[Venture, Litigation Alert]③How Startup Founders Can Protect Themselves When Drafting Investment Agreements

Thorough Contract Review: The First Step to Reducing Legal Risks
Specify "Intentional Misconduct or Gross Negligence" to Avoid Excessive Liability
Delete Illegal Clauses Such as "Special Redemption Rights"
"Strengthen Negotiation Power to Remove

Editor's Note
In advanced venture markets such as the United States and Israel, failure in starting a business is regarded as valuable experience and serves as a stepping stone for future attempts. However, in South Korea, failure still acts as a stigma for entrepreneurs and even blocks the path to a comeback. In particular, the litigation risks that require founders to take personal responsibility for corporate liabilities under investment agreements are especially critical. This three-part series analyzes recent lawsuits between startups and investors in Korea, strategies for avoiding toxic clauses in contracts, and more.

The first step for startup founders to prevent legal disputes such as lawsuits is to thoroughly review investment agreements. While contracts with investors are an essential process for business expansion and securing funds, they also impose significant responsibilities and obligations on founders. If founders hastily sign unfavorable terms in their eagerness to attract investment, they risk being exposed to excessive legal liabilities.

Experts recommend including a clear limitation of liability clause in the contract, specifying that the founder is only responsible when at fault. They emphasize that this is a key strategy to prevent the practice of indiscriminately holding founders liable for minor mistakes or trivial breaches of obligation.

Put Options That Burden Founders: Limiting Liability Is Key

The share subscription agreement is one of the contracts that founders must pay particular attention to. This agreement, which governs the rights and obligations when a company issues new shares and investors pay for them, often includes not only the company and investors but also founders and other stakeholders as parties to the contract in Korea. Therefore, every clause must be carefully reviewed.

One notable example is the put option clause, or the right to demand share repurchase, which can impose excessive responsibility on founders. A put option allows the investor to sell their shares back to the company or stakeholders at a predetermined price if certain conditions specified in the contract are met. While this is generally used as a safeguard for investors to protect against losses, Korean commercial law restricts the extent to which companies can acquire their own shares. As a result, the burden of the put option often falls on the founder personally.

Ahn Heecheol, an attorney at DLJ Law Firm specializing in startups and mergers & acquisitions, stated, "Although imposing joint liability on founders is currently prohibited, there are insufficient legal safeguards to prevent put option demands." He advised, "Since founders can still be held responsible even in the absence of fault or for minor breaches, it is appropriate to draft the clause so that the founder is only obligated to repurchase shares in cases of intentional misconduct or gross negligence."

Another clause that should not be overlooked is the mandatory initial public offering (IPO) provision, which investors often include as an exit safeguard. Lawsuits for damages following a failed IPO can become a significant burden for both startups and founders. Moon Sung, an attorney at Yulchon Law Firm, emphasized, "At the contract stage, the obligation to pursue an IPO should be limited to a 'best efforts' obligation." He added, "Given that IPOs have become increasingly difficult, it is necessary to clearly define force majeure events caused by market conditions or other external factors, and to negotiate for alternative options such as mergers & acquisitions or the sale of existing shares instead of an IPO."

Defending Management Rights and Equity: The Need for Specific Limitations

Clauses that directly affect the founder's equity stake and management rights also require special attention. A typical example is the refixing clause, which investors include to prevent dilution of their shares. Refixed conversion price clauses allow the conversion price of preferred shares into common shares to be adjusted depending on circumstances. For instance, if the company's performance or stock price falls short of expectations, the conversion price for the investor's preferred shares may be lowered, allowing them to convert to a greater number of common shares. This can lead to a sharp decrease in the founder's equity stake. Therefore, it is necessary to limit the conditions and scope related to the conversion price.

The early redemption right is similar in that it allows investors to demand early repayment of their investment from the company or founder under certain conditions, such as breach of contract or underperformance. This can worsen the company's cash flow and threaten the founder's management rights. If the conditions are vague or overly broad, the repayment burden could fall on the founder at any time, so experts advise that strict limitations, such as "material breach of contract," are necessary.

Some investors may attempt to insert special redemption rights into the contract, even though these are not legally recognized. Special redemption rights allow investors to demand repayment even when the company has no distributable profits. Since this is illegal under Korean commercial law, such clauses must be deleted from the draft contract.

Penalty clauses, often included at the end of contracts, also require caution. These provisions impose a financial penalty if a party fails to fulfill contractual obligations or breaks a promise, requiring compensation in a predetermined amount. In addition to damages suffered by the counterparty, delayed interest, and legal or advisory fees may also be claimed. Attorney Ahn stressed, "The scope and circumstances in which penalty clauses apply must be clearly and specifically limited," and advised, "Founders should strengthen their negotiating position to either exclude penalty clauses from the contract or limit liability to cases of intentional misconduct or gross negligence only."