Your First Startup Investment: What Matters in the Contracts

Anyone investing in a startup for the first time looks at the idea, the team, and the valuation. But what investors ultimately get out of it also depends on the fine print. In a masterclass in April 2024, Companisto lawyers Daniel La Marca and Till Wedemann walked through the key steps and contract clauses, and showed where even good contracts reach their limits.

The buyer is ready, and the price is right. A large corporation wants to acquire a startup outright, not at a fire-sale price but at full market value. Many of the shareholders would double their money. Only one shareholder refuses to sell: a founder, of all people, who thinks the timing is wrong and is holding out for a better offer.

The scenario is hypothetical, but hardly far-fetched. Daniel La Marca and Till Wedemann, in-house counsel at Companisto, walked through it at the end of their talk at the April 2024 masterclass “Mein erstes Startup-Investment” (“My First Startup Investment”). Whether such a sale goes through depends on more than what happens when the buyer comes knocking. The groundwork is laid years earlier, in the contracts signed when the investors come on board. As we will see, though, that does not settle everything.

Anyone who invests smaller amounts through Companisto does not have to negotiate these contracts themselves or go to a notary. The platform handles the negotiations, acting as the lead on behalf of its investors in many financing rounds. Still, what the contracts say helps determine what investors ultimately receive. This article follows an investment from the choice of startup to the exit and explains the most important clauses.

Selection: What professionals look for in a startup

At Companisto, an investment team of several people assesses whether a startup is a candidate for investment. La Marca named four things he would personally look for:

• Unique selling point: What sets the product apart from the competition, or is there no competition at all? A startup may deliver more cheaply or faster than others. Even more interesting, he said, is a technological edge: something that does not yet exist in that form.
• Team: “The idea can be as good as you want, but if you don’t have the team to execute it, it usually fails,” La Marca said. That is why investors take a close look at the leadership, with background checks and interviews.
• Cash flow and runway: The key question is how much money comes in and how much goes out. That determines the runway: how long the money will last before the company needs new funding or goes bust. If a startup spends €100,000 a month more than it takes in and has €1.2 million in the bank, its runway is twelve months.
• Exit potential: Whether a startup can be sold one day is hard to judge at the outset. That usually becomes clear only over the next four or five financing rounds, he said.

Valuation: What a share costs

Once a suitable startup has been found, the talk turns to money, or more precisely to the pre-money valuation, the value of the company before the financing round. La Marca called it the most important point in the negotiation, and a delicate one. There is no right or wrong answer, he said. It starts with the founders’ idea of what their company is worth. Then both sides have to see how they can come to an agreement, “a bit like horse-trading.”

The valuation determines the share price; the share price determines how many shares an investor receives for their money; and that in turn determines their stake. Here is a simplified example that we will come back to: a startup has 40,000 shares, all held by the founders, and is valued at €4 million before the round. One share therefore costs €100. Investors put in a total of €1 million and receive 10,000 new shares in return. After the round, the startup is worth €5 million on paper. This is known as the post-money valuation.

Ownership is recorded in the cap table, an overview of all shareholders and their holdings. Each subsequent round dilutes the stake of existing shareholders unless they invest again themselves: their percentage of the company shrinks whenever new shares are issued.

Term sheet and due diligence: Agreeing on key terms, checking the risks

The term sheet: What is agreed up front

Next comes the term sheet, a document in which investors and founders set out the essentials: valuation and share price, the outline of the warranties, and investor rights such as liquidation preference and anti-dilution protection, both of which are explained below. The valuation in particular needs to be settled early, Wedemann stressed. Otherwise, in the worst case, the two sides may never come to terms at all.

In principle, the term sheet is non-binding, although in Wedemann’s experience, raising entirely new issues later on is not standard practice in the market. Confidentiality and exclusivity, on the other hand, are binding, and at Companisto a break-up fee usually is too: a lump-sum payment due if the startup breaks off negotiations without good reason. The break-up fee is meant to stop founders from signing five term sheets at the same time, Wedemann said.

Due diligence: How investors examine a startup

At the same time, due diligence gets underway: a thorough examination of the company. Depending on the size of the round, it can cover finances, the business model and technology, the market, and legal and tax matters. With a tech startup that has valuable intellectual property, for example, the reviewers check carefully whether the rights actually belong to the company rather than to individual founders personally.

If the reviewers uncover risks, there are two options: a discount on the share price or protection in the contract, such as a warranty covering a possible tax risk. Often, however, there is not enough time for a comprehensive review, Wedemann said, which is one reason why warranties matter so much.

Shares or profit participation certificates: What rights investors have

How investors come in at Companisto depends on the financing phase. In the first phase, business angels invest larger amounts; according to La Marca, there are no more than 20 of them. They become direct shareholders of the startup. Their votes are bundled through a voting and pooling agreement: Companisto represents the group as pool leader and casts their votes as a bloc, as that agreement provides. This way, the angels do not each have to attend every shareholders’ meeting or take part in every written vote.

In the second phase, investors can come in with as little as €250. To keep the cap table manageable, a special purpose vehicle (SPV) pools their money and joins the startup as an additional shareholder. In return, the investors receive profit participation certificates (Genussscheine), which give them a share in the startup’s performance, for example in the proceeds of a sale. If the startup does well financially, their investment can gain value. If it does badly, however, the investment can lose value, up to and including a total loss of the capital invested. They do not become shareholders of the startup. Voting, information, and preemptive rights lie with the SPV, and the investors’ rights are set out in the terms and conditions of the profit participation certificates.

The following sections therefore mainly describe the rights of direct shareholders. Investor rights such as liquidation preference or anti-dilution protection can benefit holders of profit participation certificates only indirectly, if at all: to the extent that the SPV’s shares carry these rights and the terms and conditions of the certificates provide for it. Which clauses apply in a given case is set out in the documents for each financing round.

What shareholders can do, and what they are not liable for

Unlike silent partners or lenders under a profit-participating loan, who have only contractual claims (to interest or a share of the profits, for example), direct shareholders become co-owners. That comes with important rights:

• Voting rights: Each euro of a share’s nominal value carries one vote at the shareholders’ meeting (Section 47(2) of the German Limited Liability Companies Act, GmbHG).
• Information rights: Shareholders can ask management for information about the company’s affairs and inspect its books (Section 51a GmbHG).
• Preemptive rights: When the startup issues new shares, existing shareholders are generally entitled to subscribe in proportion to their stake and thus maintain it. A shareholder can be stripped of this right against their will only under strict conditions. In financing rounds, however, existing shareholders often waive it when a new investor expects a particular stake. And in any case, preemptive rights only protect shareholders who put in more money.

As a rule, shareholders in a GmbH, the German limited liability company, are not liable beyond their capital contribution. That, La Marca said, is precisely the point of this legal form. Shareholders can be required to make additional contributions only if the articles of association provide for it, and such an obligation can be added later only with the consent of everyone affected. He said he had never come across such a thing in a VC-backed startup. A shareholder would be personally liable, he added, only in extreme, exceptional cases, for instance if they colluded with management to embezzle funds. For holders of profit participation certificates, the risk is limited to the amount invested, although that amount can be lost entirely.

Dividends or exit: How investors share in success

In theory, shareholders can benefit from profit distributions, but young startups rarely make a profit. More often, money flows the other way: if cash runs short between two rounds, startups ask their shareholders for a convertible loan. It usually bears interest and converts into shares in the next round at a discount to the share price. La Marca put the discount at 1 to 25 percent, depending on the negotiation. This, too, is risk capital: convertible loans are usually subordinated, and in an insolvency, investors risk a total loss.

The biggest opportunity lies in the exit, when investors cash out, for example through a sale of the company or an IPO. But an exit usually comes at the end of a long series of financing rounds and is unlikely in the first few years. An IPO is considered the ideal route, but a majority sale is far more common. In the shareholders’ agreements that Companisto negotiates, even a change of control, in which more than 50 percent of the shares are to change hands, often counts as an exit. How the proceeds are distributed is governed by the contracts.

The contracts: Which documents govern the investment

For a direct investment, three documents are executed before a notary; investors can be represented by proxy under a notarized power of attorney. Negotiations are often conducted in English, which is why the English names of these documents are widely used in Germany too.

La Marca called the shareholders’ agreement the centerpiece, since it contains most of the clauses discussed below. But the investment agreement lays important groundwork: if a new investor pays a higher share price than earlier backers, they usually receive shares of a separate class, such as seed or Series A shares. These share classes later carry special rights.

Warranties: What happens if the information is wrong

From the investors’ point of view, the warranties are the most important part of the investment agreement. Many founders are afraid of them, La Marca said. At the notary appointment, he said, you hear things like, “How am I supposed to know what will happen in five years?” But a warranty normally relates to the day the contract is signed: whoever gives it confirms that the facts listed are true on that day. It has nothing to do with a guarantee on the capital invested. There are two types:

• Title warranties are given by all existing shareholders, including those who are not involved in day-to-day business. They confirm, for example, that they actually own their shares and that the shares are unencumbered, say by a pledge. This guards against front men holding shares for someone in the background.
• Operational warranties are typically given only by the founders, because they are the ones who know the business. They confirm, for example, that the company holds the intellectual property it needs, that there are no undisclosed liabilities such as shareholder loans that would immediately eat up the fresh capital, and that no legal disputes are pending.

Liability is capped: for title warranties, usually at the amount invested, and for the founders’ operational warranties, usually more tightly still, at an amount based on a managing director’s salary. La Marca mentioned “one or two gross salaries.” “The founders aren’t multimillionaires, after all,” he said; any higher liability would quickly drive them into personal bankruptcy. For investors, this means warranties do protect them, but only up to a point.

Liquidation preference: Who gets paid first in an exit

When a startup is sold, the liquidation preference determines the order in which the proceeds are distributed. “For our investors, this is where it really counts,” Wedemann said. When leading a round, he said, Companisto aims for the “last in, first out” principle: whoever invested last is paid first, followed step by step by the earlier investors and finally the founders. But this cuts both ways: when new backers come in later, they usually demand the top spot themselves.

Two basic forms are common:

• Non-participating liquidation preference: Investors receive their investment back first, but this amount counts toward their share of the total proceeds. In effect, they get either their money back or their percentage share of the proceeds, whichever is greater, provided the proceeds are enough to cover their investment in the first place.
• Participating liquidation preference: Investors get both: first their investment, as far as the proceeds allow, and then their share of the remaining proceeds on top. This variant is more investor-friendly.

A simplified example using the figures from above shows what this means. The investors have paid in €1 million and hold 20 percent, and the preference equals their original investment (1x). This is how much the investors receive in total:

So in a weak exit, the investors are paid first: someone who put in €10,000 would get their €10,000 back from a €2 million sale with a non-participating preference, but only €4,000 without one. In a good exit, the non-participating variant makes no difference; the participating one gives investors extra proceeds at the founders’ expense.

In April 2024, Wedemann described a simple (1x) non-participating preference as the market standard, although ultimately, he said, it is a matter of negotiation. In an insolvency, neither variant helps: the creditors are paid first, and there is usually nothing left for the shareholders.

Anti-dilution protection: What happens in a down round

Dilution is particularly painful in a down round, a financing round at a lower share price than the previous one: not only does the stake shrink, so does the value of the investment. Anti-dilution protection makes up for this in full or in part. There are two basic methods:

• Full ratchet (full adjustment): The toughest method and, in Wedemann’s words, the “worst for founders.” The investor is put in the position they would have been in had they invested at the lower price from the start. Put simply, anyone who bought 100 shares at €100 each may take up another 100 shares at their nominal value of €1 each if the next round prices the shares at just €50.
• Weighted average (partial adjustment): The entry price is only reduced to a weighted average of the old and new prices. The broad-based variant is considered the most founder-friendly: it also includes items such as employee stock options in the calculation, which makes the adjustment smaller. The narrow-based variant uses a narrower basis for the calculation and therefore adjusts more.

Companisto usually negotiates for the narrow-based variant, Wedemann said, which in his view is often a good compromise.

Decision rights and share sales: Who decides and who can sell

Investor majority: How investors secure a veto

Votes are based on the nominal value of the shares, not on the price paid for them. As a result, founders often carry far more weight than their capital contribution would suggest. In our example, they paid €40,000 for their 40,000 shares when the company was founded, while the investors paid €1 million for their 10,000 shares. Yet the investors hold only 20 percent of the votes. Without protection, the founders could always outvote them. “That would be pretty unfair,” La Marca said.

That is why the articles of association or the shareholders’ agreement usually require an additional investor majority for key decisions: on top of a majority of all shareholders, a majority of the holders of preferred share classes must also give their approval, for example for new financing rounds, restructurings, or the sale of intellectual property. This gives the investors a kind of veto.

Transfer restrictions: Why shares cannot simply be sold

Vinkulierung? “It sounds a bit odd,” La Marca conceded. The German legal term refers to transfer restrictions: shareholders may not simply sell their shares to outsiders, to keep the shareholder base stable. Anyone who wants to sell has to clear several hurdles:

• Right of first refusal: The seller must first offer the shares to the other shareholders on the terms agreed with the buyer. They can take up the offer within a set period.
• Tag-along right: The other shareholders can demand that the buyer also acquire their shares on the same terms. If the buyer refuses, the sale is, in La Marca’s words, “dead.”
• Approval: Only if no one exercises their right of first refusal is the sale put to a vote.

The practical consequence for investors is that startup stakes usually cannot be turned into cash on short notice. Companisto does offer a secondary market where investors can trade their holdings among themselves, but there is no guarantee that a buyer will be found. Anyone who invests should expect their capital to be tied up for many years.

Drag-along: When everyone has to sell

The counterpart to the tag-along is the drag-along obligation, which both lawyers regard as a must. It allows a majority of the shareholders to require the others to sell on the same terms when a buyer wants to take over the company. The aim is to prevent smaller groups of shareholders, or the founders, from blocking an exit. The threshold at which the clause kicks in, whether at more than half of the shares or not until 75 percent, is a matter of negotiation. But a broad majority, including among the investors, is always required, Wedemann stressed. Conversely, the clause can also oblige investors to sell.

Must-haves, nice-to-haves, no-gos: The lawyers’ checklist

Toward the end of their talk, the two lawyers laid out what belongs in investment contracts, and what does not.

Must-haves: sufficient warranties from the founders, a first-ranking liquidation preference, anti-dilution protection, an exit clause with a drag-along, and consent rights for key decisions, which Wedemann sees less as control than as collaboration.

Nice-to-haves:

• Insolvency clause: La Marca described the clause as, to some extent, Companisto’s “own invention.” If the startup becomes insolvent or is liquidated within a certain period (two years in Companisto contracts, he said) and the founders set up a successor company in the same industry, they must allow the investors to invest in it on the same terms. This is meant to stop founders from using insolvency as an escape hatch. The clause does not protect against losses; it merely gives investors the chance to put new money into the successor company.
• Vesting and lock-up: Under reverse vesting, founders hold their shares from the outset but earn them only over 36 to 48 months of work: a founder who leaves after one year under a 36-month vesting period has to hand back two-thirds of the shares subject to vesting. A lock-up also bars them from selling for a certain period, for example two years.

No-gos:

• Intellectual property held outside the company, without a clause ensuring that it is transferred to the startup.
• No separate share class for new investors who pay a higher share price than the existing shareholders.
• Pay-to-play clauses, under which investors lose their hard-won rights if they do not take part in the next financing round. For investors who cannot or do not want to join every follow-on round, that is a considerable risk.

The scenario from the opening shows whether a drag-along is enough when push comes to shove.

When a founder blocks the exit

Back to the corporation that wants to buy the startup, and to the founder who refuses to go along. In the scenario as Wedemann described it, the founding team holds only around 20 percent of the shares after several financing rounds. The shareholders’ agreement contains a drag-along clause that can be triggered by a 75 percent majority, provided a majority of the investors also agrees. On paper, the matter is clear: the founder has to sell too.

In practice, it may not be that simple. The clause only binds the founder in relation to the other shareholders, La Marca cautioned. If the buyer is working on a tight schedule, say one month, and the founder fails to show up at the notary, there is little anyone can do to enforce it. In that case, the deal would very likely fall through. The other shareholders could claim damages, he said. “But in the end, that gets you nowhere.”

One way to prevent this is an accelerated exit clause, which La Marca cited as an alternative. According to him, such clauses also appear in Companisto contracts and are used by many institutional and public investors, who have to sell their stakes after a few years anyway. The parties agree to hire an exit advisor after five to seven years to look for buyers. “Psychologically, that’s a whole different thing,” La Marca said. Everyone involved, he explained, knows from day one that they will have to work toward a sale once the period is up. A process like this is usually backed by a broad majority, Wedemann added. By then, the key questions will already have been settled: Is the timing right? Is the market ready? What is being sold? And will the founding team stay on board?

For investors, the case holds a sobering lesson: an exit is usually years away, and it is never certain. Asked about the biggest risk, Wedemann said, “It’s venture capital through and through, and the failure rate is relatively high.”

Conclusion

A startup investment is a vote of confidence in a team and an idea. But it also rests on a set of contracts that determine, for years to come, who has a say and who gets how much in a sale. Nobody needs to know every clause in detail. Those who understand what warranties, liquidation preferences, anti-dilution protection, and drag-along rights do, however, are better placed to assess an offer and will notice when something is missing. On Companisto, investors do not have to negotiate these clauses themselves. In many funding rounds, the platform conducts the negotiations as the lead; its lawyers and the investment team pay attention to investor rights such as a first-ranking liquidation preference or anti-dilution protection. Companisto contracts can also include other clauses, such as an accelerated exit clause or a provision against using insolvency as an escape hatch.

At the same time, the case of the holdout founder shows where contracts reach their limits: no clause on paper can replace founders and investors pulling in the same direction. And no contract changes the fact that a total loss is possible. Anyone who wants to invest in startups should therefore commit only money they can spare for the long term, and spread it across several investments. After all, when you invest, nobody knows whether a buyer will one day be waiting.

Note: This article is based on the Companisto masterclass of April 16, 2024; assessments of market standards and contract practice reflect the situation at that time. The text is provided for general information only and does not constitute legal, tax, or investment advice. Acquiring stakes in startups involves considerable risks and can lead to the total loss of the capital invested.