Hello, I am Attorney Kim Kwang-sik from Cheongchul Law Firm.

In the growth process of startups, the relationship with investors is essential and plays a significant role in business expansion. However, unclear clauses in investment contracts, changes in equity structure, and conflicts over management rights can cause disputes between founders and investors, greatly affecting the growth of the startup. In this post, we will look at common investment dispute cases in startups with specific examples and also consider methods to resolve these issues.

[Question]

What are the types of investment disputes commonly occurring in startups and what are the solutions?

[Answer]

1. Conflicts due to equity dilution

It is common for the equity of existing shareholders to be diluted when a startup attracts new investors. For example, let's assume a startup offers 20% equity to initial investors at the Series A stage, and then attracts substantial funds from new investors at the Series B stage. If 40% equity is granted to the new investors, the existing investors' equity will proportionally decrease.

In such a situation, the initial investors may feel that their early risks have been disregarded. Especially if the investment contract does not include an anti-dilution clause, this conflict could escalate into a serious legal dispute.

Solutions:

• Incorporating anti-dilution clauses: The full ratchet anti-dilution clause mentioned in past posts guarantees that existing investors can obtain additional shares at the same price as new investors, while the weighted average method minimizes dilution of the founder's equity while preserving some equity for existing investors.

• Prior discussion on equity changes: Generally, in investment contracts where follow-on investments occur, it is common for the founder, as a stakeholder, to obtain the obligation to notify existing investors about changes in equity and potential dilution resulting from follow-on investments. Even if such provisions are not established, it is advisable for the founder to transparently explain the equity changes and potential dilution to existing investors before proceeding with follow-on investments.

2. Distrust regarding the use of investment funds

If a startup uses the investment funds inefficiently or if suspicions arise that the founder is using funds for personal purposes, it can strain the relationship with investors. For example, consider a case where a startup promised to use new investment funds for product development but ended up spending most of it on marketing events. Investors may view this as a "breach of contract," resulting in high possibilities of contract termination, claims for the return of investment funds, or exercising put options.

Additionally, if the founder does not share the fund usage details or spends the funds without detailed plans, investors may raise questions about the company’s operational capacity.

Solutions:

• Clarification of the fund usage plan: The investment contract should clearly specify the purpose of the fund usage and major expenditure items. For example, establishing a specific allocation like "50% for product development, 30% for marketing, and 20% for personnel costs" can help prevent conflicts.

• Establishing a regular reporting system: The founder can include a clause that requires them to transparently report the usage of investment funds and the business progress to investors monthly or quarterly. This can help maintain investor trust and reduce unnecessary misunderstandings.

• Utilizing legal oversight systems: It is advisable for investors to include the right to verify expenditure details through a law firm in the contract.

3. Conflicts over management rights

When an investor holds a significant percentage of shares, attempts to get involved in company operations may occur. For instance, consider a situation where an investor holding 30% equity in a startup excessively interferes with management strategies and attempts to lead key decisions rather than the founder. Such situations can become major obstacles for the founder to operate the company efficiently.

Moreover, if a certain investor pressures to include close associates in the management team or unilaterally opposes the founder's decisions, it can also lead to conflicts.

Solutions:

• Limit voting rights on key issues: Including a clause in the investment contract stating that "decisions related to the company's strategic direction require the founder's approval" can help prevent conflicts over management rights.

• Shareholders' agreement (SHA): By clearly defining the scope of management participation, decision-making rights, and responsibilities through a shareholders' agreement, the founder's right to make independent judgments on major issues can be protected.

• Establishing an arbitration committee: If conflicts become serious, it may also be considered to proactively form an arbitration committee composed of neutral external experts to resolve issues quickly.

4. Disputes over the timing and methods of investment recovery

Investors typically seek to recover their investments (Exit) after a set period after investing. However, conflicts can arise if the founder intentionally delays events such as IPOs (Initial Public Offerings) or M&A (Mergers and Acquisitions) or if external market conditions lower the recovery potential. For example, an investor may become increasingly dissatisfied if they invested with the expectation of an "IPO within 3 years," but the founder focuses solely on business expansion without a clear plan.

Solutions:

• Clarification of the recovery schedule and methods: The investment contract can consider establishing clear goals such as "IPO within 5 years after investment" or "annual evaluation of recovery potential."

• Utilizing put options and co-sale rights: By stipulating terms regarding put options or co-sale rights in the investment contract, investors can use the put option to compel the founder to buy back their shares under the agreed-upon conditions or to sell the founder’s shares along with their own through drag-along rights.

• Presenting alternatives based on market conditions: If recovery is difficult due to external factors, the founder should seek new strategies (e.g., partial sale, joint venture) with the investors.

5. In conclusion

Disputes between startups and investors can hinder business growth and damage trust. To prevent this, it is essential to establish clear provisions at the initial contract stage, maintain continuous communication, and ensure transparency. In the event of conflicts, it is important to quickly and reasonably find solutions with the advice of legal professionals.

Attorney Kim Kwang-sik provides expert legal support and effective solutions for the successful growth of startups based on expertise and rich experience gained at Kim & Jeong Law Office.

A small detail can change the future of a startup. Prepare the future of your startup more robustly through careful review and appropriate advice from Cheongchul Law Firm.