11 / 15 / 2016

Why Shareholder Agreements Are Important to Startup Businesses

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Starting up a new business is exciting and stressful. You are all optimism and energy as the new company starts to take shape. You and your co-founders or investors may not want to think about anything negative happening or slow down to plan daily operations, founder exits, or share valuation. You must, for the protection of your startup. 

To protect yourself, your new business, and your shareholders, you need a shareholder agreement to cover all these contingencies and more. You already have your Articles of Association, but the shareholder agreement provides for issues outside of that document. It is especially important if this is a family business, which comes with its own set of issues. 

There is no boilerplate for shareholder agreements; each is crafted for the specific needs of each company and its shareholders. Without one, you could suffer significant financial damage. 

What Is a Shareholder Agreement?  

A shareholder agreement is a private contract entered into voluntarily by all shareholders of a business. It stipulates rules for policies and processes that fall outside the legal agreement forming the company. 

A shareholder agreement: 

  • Regulates rights, obligations, and relationships between shareholders 
  • Provides for common understanding among founders and investors 
  • Regulates day-to-day operations 
  • Formalizes processes to follow when an investor leaves the company or new investors buy-in 

This is not a simple agreement; you would be well advised to consult a corporate attorney to help you draw it up. However, you must play an active role in drafting it because you are the one who knows what is most important to your business. 

Make sure you and your signatories understand every clause and provision within the agreement to avoid misunderstandings. 

Why You Need a Shareholder Agreement 

A shareholder agreement provides legal security for your startup. You are regulating future situations and determining resolutions for potential problems down the road. 

In essence, a shareholder agreement answers the question, “What if…” 

What if: 

  • A founder leaves, dies, or becomes chronically ill? 
  • A founder decides to start another project similar to your business? 
  • You need a new partner? 
  • A founder or investor is not dedicating enough effort or finds another job? 
  • A founder or investor is not delivering? 
  • There are disagreements among shareholders? 
  • There is a deadlock after a vote? 

Types of Shareholder Agreements 

Shareholder agreements change as the business grows. As your startup matures you may need to rewrite or modify your original agreement. Alternatively, if you have been operating without an agreement, understand when you draft one that each stage of business growth has different requirements. 

Seed Stage 

Before the company is created, you can negotiate and sign a seed stage shareholder agreement. It should outline the equity stakes, contributions, obligations, and roles of each member. 

This agreement is also the best place to lock down how much time and effort the shareholders are expected to dedicate to the company as well as determine vesting regulations. 

Early Stage 

An early stage agreement has the same goals as a seed stage agreement but can also regulate new individuals joining the company. 

An early stage agreement typically comes about in one of two ways. 

1. The company already had a shareholder agreement, but it now requires modification due to the entrance of a new found or investor. 

2. The company did not have a shareholder agreement, and now it is necessary to control relationships between parties and financial rules for investors. 

Growth Stage 

By this time the company has validated its business model and found a market niche. Now it needs a cash infusion to grow faster and reinforce its position. 

If you are receiving funds from venture capitalists, they will probably lead the negotiations and draft the investment agreement. 

General Provisions 

Your startup may not need some of these provisions right away, but others should be addressed from the beginning. 

Board of Directors 

In a small company the board of directors is probably the same as the management team. In a startup, the board may only consist of you and your co-founders and initial investors. Regardless, you need to determine the composition of your board, how many individuals should be on it, and provide rules for non-executive directors. 

This is a good time to develop an election mechanism because if your startup grows quickly, you need a standardized method to bring more directors onto the board. With a family business, you need to lay out the entitlements for family members or shareholders with specific shareholding interests so they can make appointments to the board. 

Voting Rights 

What kind of majority do you need to make various decisions such as increasing the authorized share capital? You may only need a simple majority for decisions like this, but you may want a 75% majority for more significant decisions such as altering the Articles of Association or the company name. 

If you are amending the shareholder agreement, require a unanimous vote to protect the minority shareholders. 

Transfer of Shares 

How do you want shares to be transferred? Impose needed restrictions to keep shares within the family or to govern how other specific groups of investors can transfer their shares if desired. 

Also, define the type of transfer allowed and place a control mechanism on the transfer. 

Share Valuation, Discounts, and Cash Flow 

Define how shares should be valued to buy out an investor who leaves the company. You may want to stipulate shares will be sold back to the company at a discount to protect the cash flow. Another alternative is to stipulate any share buy-backs will be done over a period of time to protect the outflow of cash and cash reserve. 

Dispute Resolution 

Disputes among shareholders can get heated. If the shareholders are family members, additional emotional distress is in play. Develop a dispute resolution to resolve problems privately and confidentially. Arbitration is a common part of a company’s resolution process. 

What's Next?

This post is a brief overview of shareholder agreements. If you have a startup or are thinking of starting a new business with partners, investors, or co-founders, a shareholder agreement is your best protection against financial and emotional distress. When everyone understands how the company works and is in agreement, you will have smoother transitions when an individual leaves or a new one joins the team or when disagreements arise. 

If you have a family business, it is even more important to define working relationships, how the shares will be divided and valued, and a succession plan to transition the next generation into the business. A shareholder agreement sets out a predetermined framework to address a variety of common business situations.

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