When to start a conversation about a contract with your investor
In Silicon Valley, there exists the concept of a “handshake”: if an investor gives their word, they won’t back down on it. From that moment, you can begin drafting a contract and discussing details. For well-known investors, foundations and accelerators, this is a common procedure — which you can’t say for certain about unknown quantities. In these cases, entrepreneurs should be ready to take the initiative and assume the responsibility for doing their due diligence with a new partner.
Signing a contract can be a great way of verifying investors for new entrepreneurs. If an investor doesn’t want to legally formalize your relationship, they’re probably hiding or omitting something. Perhaps they have a shady source of funds or a type of collaboration that will ultimately become a problem for your business in the future. Problems might arise by the next round: for example, when other potential investors check your cap table. If you give away your share of the business on questionable terms, investors won’t want to invest in your work.
Remember: no honest investor will reject a legal contract! If an investor doesn’t understand the importance of legal paperwork to seal a deal, you should weigh your risks carefully. If you really need the money and there aren’t any other options, perhaps the risk is worth it. In any case, it’s best to reject investments like these.
What should be in any contract
An investor can take part in funding a company in many different ways: being a mentor, investing money or joining the board of directors. Regardless of the way an investor chooses to participate in your business, the contract should always include:
- the terms of your company’s valuation
- requirements for capital and involvement in the company’s work
- form of participation in the following rounds
- preferred modes of communication and receiving updates
But the most important element of a contract is a provision for crisis situations. Even if you think that you’ve established a perfect relationship with your investor, it’s important that you learn to manage your risks and look at the development of a business that might experience both successes and challenges. That means adding to the aforementioned points:
- conditions for exit
- conditions for sale of shares
- actions in case of the startup’s bankruptcy
With a well-drafted contract, you reduce risks both for yourself and the investor, since for many of them, proper documentation is an effective way of reducing their taxes and writing off unsuccessful investments in case a given investment fails.
Why a contract is an investment in the security of your business
It’s important to remember that any new project is subject to extremely high levels of entropy. That means that you won’t be able to lay out all the most important points for your contract. For instance, if your investor can’t or refuses to continue funding your project, their share is assumed to be forfeited. The way that it’s forfeited, however, is a matter which you should outline.
Timely funding is one of the most important criteria for a project’s growth. Any glitch in the funding process will alter your timelines for achieving your goals, which means that your company’s growth dynamics will decrease. All of this leads to lackluster results, a low valuation and loaded questions from potential investors. The company’s CEO will waste time on searching for the current round, rather than preparing for the next and for their company’s growth. All of these consequences can be avoided by including the important details in your documentation. For that reason, an investor contract is an entrepreneur’s first line of defense. Make sure you allot enough time (and money) to do it right.