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

In the early stages of a startup, securing investment funds is the top priority, but signing an investment contract without fully understanding its clauses can seriously impact the founder's management rights or equity protection. Especially if the founder does not clearly understand how the clauses proposed by the investor work, there is a high possibility of long-term operational problems for the business. In this posting, I will explain in detail three clauses in a startup investment contract that entrepreneurs must pay attention to.

[Question]

What are the main conditions that startup founders should be careful about when signing an investment contract?

[Answer]

1. Anti-Dilution Clause: Essential for protecting equity during growth stages

The anti-dilution clause in an investment contract is a mechanism designed to protect the value of existing early investors' shares if a new investor purchases shares at a lower price. This clause can affect not only early investors but also the founder's equity, so it must be carefully considered.

The anti-dilution clause is usually stated in the following ways:

l   Full Ratchet:

-      If a new investor buys shares at a price lower than the existing investors, the value of the initial investor's shares is re-evaluated based on the same lower price.

-      Example: An initial investor purchased 10% of equity at 1,000 won per share, but if a new investor invests at 500 won per share in a subsequent funding round, the value of the initial investor's shares will be adjusted to 500 won per share.

-      This method has a high possibility of significantly diluting the founder's equity, making it disadvantageous for the founder.

l   Weighted Average:

-      It calculates the average issue price of shares to adjust the existing investor's equity ratio.

-      This is relatively less disadvantageous for the founder, but the detailed calculation method must be clearly understood.

-      Points for founders to be careful about in the weighted average method:

①      The situations in which the anti-dilution clause applies and the calculation methods must be clearly specified in the contract.

②      It is possible to set exceptions in the contract for new share issues that are not included in the anti-dilution clause to prevent the misuse of this clause.

2. Preemptive Rights: Limitations on additional investments and sale of shares

Preemptive rights are key rights that investors use to protect their equity in a startup. It is a clause that provides existing investors the first opportunity to purchase shares when the company issues new shares or existing shareholders sell their shares.

However, such preemptive rights can limit the equity flexibility of founders when they try to attract new strategic investors, weakening their negotiating power. Especially, if existing investors exercise their preemptive rights and fail to meet the conditions required by strategic investors, the negotiations may fall through. Additionally, there is also the possibility of missing important opportunities due to the complex approval process required to obtain the consent of existing investors during new investments or share sales.

Therefore, founders must set the scope of preemptive rights restrictively. For example, they could clarify conditions such as, “This applies only when the company attracts new investments above a certain amount.” Additionally, it is necessary to negotiate to ensure that the preemptive rights of existing investors do not overly influence the founder's decision-making.

3. Drag-Along Rights and Tag-Along Rights: Preventing imbalance during sales

In investment contracts for startups, drag-along rights are utilized as a clause that forces founders to participate in the sale when investors sell the company, while tag-along rights are the provisions that guarantee investors the right to participate in the sale under the same conditions. The fundamental differences between them are as follows:

In the case of drag-along rights, there is a risk that the founder will not be able to control the investor's decision to sell the company, and in the case of tag-along rights, when the founder attempts to sell shares to a strategic investor, existing investors may demand to purchase shares under the same conditions, making negotiations difficult.

Therefore, founders need to specifically set the triggering conditions for drag-along rights in the investment contract and clearly define these. It is also necessary to negotiate tag-along rights in a way that ensures flexibility for the founder in the sale process.

4. Conclusion

The clauses in the investment contract directly impact the founder's equity, management rights, and the sustainability of the business. Therefore, it is crucial to fully understand and negotiate the anti-dilution clause, preemptive rights, and drag-along and tag-along rights, which are typically included in investment contracts and play important roles in future company operations, at the initial contracting stage.

Founders should not view these clauses merely as tools for securing investment funds but recognize them as crucial mechanisms for long-term business growth and protection of management rights. Therefore, when drafting or reviewing an investment contract, it is highly recommended to seek assistance from legal professionals.

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

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