These series of guest posts are written by the teams attending the Tetuan Valley Startup School 2012 Spring Edition. This post is from the Airsign team, formed by Miguel Páramo
We all know that when a venture capitalist or business angel trusts in your team and project what they actually are trying to do is make a profit from their investment.
So usually you will make an arrangement and let these investors become part of the society. But there are some clauses that you may not want to arrange. This post is about one of the worst and fearsome ones: the Drag Along Clause (Cláusula de arrastre in Spanish).
When you are reading a contract with a venture capitalist, you should be aware of texts like the following before signing it:
“In case the founder receives an offer for his participation in the society for a potential buyer that conditions the offering for a percentage superior than the founder has, the rest of the members of the society are forced to sell their participations to reach the potential buyer’s requirements. The rest of the associates will have preferential acquisition.”
In other words, that means that if you and your team own 80% of your company and a venture capitalist has the other 20%, if in the future some third organization is willing to buy more than 20% of the company, you and your associates are forced to sell this difference.
That is a nasty situation. And the big problem arises when your potential buyer wants 100% of the company. You may have preference to buy the 20% before the new investor, but this is usually a situation we don’t want to be in and we may not even have that money. Therefore, if you don’t want to sell and you can´t convince your investor to not sell, he will apply the drag along clause. You and your teammates may earn a lot of money in the process but you will be losing your baby, that little startup you have raised with all of your effort.
So, how may you mitigate this clause?
Well, it is very usual for venture capitalists to include it in their contracts, and you are not going to get rid of it easily. Venture capitalists want an exit, an easy and fast way to return their money with profitability and this clause is one of those easy exists when things are going well in the invested company.
So you and the rest of stakeholders need to make an agreement that will protect you for losing your company and years of work in just a few days. You can try to limit the scope of this clause, for example, arranging that it won’t be applicable until the third exercise, for quantities below 5M $ or for percentages higher than 30% to put some examples.
Remember, venture capitalists are here to aid you, but also to make money. Don’t be naïve; they are not usually your friends and they don’t usually care about your effort and your dreams. If you don’t agree with the conditions of a round, keep looking for other more permissive investors.