“Rules of the game” dependent of development stage as well – What do agreements between startups and investors regulate?

The startup community in Serbia is growing larger and more developed, and, considering the great potential of these companies and their fast development, they are often looking for additional funds and sources of finance.

Negotiations with potential investors are often long and detailed, and, once completed, the mutual relations are defined by agreements. An agreement between a startup and an investor usually regulated two sets of issues: financial, i.e. economic conditions, and control mechanisms. The negotiation process, therefore, practically serves to test to what extent the mutual interest of the two parties has been satisfied, and the list of the conditions of the agreement, the so-called term sheet, is a brief overview of the business agreement between the founder of the startup and the investor. The document, therefore, presents what the future business relation should look like in a simple way.

Representatives of the startup community in Serbia had the opportunity to inform themselves of the models and the key points of agreements with investors at the lecture held on June 14 at the Startit Center.

As Aleksandar Sukiban of the Karanovic & Nikolic Law Office said at the gathering, a term sheet usually covers key topics concerning the mechanism, the manner and the height of the investment of funds by the investor, the corporate management of the startup and, finally, the payments of the company's increased value or the payment of the remaining value in case the startup fails to meet the expectations. Using this document as the basis, lawyers prepare an investment agreement.

– During the negotiations about defining the term sheet, generally accepted terms such as “tag along”, “convertible loan” and such are used. The basic purpose of using these terms is for the parties to better understand each other so as to facilitate and accelerate reaching an agreement – Sukiban explains and adds that there are three main types of investment: equity – investment in main assets, debt – investment through loans and convertible debt – a loan with the right of conversion into capital.

Mutual interest facilitates agreement

Jan Kobler of the investment fund South Central Ventures, which has invested in four IT companies in Serbia since September 2015 – DryTools, City Expert, Cube and Workplus, believes that, prior to cooperation, investors and startup founders need to make sure that they have a mutual interest, which is dedication to growth and increasing the company's value.

– The details of the contract depend on the stage of development of the company. If it is in a very early stage, the number of items that are negotiated about is smaller than in the case when the company is more developed and the investment bigger. The investor and the founder should agree about the short-term business plan, the purpose of the expenditure of the invested funds, the joint strategy of the sale of the company, management, and there's also the evaluation of the company, of course – Kobler explains in his interview for eKapija.

Nebojsa Lazic of StartLabs, the first accelerator founded in Serbia, in September 2013, to the end of investing in technological startups from Serbia and the Western Balkans, explains that, generally, these agreements regulate two sets of issues: financial (economic) conditions and control conditions. As he points out in his interview for eKapija, financial conditions entail the details about the amount of money invested, the percentage of ownership the investor gets in return (provided it is that kind of an investment), the manner of the distribution of the profit on the occasion of the sale and other money-related questions.

– On the other hand, control conditions define the manner in which the company is to be run, such as clauses on the board of directors, the rights of each owner in making various decisions and such. These contracts are very detailed and generally extensive, as they need to cover each potential situation. This is why a term sheet is signed before the agreement, as a document which explains the basic terms of the agreement in a simple, clearer way.

Investors looking for security and involvement in making key decisions

Our interviewees emphasize that a formal benefit of an agreement between a startup company and an investor is the fact that, in the case of a conflict, there's a document defining the rules of the game. Informally, agreements are very important because of the very process of negotiating.

– We invest in companies in very early stages, which sometimes don't even have a product. In essence, we invest in people, the founders of these companies. The negotiation process provides a very good insight into the character and the psychological profile of our future partners – says Kobler, whereas Lazic notes that these contracts, being of a standard format, provide a precise and comprehensible look into the ownership and control structure of the startup to each next investor or purchaser looking to get involved in the company.

When it comes to security mechanisms that investors, as minority owners, require in signing a contract, Kobler believes that the best mechanism is in fact the very decision about who they will cooperate with, that is, which team they will invest their capital in.

– There are pretty detailed exit clauses (drag along, tag along) in these contracts. Also, there are several things which require of the founders to have a consensus by the investors, including investments above a certain amount, penetrating new markets, important changes in business plans – Kobler emphasizes.

As a rule, investors expect to have control over issuing new shares of the company, decisions on selling the company, the incurring of debts and the sale of other owner's stakes. Lazic says that these are rather usual expectations and that they are rarely contested. Furthermore, investors want to have the right of deciding on the next round of the investment, if it ever occurs, as well as the right of priority in the first payment from the profit of the sale of the company.

Uncompromising positions not desirable in negotiations?

The most common mistake made by startups in negotiating with potential investors is an uncompromising attitude and an attempt to negotiate about the things which are standard and generally accepted in the industry or some less important things, such as the manner of dividend payment, evaluation, or formal control mechanisms.

To startups only just beginning with business activities or those which are yet to turn into companies, it is a non-issue whether the investor will get 8 or 9% of the ownership, Lazic believes.

– It is certainly necessary for each founder of a startup to pay good attention, in raising an investment, to some other, very important items in the agreement – for example, the investor's control rights and the rights in the next investment round, the investor's participation in the company's board and such. These clauses can even lead to some potential investors giving up on investing in one of the next rounds, as the existing investors have an overly privileged status or an excessively big ownership share in the startup – Lazic notes.

In preparing for the negotiations with potential investors, startups can find plenty of useful information, advice and examples of best practices online, and eKapija's interviewees also recommend direct talks and exchange of experiences with other startup founders.

– Practically all investment documents are available, as is open source software. Therefore, I advise everybody to take a look at the structure and the value of those standard documents and think before they sign anything deviating from the structure, the format and the standard values from the documents used in the industry. Many investors even publish the contracts they adhere to on their websites – Lazic says.

Kobler claims that no universal M.O. exists, but that, unfortunately, in this region, a startup first needs to be secure, whereas the investor needs to have the necessary capital. There is, of course, a certain level of knowledge the investor should contribute to the partnership.

– When it comes to startups in special industries such as life science, biotech and such, the investor should contribute with experience and contacts, as entering the market in such cases is harder, more expensive and takes more time. My experience says that it all comes down to personal chemistry and partnership dynamics in the end. If both parties have a positive attitude and are dedicated, success must follow – Kobler concludes.

Marko Andrejic

Karanovic & Partners

StartLabs Beograd

Investicioni fond South Central Ventures

startup Serbia

start up

Startit

Aleksandar Sukiban

Karanovic & Nikolic Law Office

Jan Kobler

South Central Ventures

Nebojsa Lazic

StartLabs

term sheet

agreements between startups and investors

investments in startups

corporate management

tag along

equity

convertible debt

business plan

company evaluation

dividend

entrepreneurship