My Startup Is Ready for an Investment - How to Avoid Hard-To-Fix Mistakes?

Day 5. October 2021

Is your startup ready for an investment and are you already looking forward to being able to reach the set goals faster? But before it comes to investing, it’s good to know a few of the pitfalls for startups and how to avoid hard-to-fix mistakes.


Dr. Peter Merc iz Lemur Legal & Suricate Ventures shared some very concrete tips on how you can avoid the following pitfalls and mistakes.


#1 An intermediary offers to help me connect with investors:

When an entrepreneur starts asking for start-ups in the startup ecosystem, quite a few intermediaries often appear who have or are supposed to have very good connections to angel investors and venture capital funds. According to the principle "there is no free lunch", they offer establishing contacts with investors as their service.


When establishing such a business relationship, it is necessary to pay attention to the way in which the reward is defined for such an intermediary - what it is and when it is considered to belong to him. Some will require you to pay a fixed amount in advance before they even start their work. Such a reward for the intermediary poses a risk to the startup because it does not give any guarantee that the intermediary will really do anything in the direction of finding investors. We do not recommend paying for such rewards.


Rewards that are tied to performance are logical. However, there are quite a few pitfalls to these as well. In such case, it must be very clear when the intermediary is entitled to the reward and in what amount. From the point of view of risks for the startup, it is most appropriate that the obligation to pay the reward is linked to the moment the investor's funds are transferred to the startups's bank account. 


For example, if the reward is tied to the moment of signing the investment contract, it may happen that the startup has to pay the reward to the intermediary, while the investor withdraws from the investment contract for various reasons. A such case can occur if the disbursement of funds in several tranches is agreed with the investor - the intermediary's fee is calculated on the full amount, and the startup does not draw from all the tranches of funds for various reasons.


To sum up #1: Avoid intermediaries who ask you to prepay for their services. Avoid all methods of determining the reward for the broker, where the reward is not tied to the funds actually received by the investor.


CAUTION: Some investors, both business angels and venture capital funds, strictly forbid their funds to be used to pay rewards to brokers!



#2 Instead of a capital investment, the investor is offering his services, connections and knowledge:

"Pare na sunce" (eng. show me the money) is a nice phrase that comes from our neighborhood. When a startup starts talking to different investors, this phrase can quickly prove to be a challenge for the startup in relation to the investor. Every investor understandably wants to maximize their investment. One way to maximize is to invest as little of your capital as possible in the company and get as much business as possible for it. Usually, minimizing the capital injection is justified by the investment of "their services, endless network and comprehensive knowledge". Startups, be careful!


Once you have an investor in the ownership structure who has invested less, but much more of his services, you can quickly have a problem when that investor doesn’t deliver all (or nothing) of what he promised. And this happens very often! If the investor, as a partner, does not voluntarily agree to a reduction in his share, the process of excluding a partner is a rather tedious process, so try to avoid it.


Solution: to begin with, it is necessary to very precisely define the investor's contribution - what exactly he will do, when and what the consequences are if he does not do so. For example, if an investor undertakes to introduce a startup to potential buyers of services or products, the contract defines the minimum number of such meetings, what counts as one, the deadline and the role of the investor (only introduces or participates further in the process of establishing a business relationship). Another example: an investor undertakes to set up a functioning online store as their investment in a startup. It is necessary to contractually define when the deadline is, what functionalities it will have and what will be the further functions of the investor in connection with the online store (e.g. upgrades, maintenance, development of new functions).


Legally speaking, there are several options here. The most elegant is to sign an option contract, where the investor gradually acquires a stake in the startup, depending on the fulfillment of their commitments. Alternatively, the investor can immediately acquire the entire planned share, and the contract stipulates when and under what conditions they must transfer part of their business share back to the startup. In both cases, it is necessary to pay attention to effects on taxes (talk to a tax advisor!).


To sum up #2: Investments in the form of services, knowledge, and access to an individual’s network are not necessarily bad for a startup. However, it is necessary to be very careful how this investment is defined and, above all, what levers a startup has if the investor does not fulfill their commitments. The startup must provide an "exit" strategy for the investor, who has promised a lot and delivered very little.


CAUTION: Look out for investors who are involved in a number of startups in one way or another. Their day also has only 24 hours.. 


Dr. Peter Merc from Lemur Legal & Suricate Ventures


#3 I need financing,  but I don't want to give a share of the company - a convertible loan is the holy grail!

In the startup world, there is a very common asymmetry of expectations that startups and investors have about the investment itself. Every startup, regardless of the stage of development, estimates the value of their company at around one million euros. Investors, on the other hand, tend to have a significantly different valuation. The result in practice is the great pain of a startup when it receives an offer from an investor for EUR 50,000 in exchange for 25 percent.


As such, the most favorable option is convertible capital, where the startup obtains funds in the form of a loan and must repay them as such, and under certain circumstances these funds are converted into equity. And it is precisely these particular circumstances that are often the trap that startups fall into when they unknowingly sell their startup at a very low price.


How pragmatic is a startup's thinking: “I'll take a convertible loan, start repaying it in a year, when my startup will already generate a lot of cash, repay the loan in full and not give a share of my startup. Wonderful!”


Each convertible loan agreement contains contractual clauses that determine when and under what conditions the loan is converted into capital and who has the right to request the conversion (investor, startup, both).


So-called triggers determine when a conversion occurs. They may be linked to various circumstances related to the company's operations, the fulfillment of the company's obligations or external circumstances. Example # 1: A loan is converted into equity if the company misses two consecutive loan payments. Case # 2: If a company does not generate at least €100,000 in revenue in the third quarter of 2021. Case # 3: If a company does not enter at least two new EU markets by the end of 2021.


From the startup's point of view, the question of when a loan is converted is important, but not more than under what conditions (valuation) is it converted. If the real value of the startup is EUR 100,000, and the conversion in the convertible loan agreement is determined after the valuation of EUR 20,000, then we unknowingly gave such a lender a very high discount for the purchase of a stake in our startup. This is something that will not make any startup happy.


And the last question - who can request a conversion and who can prevent it? Everything can be agreed in contract law. Usually, however, a contractual relationship has a weaker and a stronger party who can enforce their terms of business. In the case of a convertible loan, the lender will always have the option of requesting a conversion. In most cases, the startup will not be able to prevent this.


To sum up #3: A convertible loan can really be the most optimal way to finance a startup. However, signing a convertible loan agreement can mean a cheap sale of a stake in a startup. The devil hides in the contract terms.



#4 A potential investor (or contractual partner) is requesting a lot of information from me and wants me to sign an NDA:

In banking, there is a so-called "Need to know" standard, according to which every employee in the bank must have all the information that is important for the performance of his function. However, all other information that is not strictly necessary for the performance of these tasks is available to employees only in exceptional cases. The pragmatic application of this standard also makes sense when entrepreneurs talk to investors or other external partners and share information about their company or their technological solution that is not otherwise publicly available.


Confidential information, for example regarding the technological solution itself, contractual partners, provisions in contracts, etc., should be seen as an asset of the company. In some cases, it is even the most important or most valuable asset of a company. Accordingly, such information should also be handled. We only reveal to others what we think they need to know, while not compromising our trade secrets, which give us a competitive advantage.


In business practice, under the pretext of various potential investments or potential business collaborations, they only wish to acquire additional information, which would enable them to reduce the aforementioned competitive advantage. Often, quasi-investors (or business partners) want to obtain a disproportionate amount of information in the initial stages of conversations. Such actions must be a warning. Why would anyone be interested in patent details, detailed information about our suppliers right at the beginning of the conversation, or would want to access the program code on GitHub?


Such curious people often offer a non-disclosure agreement (NDA) for you to sign. Such a contract obliges one or both parties not to disclose information received from the other party. On paper, everything is OK, it should reassure us. What about the real world? In the event that we disclose our trade secret to someone, who then uses this secret for themselves or reveals it without our permission, we can file a lawsuit against the villain to demand the payment of a contractual penalty (if specified in the contract) and compensation. How long the court proceedings last, how much the “thief” can earn at the expense of our business secret in the meantime, and what will happen to our company, become important questions. An additional question is how to prove (evaluate) the damage caused by the disclosure in court.


To sum up #4: The problems in case our business secrets are misused can be avoided by being careful about sharing information. Of course, certain information needs to be disclosed, otherwise it's difficult to get any deals. However, it is necessary to assess the risks each time and do a little investigation to whom we disclose the data.



#5 I am the owner of the program code, the web domain is owned by my partner, the brand is registered to my other company:

The company's assets do not just include material assets. Increasingly, the majority of assets are dematerialized assets such as registered intellectual property rights, program code and web domains. There are several reasons why it is very important to concentrate all these resources in the company and clearly define the “ownership” of them.


The first reason is problems in the case of a dispute. The company has hired an external contractor to develop the program code. After a certain time, the company terminates the contract with the contractor. The contractor claims that the ownership of the code is theirs, despite the fact that the company paid for the work. It should be determined in advance that whatever the contractor develops for the company becomes the property of the company. Another example: one partner registers a trademark or buys a web domain in their own name. The partners get into a dispute and expel the partner from the company. The latter does not want to transfer the ownership of the brand or domain to the company.


The second reason deals with tax. If assets that have some value are transferred, this creates a tax event. Example: As a developer, I develop a software code in the form of an online casino platform. This platform is used by the company in which the developer is a co-owner. The use of the platform generates revenue for the company. The developer then decides to transfer ownership of the code to the company. There was, of course, a difference in the value of the program code, from the time it was written to the time it was transferred. The developer actually made a profit. The same case may apply to a registered patent or trademark. If we want to avoid tax obligations, we must transfer the funds to the company as soon as possible.


The third reason is related to the investment itself. Only a startup that has everything related to the company's assets will be interesting for investors. This is the reason why serious investors undergo a legal (and also business) due diligence before the investment itself. Unresolved issues regarding the company's assets are a "showstopper" for investors.


To sum up #5: Concentrating all assets should be a concern of every entrepreneur from the very beginning. Subsequent transfer may result in consequences that do not have a beneficial effect on the business.

Izvedba: Mojdenar IT d.o.o.