Most important points

• An investment agreement is a contract between a company (startup) and investors that regulates the conditions of an equity investment (e.g. as part of a financing round). It is often also referred to as an investment or participation agreement or shareholders agreement.

• Typically, the agreement contains provisions on the amount and form of the contribution (cash investment, contribution in kind), the participation quota or new shares, as well as the rights of the investors (e.g. seat on the advisory board, information rights).

• Important clauses in investment agreements include valuation (pre-money/post-money), liquidation preference, vesting for founders’ shares, co-sale rights/obligations (tag-along, drag-along), veto rights for important decisions and anti-dilution.

• The participation agreement often supplements the articles of association: while the latter sets out the basic structures (e.g. in the articles of association of a GmbH), the participation agreement regulates specific agreements between the shareholders and investors.

• A clearly formulated participation agreement creates legal certainty for all parties and prevents later conflicts over influence and expected returns.

Background: Investments in start-ups

When a startup raises external capital, this is often done by issuing new company shares to an investor (e.g. business angel, venture capital fund) or by selling existing shares. The key points are often initially set out in a term sheet. The subsequent investment agreement specifies these points in a legally binding manner. It serves to balance the interests of the investor (return, right to a say) and the founders (capital injection, but continued control over the company).

Depending on the legal form of the start-up (in Germany often a GmbH), other documents such as an amended articles of association or a separate shareholder agreement are part of the overall package. The investment agreement itself is usually concluded between the company, the founders and the new investors.

Typical contents of the participation agreement

A participation agreement contains, among other things

• Investment amount and shares: How much capital is invested and what participation (number/class of business shares or shares) does the investor receive in return. The company valuation (pre- and post-money) becomes visible here.

• Closing conditions: Conditions that must be met for the agreement to become effective (e.g. consent of existing shareholders, no significant negative changes since due diligence).

• Rights of the investor: These often include information rights (regular reports, access to financial statements), control rights (e.g. seat on the advisory board/supervisory board, observer rights at management meetings) and co-determination rights in certain decisions (e.g. veto rights in the event of amendments to the articles of association, major investments, sale of the company).

• Use of funds: It is sometimes stipulated what the capital raised is to be used for (e.g. growth, specific projects) to ensure that it is used in line with the jointly planned strategy.

• Representations & Warranties of the founders/existing shareholders: The investor obtains confirmation that certain conditions are true (e.g. no hidden liabilities, property rights belong to the company, no legal disputes). In the event of a breach, compensation or reversal can be agreed.

Special clauses in investor protection agreements

In order to secure the investment and control future developments, special investor protection clauses are often included in the investment agreement:

• Liquidation preference: If the company is sold or liquidated, the investor first receives his invested capital back (possibly with a premium) before the remainder is distributed among all shareholders.

• Anti-dilution (protection against dilution): If a financing round takes place later at a lower valuation (down-round), the investor receives compensation (e.g. additional shares or price adjustment of the old shares) to compensate for loss of value.

• Vesting: The founders’ shares are often subject to vesting, i.e. they earn their shares over a period of time (e.g. 4 years) and lose a portion if they leave the company before the end of this period (bad leaver/good leaver regulations).

• Tag-along and drag-along: Tag-along allows minority shareholders to transfer their shares when someone else sells. Drag-along allows majority shareholders (or the investor if agreed) to force the minority to sell on the same terms when a sale of the whole company is imminent. These clauses ensure that no one is disadvantaged or blocked in exit scenarios.

• Subscription rights: Investors often receive a pre-emptive right or subscription right in future capital increases in order to be able to hold their share.

• Resolutions: Qualified majorities for important resolutions (capital calls, amendment of shareholders’ agreement, etc.) and reservations of consent for investors for certain transactions.

Significance for founders and investors

The participation agreement has far-reaching consequences for both parties:

• Founders relinquish some control and must ensure that they fulfill their contractual obligations (reporting obligations, obtaining approval rights, etc.). Vesting and investor-friendly clauses incentivize them to stay in the company and increase its value.

• Investors secure influence and protection against loss of value. However, they must be careful not to stifle the start-up dynamic with excessive control rights and maintain the founders’ trust.

It is advisable for start-ups to have a basic knowledge of these contractual mechanisms or to obtain legal advice prior to specific discussions with investors. This enables them to better negotiate the terms of an investment round and understand which commitments are common or critical. A well-balanced investment agreement lays the foundation for a successful collaboration between startup and investor.