Part II - Cracking The Contract Code: Essential Startup Contracts Explained

In the first part of this article,¹ we discussed the classification of startups in Nigeria, providing insights into the criteria and benefits of attaining startup status under the Nigeria Start Up Act, 2022. We also explored a few foundational startup contracts (Founders Agreements, Intellectual Property Agreements and Employment Agreements), highlighting their importance to a startup's business structure and success.

In this second part, we will take a deeper dive into the world of startup contracts, focusing on two critical contracts instrumental in securing funding, shaping the governance structure, and defining the relationships among key stakeholders within a startup: investment/funding agreements and shareholders agreements. Additionally, we will explore best practices for negotiating and crafting these vital contracts, offering practical strategies to ensure favorable outcomes for startups.

Key Contracts Essential for Startups (Part II)

Investment/Funding Agreements

Investment contracts are crucial for financial transactions between startups and investors. These agreements set the terms and conditions for capital injections, forming the foundation of investment deals. They aim to protect the interests of both founders and investors, offering solutions for breaches and guiding actions in various scenarios. Key clauses in investment contracts include:

• Investment Specifics: These clauses detail the amount and form of the capital infusion, whether it's equity, debt, convertible notes, or Simple Agreements for Future Equity (SAFE). They also provide a comprehensive estimate of the company's valuation at the time of investment.
• Equity Ownership and Mitigating Dilution: For investments made in exchange for equity, these clauses clarify the investor's ownership share. They may also include anti dilution provisions to protect investors from ownership dilution in future funding rounds.
• Investor Rights: These clauses outline the rights of investors, such as voting rights, access to regular financial reports, pre-emption rights to purchase additional shares in future funding rounds, and preferences on dividends, liquidation, and conversion rights.
• Utilization of Funds: These clauses govern how the invested funds can be used to prevent misappropriation. They may include broad restrictions, such as prohibiting non-business expenditures, or specific restrictions based on industry or investor concerns.
• Representations and Assurances: These clauses affirm the startup's legal status, financial health, and intellectual property ownership. They also include investors' assertions of their legal authority and financial capacity to make the investment, protecting both parties from misrepresentations or fraud.
• Conditions and Commitments: These clauses outline specific conditions and commitments the startup must adhere to as long as the investment persists. This may include financial criteria, like maintaining profitability or meeting revenue targets, or operational commitments, such as staying within defined business parameters or retaining key personnel. Shareholders Agreements
• Default and Termination Provisions: These clauses provide the framework for ending the investor-startup relationship. They outline default events, the consequences of such defaults, and the terms governing contract termination.

Shareholders Agreements

Shareholders agreements outline the terms and conditions governing ownership and equity in a startup. These agreements enable shareholders to understand their rights, responsibilities, and the rules guiding the company's operations, while offering a clear roadmap for addressing potential conflicts and changes in ownership. Key clauses in shareholder agreements include:

• Ownership and Equity Structure: These clauses specify the ownership structure, including the allocation of shares to founders and members, and the rights associated with each class of shares. They provide clarity on ownership distribution and conditions under which ownership may change.
• Rights and Responsibilities: Beyond ownership, these clauses detail the rights and responsibilities of shareholders, including voting rights, decision-making processes, and restrictions on share transfers.
• Governance and Decision-Making: These clauses establish governance mechanisms, such as board composition and voting procedures, ensuring that shareholders have a say in the company's strategic direction and major decisions.
• Transfer of Shares: These clauses address the transfer of shares and the rights of existing shareholders in the event of a sale or transfer. They may include pre-emption rights, rights of first refusal, and conditions for approving new shareholders.
• Exit Strategies: These clauses outline exit strategies, including buy-sell provisions and mechanisms for handling the departure of shareholders, to protect the interests of remaining shareholders and ensure a smooth transition.
• Dispute Resolution: These clauses provide a framework for resolving conflicts between shareholders, usually avoiding costly litigation, and specifying alternative dispute resolution methods such as mediation or arbitration.
• Default and Termination Provisions: These clauses delineate the framework for terminating the shareholder relationship under specific conditions. They define default events, the consequences of such defaults, and the terms governing agreement termination.

By understanding and meticulously crafting these key startup contracts, startups can better protect their interests, ensure smooth operations, and foster long-term growth and stability.

Optimal Strategies for Negotiating and Crafting Vital Startup Contracts

Negotiating essential contracts is a pivotal phase in a startup's journey. These agreements underpin the company's operations, define roles, manage expectations, and mitigate risks. Transparent and fair negotiations foster trust and set the tone for future relationships. Well drafted contracts, marked by clarity and fairness, prevent conflicts, maintain positive working relationships, and ensure legal compliance. Poorly drafted contracts, on the other hand, can lead to legal issues, disputes over intellectual property and ownership, and regulatory penalties.

It is crucial for startups to employ best practices during contract drafting and negotiations as the resulting agreements can profoundly impact a startup's growth, stability, and long-term success. These best practices include:

1. Use Precise Language: Clarity is paramount in contract language to avoid misunderstandings or misinterpretations. Avoid convoluted jargon and meticulously define all terms and conditions.
2. Ensure Equitability: Equitable terms are crucial for all parties involved. One-sided agreements can breed resentment, disputes, and legal challenges. Negotiations should be collaborative, safeguarding the interests of all stakeholders.
3. Review and Revise Regularly: Drafting is not a one-time affair. Contracts demand periodic scrutiny and adaptation to reflect changes in the business landscape, legal requirements, and the startup's strategic course.
4. Incorporate Safeguarding Provisions: Protective clauses, such as confidentiality, non disclosure, and non-compete agreements, are indispensable for shielding valuable startup assets.
5. Prioritize Transparency: Transparency is the cornerstone of all startup agreements. Lay out terms and conditions transparently, leaving no room for hidden clauses. Full disclosure is essential to prevent allegations of misrepresentation or fraud that could jeopardize the agreement's validity.

The Strategic Importance of Startup Contracts

Startup contracts go beyond mere administrative formalities; they represent strategic investments in a startup's future. These contracts should not be seen as cumbersome paperwork but as integral components of business strategy and operational excellence. With the right legal expertise, these agreements can serve as powerful tools for growth and success.

Maximizing Startup Potential Through Strategic Contract Management

Startups operate in a complex and ever-changing business and regulatory landscape that presents both abundant opportunities and formidable challenges. Contracts are essential for navigating these challenges, mitigating disputes, and ensuring compliance with relevant laws and regulations. Drafting, negotiating, and managing these agreements must be done with careful consideration and tailored to meet the specific goals and objectives of each startup.

Footnotes

1 Please see Part I of this article here: https://www.mondaq.com/nigeria/contracts-and-commercial-law/1482480/part-i---cracking-the-contract-code-essential-startup-contracts-explained

For more information on how to maximize your startup’s potential through strategic contract management, please contact: John Ojelabi, Oluwadolapo Owoyokun and Onyinye Igweonu.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.