My partners and I have given an extensive amount of thought to the contracts we negotiate when investing in start-ups. After about a year of debate back and forth and executing on multiple options, we've become convinced that many terms we used to add to our contracts are basically crap. I also feel that the mentality in the industry of using boiler-plate contracts to begin negotiations is flawed. I do admit that we have a standard contract which we use as a template but basically we put as little in it as possible and add as necessary. Most deals I've seen in the past start the other way around. Take a template from a lawyer which includes everything plus the kitchen sink and then whittle away at it as part of the negotiation. Why did we switch to what we call our contract-lite? Basically to avoid all the bad blood which comes into play when negotiating with a start-up.
It's very difficult to standardize contracts but one thing which I'll focus on as an example is the drag-along clause. It's simply a bullshit term which makes sense to lawyers but not to us or most entrepreneurs. Have we had it in contracts before? Yes, it's made it way into many contracts. Will we never use it again? We'll try to avoid it but it's inevitably going to show up in certain situations. Why do we see the drag-along as unnecessary?
1. First of all, the drag-along is one of the clauses we saw really hitting a nerve as part of negotiations. It's actually a really weak term in a contract, especially in Germany, where in hindsight you could have many legal implications by triggering it.
2. It psychologically terrifies the entrepreneur because he starts playing out the scenarios where it could be triggered. The reality is far from what he or she often believes is inevitable. We're not out to invest in companies and take them over to optimize our gain, screwing the founder in the process. Unfortunately, a drag-along stinks of this no matter how you dress it up. Further, the dynamics of a deal are totally different at the initial investment in comparison to the exit phase.
3. It's often, if not always impossible to sell a company without the founder. We invest early in businesses. We also invest predominantly in management/founders and not just concepts. Hence, in all likelihood, when we sell the company, the buyer wants the founders as well. Historically, we've seen that the best exits we've had almost always had the original founders still running the company or in some senior management position. The buyer always wanted them for at least the transition and earn-outs always came into play. Combine a drag-along clause and earn-outs demanded by the buyer and you have a mess on your hands.
4. You can easily negotiate other clauses to be both beneficial and fair to both the VC and the entrepreneur allowing you to avoid the bad blood which creeps up when fighting over a clause which is so one-sided.
Do we have the perfect solution? No, not yet in my opinion. We still end up having lots of discussions which revolve around the value the founder sees in his business and his role as opposed to our view of this. This post could be ten times as long were I to go into each and every term we've decided to pull out of the initial investment negotiation. The drag-along is just one term which I think clearly shows our thinking on this and it's an ongoing process. Nevertheless, we made the conscious decision to make the contract as "lite" as possible to be able to close the deal quickly and smoothly without lots of back-and-forth.
Other VC's will have their own view on this. There are probably as many views as there are VC's. Add the lawyers to this equation and you can multiple that number by a factor of N, where N equals the number of lawyers out there. Still, we will continue trying to make our contract as simple and straight-forward as possible. This is necessary to close deals quickly and get to the important execution part on the side of both VC's and entrepreneurs. No matter how good your contract, without execution, it's basically the basis for a pissing contest without winners.