‘Beware the toxic clauses’ in S Korea: lawyer

A STARTUP entrepreneur may heave a sigh of relief when finally signing an investment contract, taking it as a tangible solution to the uncertainties lying ahead of the budding business.

But it is at this stage that one should take the upmost guard, looking out for possible “toxic clauses” which may deliver irrevocable consequences upon the business in moments of crisis, according to lawyer Roh Jong-eon.

“People, most of all startup founders who are new in the business realm, tend to be intimidated by legal contracts,” Roh told the Korea Herald in an interview. “These novice businesspeople also get easily carried away by the investment itself, which may mislead them to overlook some critical clauses in the contract.”

Roh, former head of the legal depart- ment at Mirae Asset Global Investments, is working as a lawyer at Help Me, a startup providing low-cost legal consultation via an online platform.

“All investors, whether individual, venture capital or private equity, base their action on the fear of losing money and the goal of creating large profits from their investment,” the legal adviser said. “It is thus only natural that startup investors should insert protective clauses so as to build a buffer zone against possible losses.”

In the investee’s perspective, however, these preventive measures turn out to be toxic clauses to infringe on management rights or impose excessive damage compensations.

While the responsibility lies in both parties to take due precaution, it is usually the startup entrepreneurs who find themselves in a weaker position compared with experienced investors, the lawyer explained.

An example of such a toxic clause is a ring-fence on investment which limits the use of money to specific purposes or the investor’s consent right on the company’s key decisions such as the appointment of directors.

“These are usually the kind of clauses which trigger conflict in investment deals as the investee, who is also the founder and major shareholder of the company, is to be bound by minority shareholders’ interest,” he said.

The expert also advised investees to double-check on the format of damage compensation in case of violation.

“What one should avoid at all costs is a penalty clause, which obligates the business operator to pay an extra amount, along with the actual damage compensations,” he said. “If the compensation amount comes in fixed amount, it is important to compare the figure to the industry average.”

Another intrinsic risk is the “dragalong right”, which allows the investor to sell off the major shareholder’s share unless the company goes for initial public offering within a given time.

Even conglomerate affiliates have suffered from these conditions.

Upon signing an investment deal with Doosan Infracore’s Chinese affiliate DICCin 2011, investors inserted a drag-along clause to guarantee their rights to sell off Doosan Infracore’s shares, should DICC fail to go public by March 2014. The legal battle over the legitimacy of this contract is yet pending at Seoul’s appeal court.

“Despite the complicated contract terms, it all comes down to two questions for entrepreneurs – under what circumstances will I be liable for damage compensation and how much will I have to pay in that case?” Roh said.

For small-size startups with limited funds and manpower, the lawyer suggested they consider partial legal consultation as an alternative to save costs.

“The legal circles have been evolving out of their old practices and there are now an increased number of ways to get legal counselling at a more reasonable cost,” Roh said.

Help Me kicked off in 2015 as an online legal consultation platform, allowing the user to review lawyers, apply for an online consultation and pay on an hourly basis.

“Korea’s legal market remains in that transition stage, where the number of lawyers has soared but the service level is yet underdeveloped,” said Park Hyo-yeon, one of the three co-founders of the business.

“One of our goals is to open up the market to a broader public via a low-cost, open platform.”