What is the Shareholders’ Agreement?
In this article, we aim to explain the Shareholder’s Agreement and the key points surrounding it.
The latest point at which you will have to have a shareholders agreement (‘SHA’) would be when your startup is ready to move ahead with angel/institutional investments. It is one of the most crucial startup documents that help determine everyone’s rights and responsibilities holding equity in the company. This kind of contract is critical as it defines the relationship between a particular company’s shareholders beyond the company statutes (the document you file when incorporating the entity). It covers not only the equity matters (transfer of shares etc.), but it governs everyone’s involvement in the business. Thus, it is essential to make sure that every shareholder operates under the commonly accepted framework. Investors want to ensure that each co-founder is obliged to participate in the business activities and have the necessary protection if anyone decides to act against the company or leave. The essential elements that you would probably like to consider are outlined below.
The notion of an SHA
The SHA is a document executed by the shareholders in a company to define how the latter should be run, the shareholders’ rights and duties, the fair price of shares, and the relationship between passive (advisors & investors) and active (co-founders or first employees) shareholders. The SHA can protect minority shareholders and majority shareholders, regulate the ways of share transfer, impose restrictions, govern decision-making, and much more. It is a flexible and complex document aiming to cover all risks that may occur regarding each shareholder’s actions and omissions regarding their role in the business. Its primary function is to balance the powers between what a shareholder may be able to or is allowed to do by law and the protection of the other shareholders that may be vulnerable in certain cases. In general, the SHA preserves the value of the company for everyone.
Correlation between Article of Association (AAs) and SHA
The AAs are closely related to the statutory requirements at the place where the company is incorporated. Usually, this is a public document reviewed by the company registry before incorporation, and it has to contain all provisions required by law (company name, address, shareholders, number of shares and nominal value, voting rights, management, the way shareholders meetings are to be conducted, etc.). The SHA, on the other hand, is an entirely private document drafted according to industry standards and the specific risks of each project. It is often the case that the law where the company is seated does not allow or enable specific business-related provisions to be included in the AAs. For example, in some countries, the shareholders’ active involvement in the day-to-day activities may not be imposed by the AAs. Accordingly, it is vital to ensure that the company’s AAs are consistent with the SHA to avoid uncertainty or conflict and ensure adequate remedies are available in the event of a breach of contract. Below are provided some of the significant points in the SHA.
Vesting
Vested shares could be easily presented as part of the reward for shareholders, particularly for startups. This approach provides that the founders or first employees do not own the shares until some conditions are fulfilled. This benefits the company in multiple ways, including encouraging retention and lowering the initial salary expenses while aligning the undertaking’s interests and key participants. The conditions and details of how shares are vested are known as vesting terms, which should be stated in the SHA to avoid disputes. Some terms of vesting include remaining with the business for a minimum time or hitting specific individual targets. The company has an automatic right to purchase any unvested shares at the original purchase price or at fair value, depending on how the SHA stipulates. The vesting scheme should be in line with the limitations of the applicable law, and the AAs need to be drafted in a way that enables the fulfilment of such obligations.
Pre-emptive rights and right of first refusal
These clauses serve to protect existing shareholders from the involuntary dilution of their stake in the company. Any new issuance of shares (pre-emptive right) or outgoing shareholder’s shares (right of first refusal) must be offered first to existing shareholders before they are sold to a third party. Such rights are usually on a pro-rata basis, although in some cases, the parties may agree to a “super pre-emption”, which means some shareholders may be entitled to invest more than pro-rata. Without these crucial safeguards, existing shareholders with a smaller piece will eventually end up with a larger pie. The critical point here is to ensure a balance between the envisaged protection and future capital increase and financing or a fair exit of each shareholder.
Special rights to appoint directors and supermajority clause
The company management is a crucial aspect for the successful undertaking as the directors operate the business day-to-day. In general, minority shareholders cannot block the passing of ordinary resolutions, such as the appointment and removal of board directors. In other words, a minority shareholder can have 49% of shareholding but still have no power to influence the board of directors’ composition. To mitigate such rigidity, the SHA can provide a clause that enables a minority shareholder with a minimum percentage of share to appoint or remove a director. This prevents minority shareholders’ voices from being buried and affords them more bargaining power in the company.
Non-competition
Non-competition clauses are commonly found in the SHA. Usually, the management is covered by non-compete obligations by law. However, it is necessary to establish that the shareholders in startup or scaleup entities are obliged not to participate in competing with the one in hand. This eliminates any ambiguity about the carry of such rival activities during and after their being a shareholder. Such restrictions protect potential leaks of know-how and other confidential information that may lead to losing competitive advantages. The SHA should provide a clear list of the dos and don’ts, including the scope and period of the restrictions. Notwithstanding the above, non-competition clauses must be reasonable to ensure their enforceability. Otherwise, the court may rule that such a clause does not affect the shareholder.
Deadlock resolution clause
A pre-agreed dispute resolution mechanism is constructive towards overcoming deadlocks. When shareholders with equal standing are unwilling to budge from their stance or when a supermajority or unanimous consent is required but cannot be attained, the company enters a deadlock. This would force an otherwise completely functional business into a standstill if the shareholders cannot compromise and move forward as one. There are various formulations of deadlock resolution clauses. For example, the “Russian Roulette Provision” allows a shareholder to issue a notice indicating the intention to buy out the other shareholders at a specified price. On the other hand, a “Put Option” is more beneficial to shareholders with weaker financial abilities as the latter is entitled to sell his/her/its shares to another shareholder at a predetermined, fair price. A “Sealed Auction Provision” enables the shareholder with the highest bid to purchase the others’ shares at the stated price. There is no absolute answer to which provision is the best; it all hinges on the shareholders’ preferences and course of negotiations.
The potential for shareholder disputes is ever-present and a significant risk to the viability of any business. Many legal clauses can help reduce uncertainty when such disputes arise by predetermining the mechanism to resolve them and ensuring that a fair outcome is achievable. Unfortunately, many founders enter into companies without understanding the importance of such clauses in an SHA and can end up with toxic shareholders, lost opportunities, and many years of wasted effort. Ensure your startup would not face any of these risks and consult with a professional before drafting the SHA for your undertaking. Remember that each great fortress has been undertaken from the inside, which is what the well-composed SHA prevents.
