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At JVH Ventures, we appreciate the interplay between substantial risk and remarkable rewards associated with early-stage startup investments. To ensure a secure and mutually beneficial agreement, we place great importance on effectively managing this risk/reward relationship through some important contractual elements.
As we often get asked what our legal checklist looks like, we want to share our most important legal clauses for Shareholder Agreements (SHA) at our early-stage startup investments. As we are no lawyers ourselves, we are happy to include the professional opinions of Dr. Alexander Wulff and Jacob Düwel-Hollingsworth of BMH BRÄUTIGAM - one of the leading venture capital law practices in Germany.
Let's dive into our checklist!
1. Founder Vesting and Lockup
The commitment of the founders to their company's long-term success is a key determinant of a venture’s trajectory. To ensure that the founders stay the course, we and most other early-stage investors demand vesting and lockup provisions. By tying the founders' equity to a set timeframe, these clauses ensure that founders remain incentivized to stick with the company and contribute to its growth.
What we mostly see is a vesting timeframe of 3-4 years, with a cliff period of 6-12 months. In addition, the most common vesting scheme is monthly or quarterly vesting.
What BMH BRÄUTIGAM thinks:
Importantly, these provisions also protect the interests of the remaining founders in the event that one decides to leave, ensuring that the fruits of their ongoing labor are not unduly shared. In a leaver case without a vesting arrangement, the remaining founders would bear the burden of all future work, while the exiting founder still benefits from the venture's performance.
2. Liquidation Preference
Another key contractual element is the Liquidation Preference clause, which provides a layer of protection in a liquidation event, such as a sale or merger, by ensuring that the investor recoups its investment before other equity holders. As a matter of practice, we incorporate a one-time non-participating liquidation preference clause into our investment contracts, which reflects the predominant market standard.
What BMH BRÄUTIGAM thinks:
While offering downside protection to the investor, this clause also strikes a balance by incorporating a catch-up mechanism for junior share classes. In high-value liquidation events where the proceeds exceed the post-money value of the last financing round, this mechanism ensures that all stakeholders receive a pro rata share of the surplus.
3. Drag Along
The Drag Along provision is another cornerstone of our contractual strategy. Triggered during significant corporate events, like a sale or merger, this provision grants the power to enforce the sale of other equity holders' shares.
What BMH BRÄUTIGAM thinks:
Typically, activating the Drag-Along provision demands concurrence from both the majority of most preferred shares and the founder majority. However, a specified timeline in the agreement may permit investors, should they hold a majority stake, to trigger this provision independently after a certain number of years.
While it ensures that the investors can exit the investment alongside other equity holders, guaranteeing a predictable outcome and a fair share price, it also aids the founders. It prevents minority shareholders from obstructing a transaction backed by the majority, making negotiations smoother and enhancing the company's attractiveness to potential acquirers. Thus, a drag-along provision balances investor and founder interests, promoting efficient transactions and potentially maximizing returns for all.
4. Tag Along and Right of First Refusal
These two clauses are also included within most Shareholder Agreements. We seldomly need to discuss the presence of the clauses with founders, but their implementation is also crucial from our perspective.
What BMH BRÄUTIGAM thinks:
We emphasize the importance of Rights of First Refusal (ROFR) and Tag Along rights. These rights form a critical line of defense against the unwanted imposition of new shareholders on existing ones, helping to preserve the trust-based relationships among shareholders, which is particularly important in limited liability companies.
The ROFR allows any investor shareholder to maintain influence over the shareholder base, a critical component in a venture's success trajectory. It provides the opportunity to acquire additional shares before other potential investors, allowing for the maintenance or even increase of ownership stake as the company grows. This ability to participate in the company's growth and evolution is a vital part of many investors’ long-term investment strategy.
The Tag Along Right ensures that if a shareholder decides to sell its stake and the ROFR is not completely exercised, the investors as well as the founders after the lock-up have the right to join the transaction and sell their stake pro rata, preventing any potential disadvantageous disparity in the conditions of sale.
5. Downround Protection
As the current development in the venture capital market has illustrated, the possibility of future financing rounds at lower share prices, or 'downrounds', is a risk all investors face. We mitigate this risk by insisting on the inclusion of Downround Protection provisions in our contracts. The method we use and which in our opinion is a fair and market standard approach is the Broad Based Weighted Average method.
Downround protection can potentially lead to the founders being stripped of a significant part of their shares in the worst case scenario. However, it also creates an incentive not to gamble too much on high valuations in the first place.
What BMH BRÄUTIGAM thinks:
The Broad Based Weighted Average method and …
The Broad Based Weighted Average method calculates an average price across financing rounds and weighs this average price by the volume of the financing rounds. The investor is placed in the same position as if he had invested his entire investment at a weighted average price with an unchanged investment amount, by receiving additional shares.
… Full Ratchet Method
The investor friendly Full Ratchet Method on the other hand places investors in the same economic position as if they had fully invested at the price per share of the downround. This means that the different issue prices of the financing rounds are not taken into account; in other words, no average price is calculated for the entry financing round and the down round.
6. Pro Rata Rights
Pro rata rights are a significant pillar of our investment strategy at JVH Ventures. This provision ensures that we have the right to maintain our ownership percentage in the company in future financing rounds. Given our portfolio strategy, we like to double down on the winner, so ideally even extend our share in companies that develop well.
What BMH BRÄUTIGAM thinks:
These rights create a shield against dilution of ownership stakes, a common challenge during subsequent funding rounds. By integrating Pro Rata Rights into Shareholder Agreements, the investors can preserve their proportional ownership as the startup expands its capital base.
Additionally, the Super Pro Rata Rights offer the opportunity to invest a larger percentage of capital in subsequent rounds than the initial ownership stake. This powerful right not only shields against dilution but also allows for the amplification of the investors stake in promising startups. However, this Super Pro Rata Right only applies in case other shareholders do not exercise their respective pro rata rights.
7. Future Financing Rounds
Startups navigate a treacherous financial landscape and the need for continued capital infusion isn't just a desire but a necessity for many. From JVH's perspective, the "Future Financing Rounds" clause in shareholders' agreements is emblematic of this often pressing need, as it enables a certain majority to enforce the cooperation of all shareholders in the implementation of further financing rounds. If a majority of shareholders, normally the majority of preferred shares and the founders’ majority, discern an opportunity or a pressing need to secure more funds, it’s in the venture's best interest to move swiftly and this clause ensures such agility. While it might seem to be an imposition on the minority shareholders, the overarching goal is clear: the collective health and growth of the company.
Moreover, from an investor's viewpoint, such a clause signals commitment and coherence among shareholders, making the venture a more attractive investment proposition. It suggests a collective willingness to pivot or scale as necessary, even if it means momentarily subduing individual reservations.
What BMH BRÄUTIGAM thinks:
The "Future Financing Rounds" clause enshrines the principle that a majority-backed decision, especially one as consequential as a financing round, should be given precedence. However, we include protective stipulations within the clause that ensure individual shareholders' rights aren't entirely overshadowed.
For one, no shareholder can be compelled to make additional investments or other payments. This limitation ensures that while they might have to work in tandem with the majority's vision, their financial commitment remains at their discretion. Furthermore, the clause ensures that no shareholder is disproportionately affected, according due respect to individual shareholders' rights and positions while emphasising collective decision-making. The clause strikes a balance between the need for rapid, majority-driven decisions with the inherent rights and interests of each shareholder, no matter how large or small their stake.
We often encounter inquiries about the clause's relevance with the argument that a statutory majority of 75 % can drive a capital increase anyways and enforce the future financing. While this is true from a mere technical point of view, in real life new investors normally demand key privileges like a most senior ranking liquidation preference or a board seat. To meet these requests the shareholders’ agreement needs to be amended, which is subject to the approval of all parties under German law. Hence, without provisions like the "Future Financing Rounds" such approval cannot be enforced.
8. Protective Provisions / Basic Investor Majority Veto Rights on Critical Decisions:
Lastly, we require the incorporation of protective provisions, meaning basic investor majority veto rights on critical decisions in our investment contracts. These provisions ensure that we have a say in important company decisions such as hiring and firing executives, making major financial decisions, or selling the company. This provides us with a basic level of control over our investment and ensures that we can protect it if the company is not performing as expected.
What BMH BRÄUTIGAM thinks:
These provisions confer upon the investor majority a voice in key decisions concerning the company's direction and future and draw its structure from the crucial differentiation between extraordinary management matters, the responsibilities of which lie with the company's founders acting as managing directors, and extraordinary shareholder matters.
Extraordinary management matters may include approving the annual budget or recruiting key personnel. Extraordinary shareholder matters usually involve more strategic decisions on shareholder level, e.g. capital measures or amendments to the Articles of Association. Such decisions hold a different level of significance than decisions in the ordinary course of business and require a higher degree of scrutiny. To achieve this, the investors require a veto right in such decisions that are out of the ordinary course of business.
However, it’s generally also desired that the operational control of the company should primarily be with its founders. Thus, investors should maintain a careful balance between allowing the founders to run the day-to-day operations and having a say in important strategic decisions.
These provisions are not just advantageous to the investors, they also serve the founders' interests. They underscore the investors’ active involvement and commitment to the company's strategic direction and success. Their ability to safeguard the investment against unfavorable circumstances doesn't only protect our interests but also contributes to the stability and continuity the founders can rely on. Furthermore, the investors proactive involvement and strategic input can bring to the table our experience and network, potentially benefiting the company's growth. This balance between oversight and cooperation is a crucial aspect, helping both investors and founders to ensure a prosperous outcome for all parties involved.
Conclusion and a big Thank You!
In conclusion, venture capital investment entails a delicate balance between risk and reward. At JVH Ventures, we carefully manage this balance through a comprehensive and strategic approach embodied in our investment contracts. The clauses discussed in this article are critical to our strategy, acting as fortresses to secure our interests, ensure a robust and fair investment environment, and support the long-term success of the startups we invest in.
In addition, we value to have a strong partner with BMH BRÄUTIGAM who understands both sides of the table. As we worked together with them from both perspectives already, we saw for ourselves that they are always able to find mutually beneficial solutions for founders and investors alike. With their vast experience in the legal world of startups and their pragmatic approach, they established their household brand in the German Startup Ecosystem.
Feel free to contact Dr. Alexander Wulff if you need good legal advice!
They are happy to get to know ambitious founders and angels.
Once again, we would like to thank BMH BRÄUTIGAM for co-authoring this article!
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