Legal aspects of equity deals in start-ups

Equity deals are a central component of the financing and development of start-ups. They enable founders to raise capital while investors acquire shares in the company. However, there are complex legal aspects behind these transactions that need to be carefully considered in order to protect the interests of all parties involved. Typically, the process begins with a thorough due diligence process that examines the financial situation, intellectual property and legal stability of the startup. This review is crucial in order to identify potential risks and strengthen the negotiating position. In addition, founders should ensure that the valuation of the startup is fair and in line with the market to ensure an appropriate equity distribution. A valuation that is too low can lead to unwanted dilution of the founders’ shares, while a valuation that is too high could deter investors. It is also important that all parties understand the long-term implications of an equity deal, including the potential impact on corporate structure and decision-making power. Finally, an experienced lawyer should be involved in the negotiation process to ensure that all legal aspects are properly covered.

Equity and investment conditions

A key aspect of equity deals is the regulation of the equity and investment conditions. This determines how much equity the investor receives and at what valuation. Founders should ensure that the valuation is fair and in line with the market to ensure that the company is not undervalued and that the founders do not inadvertently give up too much control. Dilution provisions should also be put in place for future financing rounds to ensure that the founders do not inadvertently lose control of the company. This can be achieved by granting preferential rights or establishing protective clauses that protect the interests of the founders.

A clear definition of the investment terms is also crucial, including the term of the investment, repayment terms and potential exit strategies. For example, investors may expect a certain rate of return or set certain milestones that must be achieved to secure further investment. These milestones can be of a financial nature, such as the achievement of certain sales figures, or of an operational nature, such as the development of new products. In addition, the rights and obligations of all parties involved should be clearly defined, including the right to have a say in important company decisions. This can be achieved by granting board seats or by defining decision-making reservations.

Comprehensive contract drafting can help to avoid potential conflicts and create a stable basis for cooperation. It is also important that all parties understand the potential risks and opportunities associated with an equity deal and are prepared to respond flexibly to changing market conditions. This can be achieved through regular reviews of market conditions and adjustments to strategy. Finally, the deal structure should be regularly reviewed and adjusted to ensure that it meets the changing needs of the business. This can be achieved through regular negotiations between the parties or through the inclusion of adjustment clauses.

In practice, this means that founders and investors should work closely together to ensure that all aspects of an equity deal are carefully planned and implemented. They should focus on clear communication and transparency to avoid misunderstandings and build a trusting relationship. They should also be aware of current market conditions and legal requirements to ensure they are compliant with the latest regulations. Through careful planning and execution, startups can reap the benefits of equity deals and be successful in the long run.

In addition, founders and investors should also consider the long-term effects of an equity deal. This includes the potential impact on the company structure, decision-making power and relationships between shareholders. A clear definition of roles and responsibilities can help to avoid conflicts and promote effective cooperation. In addition, the parties should agree on clear exit strategies to ensure that all parties know how to exit the investment if this becomes necessary. This can be achieved by defining exit clauses or granting preferential rights.

Overall, careful planning and structuring of equity deals is crucial for the success of startups. By considering all relevant aspects, founders and investors can create a strong foundation for their collaboration and ensure that all parties can reap the benefits of an equity deal.

Tag Along and Drag Along clauses

– Tag Along (co-sale right): This clause protects minority shareholders by granting them the right to sell their shares on the same terms as majority shareholders. This prevents minority shareholders from being disadvantaged when the company is sold. This clause is particularly important as it ensures that all shareholders are treated equally and that no one is forced to sell their shares at an unfavorable price. It can also help to ensure that potential buyers are willing to purchase the entire company, as they know that all shareholders are interested in a sale. However, it is important that the tag along clause is carefully drafted to ensure that it does not lead to unexpected consequences, such as a delay in the sale process. In practice, founders and investors should decide together whether and how such a clause should be included in the contract.

– Drag Along (co-sale obligation): This regulation enables majority shareholders to force minority shareholders to sell their shares along with them if a buyer wishes to acquire the entire company. This facilitates the sales process, but can also lead to conflicts if minority shareholders do not agree with the sales price. A drag along clause should therefore be carefully drafted to ensure that it is fair and takes into account the interests of all parties involved. It is also important that the clause sets out clear conditions for the use of the drag along option, such as a minimum number of voting shares required to exercise it. In addition, the legal and financial implications of such a clause should be carefully considered to ensure that it does not lead to unexpected consequences. In practice, it is advisable that all parties agree on clear procedures to avoid potential disputes.

Liquidation preference

A liquidation preference determines how the proceeds from a sale are distributed. It is often stipulated that investors are paid out preferentially by first receiving their investment back before the founders and other shareholders receive their share. This can lead to a situation where founders only receive a small share of the sale proceeds, especially if the sale price is low. A liquidation preference can also act as an incentive for investors as it ensures that they are served first in the event of a sale or insolvency. However, it is important that the liquidation preference is designed fairly to ensure that it does not unduly disadvantage the founders. In practice, founders and investors should decide together how to structure the liquidation preference to ensure that it is fair to the interests of all parties involved. In addition, the clause should be formulated clearly and comprehensibly in order to avoid misunderstandings.

KYC obligations

Know Your Customer (KYC) obligations are of great importance in the private equity sector. They serve to prevent money laundering and terrorist financing. In Germany, these obligations are based on the EU Money Laundering Directive and the Money Laundering Act (GwG). Investors and founders must ensure that all parties involved are comprehensively identified and verified. This includes verifying the identity of natural persons and verifying the beneficial owners of legal entities. In addition, the sources of capital must be verified to ensure that they are legitimate. Compliance with these obligations is crucial to minimize legal risks and ensure the integrity of the investment. In practice, founders and investors should start the KYC check early to ensure that all necessary information is available on time. They should also be aware of the current legal requirements to ensure that they comply with the latest regulations.

Intellectual property (IP) and confidentiality

Protecting intellectual property is extremely important for start-ups. The contract should clearly define who owns the ideas, technologies and products developed during the program. Robust confidentiality clauses are also crucial to regulate the exchange of sensitive information. These clauses should ensure that all parties involved are obliged to keep confidential information secret and not to disclose it without consent. In addition, intellectual property rights should be clearly assigned to ensure that the startup has the necessary rights to develop and commercialize its products and services. In practice, founders and investors should decide together how best to protect intellectual property to ensure that the interests of both sides are taken into account. They should also inform themselves about the current legal requirements to ensure that they comply with the latest regulations.

Trends 2025

In 2025, several trends will influence equity deals in start-ups. One of the most important trends is the increasing importance of sustainability and ESG (Environmental, Social, Governance) criteria. Investors will place more and more value on companies that follow sustainable practices and take on social responsibility. This may lead to a shift towards investing in startups that offer innovative solutions to environmental problems or social challenges. For example, startups that specialize in renewable energy, sustainable agriculture or social inclusion could become particularly attractive to investors. This shift towards sustainable investments is driven not only by growing environmental awareness, but also by increasing regulatory requirements in many countries.

Another trend is the increasing role of AI and technology in due diligence. By using AI tools, investors can more quickly and efficiently identify potential risks and assess the financial stability of startups. These technologies make it possible to analyze large amounts of data and identify patterns that may not be immediately obvious. In addition, the digitization of contracts and transactions will continue to gain importance, which can lead to increased efficiency and cost savings. In practice, this means that founders and investors should adapt to these trends in order to remain competitive. They should adapt their strategies to meet ESG criteria and reap the benefits of technology. It will also be important for startups to clearly communicate their values and missions in order to attract investors who share similar goals.

Another emerging trend is the increasing importance of cross-border investments. Globalization and digitalization are making it easier for start-ups to attract international investors. However, this also requires careful consideration of the legal framework in different countries. Founders should inform themselves about the different regulatory requirements and ensure that their contracts and investment conditions meet international standards. It will also be important for startups to expand their global presence in order to benefit from the advantages of the international market. In practice, this means that founders and investors should build strategic partnerships to expand their reach and enter new markets. This can be achieved by involving local partners or establishing subsidiaries in other countries.

The increasing importance of AI and technology will also influence the way start-ups develop and market their products and services. Investors will focus on startups that use innovative technologies to meet customer needs and create competitive advantages. In addition, the digitalization of contracts and transactions will lead to greater transparency and efficiency, which in turn can strengthen trust between investors and founders. Overall, it will be crucial for startups to remain flexible and adapt quickly to changing market conditions in order to reap the benefits of these trends.

In addition, the increasing focus on ESG criteria will also influence corporate culture and stakeholder relations. Startups that focus on sustainability and social responsibility will often build a stronger bond with their employees and customers, which can lead to greater loyalty and motivation. This in turn can have a positive impact on the company’s long-term success curve. In practice, this means that founders and investors should not only pay attention to financial metrics, but also to the social and environmental impact of their investments.

Overall, the trends in 2025 will have a significant impact on the way equity deals in startups are structured. By integrating sustainability, technology and global investment, startups can not only become more competitive but also make a positive contribution to society. It will be crucial that all stakeholders adapt to these trends and adjust their strategies accordingly in order to be successful in the long term.

What to watch out for in the current wave of investment in AI start-ups

The current wave of investment in AI start-ups brings with it both opportunities and challenges. One of the most important aspects is the protection of intellectual property. AI startups often develop highly innovative technologies that need to be protected by patents and other intellectual property rights. Founders should ensure that they clearly define and protect their intellectual property rights to avoid potential disputes. This can be achieved by filing patent applications, registering trademark rights and using confidentiality agreements. They should also be aware of current legal requirements to ensure that they comply with the latest regulations. Many countries have specific laws and regulations that govern the protection of intellectual property in AI startups, and founders should be aware of these to ensure they are taking all necessary steps.

Another important aspect is due diligence. Investors will often have more stringent due diligence requirements for AI startups to ensure that the technology works and that the company is viable in the long term. Founders should therefore ensure that they can provide comprehensive information to convince investors. This can be achieved by providing detailed financial reports, technical documentation and market analysis. It will also be important for startups to clearly communicate their values and missions in order to attract investors who share similar goals. Clearly communicating the company’s vision can help build trust and convince investors that the startup will be successful in the long term.

In practice, this means that founders of AI start-ups should take a strategic approach in order to benefit from the current wave of investment. They should carefully protect their technologies, draft their contracts clearly and adapt to the needs of investors. They should also keep abreast of the latest trends and legal developments to ensure they remain competitive. Through careful planning and execution, AI startups can benefit from the current wave of investment and be successful in the long term. It is also important that founders and investors work closely together to ensure that all aspects of an equity deal are carefully planned and executed.

Another important aspect is the integration of ethics and responsibility in AI development. Investors will increasingly value startups that adhere to ethical standards in AI development and ensure that their technologies are not harmful. Founders should therefore ensure that they develop and implement ethical guidelines to gain the trust of investors and the public. This can be achieved by involving ethics experts, conducting risk assessments and developing transparent algorithms.

The increasing importance of partnerships and collaborations in the AI sector will also play an important role. Startups can gain access to new technologies, markets and talent through strategic partnerships with other companies or research institutions. These partnerships can also help to spread the risk and accelerate the development of innovative solutions. In practice, this means that founders of AI startups should actively look for opportunities to build strategic partnerships and reap the benefits of collaboration.

Overall, the current wave of investment in the AI sector offers tremendous opportunities for startups that are willing to adapt to investors’ needs and carefully protect their technologies. By clearly communicating their values and missions, conducting careful due diligence and integrating ethics and responsibility, AI startups can be successful in the long term and reap the benefits of the current wave of investment.

Conclusion

Equity deals in start-ups offer both opportunities and challenges. In order to protect the interests of all parties involved, it is crucial to carefully consider the legal aspects. Clear contract drafting that covers all relevant clauses and obligations is key to successful and fair transactions. Founders should always seek advice from an experienced lawyer to ensure that their interests are protected in the best possible way. They should also keep abreast of current trends and legal developments to ensure they are compliant with the latest regulations. With careful planning and execution, startups can reap the benefits of equity deals and enjoy long-term success.

Author: Marian Härtel

Marian Härtel ist Rechtsanwalt und Fachanwalt für IT-Recht mit einer über 25-jährigen Erfahrung als Unternehmer und Berater in den Bereichen Games, E-Sport, Blockchain, SaaS und Künstliche Intelligenz. Seine Beratungsschwerpunkte umfassen neben dem IT-Recht insbesondere das Urheberrecht, Medienrecht sowie Wettbewerbsrecht. Er betreut schwerpunktmäßig Start-ups, Agenturen und Influencer, die er in strategischen Fragen, komplexen Vertragsangelegenheiten sowie bei Investitionsprojekten begleitet. Dabei zeichnet sich seine Beratung durch einen interdisziplinären Ansatz aus, der juristische Expertise und langjährige unternehmerische Erfahrung miteinander verbindet. Ziel seiner Tätigkeit ist stets, Mandanten praxisorientierte Lösungen anzubieten und rechtlich fundierte Unterstützung bei der Umsetzung innovativer Geschäftsmodelle zu gewährleisten.