
Imagine you, the founder, hold 51% of the company after your Series A. You’re ready to sell to SearchEngine Inc., but your minority VC wants to hold out for a better deal. Without drag-along rights, they could block your sale. Drag-along rights let you, the majority shareholder, force the minority shareholders to sell their shares too. This prevents any minority stakeholder from halting a sale that has the backing of the majority.
On the flip side, tag-along rights protect minority shareholders. If the majority finds a sweet deal, these rights allow minority shareholders to join the sale on the same terms. It ensures everyone gets a fair shake and doesn’t get left out of a profitable deal.
Note: These rights typically phase out after an IPO, as public market rules take over.
Now, let’s talk about the redemption clause—a ticking time bomb for startups if not handled carefully.
This clause lets investors demand their money back after a certain period. For venture funds, this is great because they need to return cash to their partners within a set timeframe, usually 10-12 years. But for your growing startup, this could mean trouble.
When investors invoke redemption rights, you might be forced to sell the company quickly or scramble for a new round of financing to pay them back. The company usually has to pay either the market value of the shares or the original purchase price plus interest (around 5-10%).
These rights kick in after a certain number of years, typically five, or upon specific events. The clause will detail how much time you have to complete the redemption and whether it covers part or all of the investment.
Some key clauses in a VC clause contract have already been covered. But watch out for these common traps:
Redemption rights are a favorite for many VCs. These rights let investors sell some of their stock back to the company at a specific price (a “put-option”). They’re designed to protect investors if the start-up’s growth stalls, making it unattractive for an acquisition or an IPO.
The hitch? Start-ups in that “stalled” phase usually can’t afford to buy back the stock. Plus, many countries have laws limiting share buy-backs if the company doesn’t have enough capital.
What should founders do? Simply put, redemption rights are a deal-breaker. Push back and try to remove them from the clause contract. If the VCs won’t budge, consider if you really want to work with them.
If you’re out of options (no funds or other interested investors), only agree to redemption rights after five years at the initial investment price.
Milestone-based financing means the investment comes in stages, tied to specific milestones. For VCs, this reduces their risk and ensures more capital only flows in when milestones are hit.
What should founders do? This isn’t standard practice in Silicon Valley or most of the world anymore. Push back if you see it in a clause contract.
Economic downturns like the 2009 recession, COVID-19, or political and economic instability can freeze VC deals. Getting all the money upfront is way better than having it tied to milestones.
Some VC clause contracts sneak in “monitoring fees” or “board fees,” charges for investors’ presence on the Board. Founders should push back on these unnecessary fees that are unfair to the start-up and could hurt future funding rounds.
What should founders do? It’s normal to agree to legal fees for documentation and compliance with local laws. Some clause contracts also include due diligence and advisor fees, where third parties review your documents.
As a founder, try to cap these fees to protect yourself if the deal falls through. And definitely push back on “monitoring fees” and “board fees” – get them out of the clause contract.
If you've stuck with us to the end, you're now armed with knowledge about common contract clauses and ready to dive into clause contract negotiations. We know it's a nerve-wracking process, especially when you're in the dark about the other side's game plan. But don't sweat it. Mastering the twists and turns of startup funding deals means thinking beyond just the valuation.
Remember, every clause in that clause contract—whether it's liquidation preference, anti-dilution protection, or the right of first refusal (ROFR)—carries weight. It’s not just about getting the money, but also about protecting your startup’s future. So, take your time, understand the implications, and don't be afraid to push back on terms that don’t feel right.
And here's a pro tip: always have a savvy legal team in your corner. They'll help you sidestep potential pitfalls and keep things smooth between you and your investors. With the right preparation and guidance, you'll not only secure the funding you need but also lay a solid foundation for your startup's success.
For more in-depth insights, check out our articles on term sheet tactics, finding the right investor fit, and VC coaching.
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