"rutschgefahr!" founders terms in german venture capital contracts

multiple liquidation preferences, full ratchets and founders warranties are on the rise on the german startup market. the positions for founders and new investors in new financing rounds get worse in 2010, as a bearish venture capital (vc) market dictates tougher conditions.

in order to avoid "rutschgefahr", german for slip hazard, when negotiating an investment round, read on to get the facts right.

a recent study of the german "mlawgroup" on "vc deal terms report 2010" (german only) gives quantitative insights into an often less transparent market. take the waring, plenty of numbers coming up - plenty of facts to get the own expectations right.

the study is based on feedback on 30 seed fundings, 36 series a and 16 series b rounds. the german "high tech gründerfonds" was taking the lead with 27 investments of 66 early rounds, thus making it the first address for young german startups.

so what to expect as a founder team, when sitting down with investors?

founder vesting is dominant, in 73% of the seed investments. vesting periods are between two to four years. allowances on the vesting are the minority with just 40% of the deals for only 25% of the founders shares.

good leaver/bad leaver clauses gain 18%, up from 32 to 50% of the investments. most good leavers can expect to gain a fair valuation of their shares (73%, up from 49%) though.
venture capitals seek for preferential rights in 78% of their investments. simple (1x) liquidation preferences are seemingly unavoidable in the seed stage (73%), while multiple preferences (2x) are a minority with only 7%. 20 percent of the feedback forms contained no answer on that question though.

exit preferences are common (53%) with an average of 5% interest p.a. on capital invested (8% last year) , although a maximum of 20% was reported.

while founders warranties remain an imperative (95%), pay to play seems to become a scare species. no seed round saw such rulings, series a rounds just in 23% of the cases.
non compete clauses for founders are enforced in 100% of the seed and in 75% of the a rounds with average durations of 2 years. on average founders get a half year salary in return.

anti dilution provisions are either weighted averages (51%) or full ratchets (35%), with a clear rise in the latter.

mlawgroups commented the tightening of conditions for founders as questionable. they could not understand how the worsening positions of the founders could help to prepare the founders (and existing investors) well for exits. for a law firm, this is a rather strong statement.

so much on the numbers. good thing with the study is, that it provides a useful basis to get one own´s negotiation aims right.

read more on general terms & conditions of vc contracts in "legal gibberish of investors in plain english" and in the series "six steps to venture capital".

legal gibberish of investors in plain language

investors inject money in start.ups and they want it back. x-times in the best case, although most of the time the just loose it. so in those selected cases where a start.up works out well ,they make sure to get their money out. how they want their investment back is nailed down in the legal contracts which come along the money. every start.up should know this terms ahead of an investment. why? because otherwise they are in a game in which they do not know the rules. and that makes succeeding impossible.

this is no legal advice - as that´s the job of attorneys. rather putting legal gibberish in plain language. links are there to offer alternative explanations and resources. this post goes in line with the series "six steps to venture capital" , in particular part 5 on negotiating: in order to negotiate well, one has to know the typical terms in vc contracts. so here we go:

tag along rights/co sale rights
protection for minority shareholders. in case the majority shareholder sells his shares, the minority share holder can demand his shares to be sold on the same terms to the buyer.
this avoids that e.g. a big stake of the company get´s sold off to a strategic buyer making the remaining shares de facto un-sellable=worthless.
link investopedia

drag along rights
protection for majority shareholder. obliges the minority shareholder to sell his shares to a buyer on the same terms as the majority shareholder.
the idea is, that e.g. a one percent shareholder must not be able to block sale respectively the exit of an investor.
links: investopedia, slashstar

pre- post money valuation
definitions of company value. if a company is worth one million before an investment, this is the pre money value (before vc money gets invested).
after a two million investment, the value increases to three millions (one million company value plus two million cash), called post money value.
link investopedia, socaltech

anti dilution provision/clause
protection for investor. forces the transfer of shares from the initial shareholder to the investor in case the value of a firm decreases in the period after the investment.
if an investor a puts 1 million in a company which was worth 10 millions (before his investment = pre money) he will get 10% of the shares and the company value increases to 11 millions (post money). now assume there is another investment round with investor b only willing to invest 1 million at a company valuation of 6 million. this will trigger the anti dilution clause, as the company value decreased from 11 million to 6 (=down round). in this case investor a will demand shares form the initial shareholder in order to be compensated for the devaluation. e.g. increase his shareholding such that (after the investment of investor b) he will finally hold 15,71% of the shares (0,1571*7=1,1).
links vcexperts, investopedia

(full) ratchet
protection of investors. typically a performance depended anti dilution provision which (completely) compensates an investor for the devaluation of his shares (see above) as agreed goals are not met.
e.g. an investor injects money in company according to milestones, like sales revenues. if milestones are not met – thus leading to a lower company valuation - the initial shareholders loose shares to the investors.
link vcexperts

earnout
protects buyers, brings upside for sellers. the final price of a company depends on the performance within a time period after the transaction.
buyers of a company pay a base price for the takeover of a company. if e.g. in a period of one year after the buying the company outperforms its profits, the sellers gain a premium.
link investopedia

exit preference / participating preferred stock
protects investor. in case of a company sale, money gets first distributed to the investor and the remains to the initial shareholder. the method of distribution can vary widely.
one way would be as follows. A company gets sold 5 years after the investment of 1 million for 50% of the shares. of the exit proceeds of 5 millions the investor gets the initially invested 1 million. then he takes the interest rate of 15% per year for his invested money (around 1 million), leaving 3 millions. having 50% of the shares he takes another 1,5 millions, leading to a total of 3,5 million (3,5x or 28% per year). the remaining 1,5 millions go to the initial shareholder.
link wikipedia

pay to play
protects new investors. In case of a new investment round, the former investors/shareholders only keep special rights, if they participate in the financing.
special rights can be e.g. nomination rights for the advisory boards, anti dilution protections, or exit preferences. this clause intends to motivate old investors to support the company if further financing is required. also the governance is simplified, as old special rights get successively removed in new financings round.
links altassets, wikipedia

so much about legal stuff. no reason to let it come in-between the core business and the product. just one thing to look after and to get done right.