Startup Investment Contract Guide: Avoiding Poison Clauses and Negotiating Favorable Terms

1. Introduction

1.1 What is a Startup Investment Contract?

A startup investment contract is a legal document that specifies the rights and obligations between investors and founders. It defines the equity, rights, and obligations that investors receive in exchange for providing capital, and encompasses the future management direction of the startup and its exit strategy.

1.2 Why is an Investment Contract Important?

Investment contracts are essential during a startup's growth. This document clarifies the relationship with investors to prevent disputes and ensures the stable operation of the startup. A poorly drafted contract can lead to problems such as loss of management rights, unfair exits, and obligations to return investments.

1.3 Purpose and Expected Effects of this Article

This article aims to help startup founders understand the key clauses and poison pill clauses in investment contracts, propose reasonable amendments, and learn how to review contracts to avoid unfair investment terms.

2. Understanding the Key Clauses of an Investment Contract

2.1 Investment Terms: Investment Amount, Equity Ratio, and Type of Stock

Investment Amount: The amount of capital the investor will provide and the payment method.

Equity Ratio: The percentage of equity the investor will receive. The dilution of the founders' equity should be considered.

Type of Stock: Specifies whether the stock is issued as common stock or preferred stock.

2.2 Difference between Preferred Stock and Common Stock

Common Stock: Stock with basic voting rights and dividend rights.

Preferred Stock: Stock with special rights such as liquidation preference and dividend preference. Primarily issued to investors.

2.3 Voting Rights and Board Composition

Verify if the voting rights of the investor correspond to the equity ratio when the investor has voting rights.

Specifies whether the investor has the right to participate in the board of directors or nominate specific directors.

2.4 Dividend and Liquidation Preference

Includes cases where the investor is given priority in recovering the investment (1x or more).

Clearly state whether dividend preference exists.

2.5 Tag-along Rights and Right of First Refusal (ROFR)

Tag-along Rights: Allows minority shareholders to sell their shares under the same conditions when a majority shareholder sells their shares.

Right of First Refusal: Gives existing shareholders the first opportunity to purchase shares before they are sold to others.

2.6 Stock Sale Restrictions (Lock-up, Transfer Restrictions)

Lock-up clauses restrict the sale of shares for a certain period.

Transfer restrictions require prior consent from the company or existing shareholders when selling shares.

2.7 Exit Strategy Related Clauses

The investor's right to receive minimum compensation during the exit process (M&A, IPO, etc.).

Clauses guaranteeing the investor's equity recovery upon exit.

2.8 Confidentiality and Non-Competition Clauses

Imposes a confidentiality obligation on investors to prevent the leakage of company information.

Restricts investors from investing in the same industry.

3. How to Identify Poison Pill Clauses

3.1 Definition and Main Examples of Poison Pill Clauses

Poison pill clauses refer to unfair contract terms that grant excessive power to investors or restrict the management and autonomy of the startup. Main examples include IPO control and unreasonable put option demands.

3.2 Excessive Rights Clauses for Investors

Clauses requiring prior approval from investors for all management decisions.

Cases where investors have the sole authority to decide on management changes.

3.3 Excessive Control Demands Regarding IPOs

Clauses requiring investor approval for all major decisions when pursuing an IPO.

Forcing the decision on the listing market and offering price by a majority of investors.

3.4 Unreasonable Guarantee and Collateral Demands

Demanding that the founder personally guarantee the investment or provide collateral.

3.5 Unfavorable Exit Clauses

Cases where only investors are prioritized for exit, excluding founders.

3.6 Clauses that Infringe on the Startup's Management Autonomy

Excessive restrictions requiring prior consent for new businesses or large-scale investments.

4. Amending Unfair Investment Contract Clauses

4.1 Amendment Procedures and Negotiation Tips with Investors

Clearly identify problematic clauses and prepare grounds for reasonable amendments.

Emphasize mutual benefit during negotiations with investors.

4.2 Examples of Amendments to Key Poison Pill Clauses

IPO Control: Change from requiring majority investor consent to submitting opinions.

Put Option: Limit to a certain period and set an upper limit on the amount.

4.3 How to Propose Amendments Favorable to the Company

Specifically propose alternatives to problematic clauses.

Provide logical justification that also benefits the investor.

4.4 Amendment Examples: IPO Control, Put/Call Options, Governance Clauses

"Major matters related to the IPO will be decided by the board of directors, but the majority consent of investors will only apply if the secondary offering or equity dilution exceeds a certain percentage."

5. How to Review an Investment Contract

5.1 Points to Note When Reviewing a Contract

Review whether all clauses align with the startup's growth.

Check for ambiguous expressions or missing content.

5.2 Key Points to Check When Reviewing a Contract

Investment terms and preferred stock rights.

Management rights and exit-related clauses.

5.3 Utilizing Legal Professionals and External Reviews

Review the contract with the help of a professional lawyer or accountant.

Refer to the opinions of experienced mentors or investment professionals.

5.4 Reaching Internal Agreement Among Founders After Review

Share the review results with the founders and reach a final agreement.

6. Tips for Drafting and Negotiating Investment Contracts for Startups

6.1 Points to Note When Drafting an Investment Contract

Draft a contract that aligns with the company's vision and long-term growth strategy.

Clearly define the rights of all stakeholders.

6.2 Common Mistakes in Negotiations with Investors

Overlooking poison pill clauses or uncritically accepting investor demands.

Disagreements among founders during negotiations.

6.3 Designing Investment Contracts from a Long-Term Perspective

Drafting a contract that considers not only initial growth but also the exit strategy.

Maintaining a trusting relationship with investors while securing management autonomy.

7. Conclusion and Summary

7.1 Key Summary of Drafting and Reviewing Investment Contracts

It is necessary to understand the key clauses of the investment contract and remove poison pill clauses.

Secure favorable terms for the startup through the proposal and review of amendments.

7.2 Importance of Contracts that Foster Mutual Benefit Between Startups and Investors

Contracts that are beneficial to both startups and investors ensure long-term success.

7.3 Additional Resources and Recommended Materials for Startups

Examples and sample documents of investment contracts.

Startup legal guides and consultations with investment professionals.