How startups can strive for clarity in contracts

This post is a part of a series based on my Law for Startups workshop at MaGIC in September 2015. It’s a basic introduction to legalities for startup founders. You can access the slides here.

Read the earlier posts for context:

  1. Law for startups in Malaysia — building on the best foundations.
  2. The legal landscape in Malaysia for startups — a hybrid of traditional corporate practices and Silicon Valley models.
  3. Choosing the right business vehicle for your startup or small business in Malaysia.
  4. When should a startup hire a lawyer?
  5. Oversights which could destroy your startup or small business.
  6. The dangers of using “standard” or template legal documents.

A couple of posts ago, I explained the importance of bringing all the issues to the surface when reviewing contracts. This post will explain how to strive for clarity in contracts.

Turn to clear image.
Turn to clear vision.

The cover slide for this section features one of those binoculars which can be found in popular tourist spots. Users have to insert the required amount of coins, and then usually have to turn a knob to get the right focus — a common make of these binoculars marks this knob in bright red with the wording “turn to clear vision“. By doing so, an image which looks blurry initially will become crystal clear.

A similar, more commonplace, analogy is when taking photos with our smartphones. In situations where there is a strong backlight, we may have to tap different places on the screen in order to get a clear, well-lit image, before taking the photo.

This is the approach to take with legal documentation — if something isn’t quite clear enough, keep “turning to clear vision” — I will share how this works.

An instruction manual for your business

An important document such as a shareholders’ agreement should be viewed as an instruction manual for your business.

You should be able to turn to this instruction manual when you come across situations which make you go “how do we…” or “what happens if…”

Having this mindset ensures that, before signing a shareholders’ agreement, you will strive to make every clause as clear as possible so that your user manual doesn’t end up being one of those badly-translated Japanese ones in broken English and with ridiculously undecipherable illustrations.

Agreements should be comprehensive and clear

When drafting contracts, parties sometimes place too much importance on being comprehensive — covering all the bases. But being comprehensive isn’t good enough.

A contract can cover all the important areas (by getting sample clauses) and be a really comprehensive contract, but the contract must also be clear or well-drafted to be as clearly understandable as possible. (I previously wrote about why you should understand every clause.)

People often enter into contracts without fully understanding what the clauses mean. Perhaps some clauses were lifted off the internet somewhere — or even an entire contract was lifted off the internet somewhere — and you have a half-page long clause with the heading “liquidation preference” and based on what you’ve read on blogs and websites and Investopedia, “liquidation preference” is a good thing, so you leave it in without really understanding it.

Then when something happens, you say okay, here’s the relevant clause and you read it and you still don’t understand it — or you think you understand it, but there’s a dispute later on because the other party understood it differently. There’s no point being comprehensive if the contents of a contract are unclear.

If a clause in a contract is unclear — “turn to clear vision”.

How to achieve clarity

But how does “turn to clear vision” work in practice? Achieving clarity is actually pretty simple. There are two basic steps which startups can learn:

  1. Request that contracts be drafted in plain language. Bad lawyers often just recycle precedents which are sometimes more than 10 years old, and which are therefore drafted in legalese. These precedents date back to a period where it was still thought that a contract must be in convoluted “legal language” in order for it to be enforceable. Obviously that’s not the case — ask for clauses to be drafted in normal human language.
  2. Redraft and redraft again. And use examples. Some clauses need to be reworded several times to achieve clarity. I also always recommend including examples or illustrations to ensure that there’s no confusion over what a clause means.

The example below will show what I mean.

Example of reworking a clause to achieve clarity

Here’s an example of a fairly common liquidation preference clause:

Liquidation Preference:

The parties hereto hereby agree that in the event of the occurrence of a Trigger Event in accordance with the terms and conditions of this agreement, the holders of the Series A Preference Shares shall be entitled to receive in preference to the holders of Ordinary Shares a per share amount equal to 1x the Original Purchase Price.

If you ask the lawyer who drafted the clause to explain what it means, he might say: “Well, it means that if a Trigger Event happens, the original investment paid by the Investor into the Company must be repaid to the Investor before holders of Ordinary Shares receive any of the money.

The next question you should ask the lawyer is — why can’t we write down what you just said instead of that original clause which isn’t that clear?

It may be difficult to convince a lawyer to go all-out plain language though — and in some cases, stronger legal language may be necessary to offer the best legal protection.

Therefore, a compromise would be to remove some of the unnecessarily bloated language — “The parties hereto hereby agree that in the event of the occurrence of a Trigger Event in accordance with the terms and conditions of this agreement…” is unnecessarily bloated because —

  1. “The parties hereto” — obviously the agreement is between the parties, so there’s no need to repeat this in every other clause.
  2. “hereby agree that” — it should already be stated at the outset that this is an agreement between the parties, and therefore the clauses are what the parties agree!
  3. “in the event of the occurrence of” — basically “if [event] happens”.
  4. “in accordance with the terms and conditions of this agreement” — if it is a defined event such as “Trigger Event” it is obviously in accordance with the agreement.

The clause can then be revised to — (1) remove the unnecessary wording; and (2) add the plain language clarification, which would result in a revised clause as follows:

Liquidation Preference:

If a Trigger Event occurs, the holders of the Series A Preference Shares will be entitled to receive in preference to the holders of Ordinary Shares a per share amount equal to 1x the Original Purchase Price. This means that the original investment paid by the Investors into the Company must be repaid to the Investors before holders of Ordinary Shares receive any of the proceeds.

As mentioned above, I would always recommend including an example of how the clause works in practice. This adds the final sheen of clarity and removes any remaining doubt when it comes to future interpretation.

Here’s the clause with the example added:

Liquidation Preference:

If a Trigger Event occurs, the holders of the Series A Preference Shares will be entitled to receive in preference to the holders of Ordinary Shares a per share amount equal to 1x the Original Purchase Price. This means that the original investment paid by the Investors into the Company must be repaid to the Investors before holders of Ordinary Shares receive any of the proceeds.

For example —

(a) where the Original Purchase Price is RM1.0 million; and

(b) the Company is sold for RM3.0 million (“Sale Price”) (resulting in a Trigger Event),

then RM1.0 million of the Sale Price will be repaid to the holders of the Series A Preference Shares before the remaining RM2.0 million is distributed to the holders of Ordinary Shares.

The result of this “turn to clear vision” exercise is that the original clause is retained, but in a version which is much clearer, and leaves very little room for dispute.

Having discussed all the principles which startups and small businesses can hopefully appreciate and use when dealing with legal documentation, the next and final part of the series will address the common contractual land mines — very practical tips on the terms and conditions to look out for.

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3 thoughts on “How startups can strive for clarity in contracts

  1. Lyndon @ CLS 4 November 2015 / 7:07 pm

    I always demand my legal documents be drafted in plain language. If it’s worth doing, it’s worth doing correctly.

    Like

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