Startup shareholders’ agreement is a key document in investing in a startup. Known also as the SHA, this document governs the roles and responsibilities of the parties from the investment to the exit of the company (unless, of course, replaced with a new one, e.g., in connection to a funding round). In this article, we look into key clauses that a typical shareholders agreement in a startup with external investors.
Shareholders’ Agreement in a Startup
A shareholders’ agreement is an agreement between the founders, investors, management shareholders, and the company. In the agreement, the parties set out their agreement on the company’s governance and pre-agreed actions and procedures in certain situations.
While many companies with multiple shareholders have shareholders’ agreements in place, a shareholders’ agreement is of utmost importance for startups. Since the external investors typically hold only a minority of the company, they need some additional insurance that the company is run as agreed. Also, since the founders are the most essential element of an early-stage startup, their rights and responsibilities should be well defined, especially in unfortunate but sometimes inevitable leaver situations.
You should always use a shareholders’ agreement model suitable for startups and with clauses for investors (even if you do not have any yet). Shareholders’ agreement models for traditional businesses typically miss some key elements that would be good to agree on in a startup.
In many jurisdictions, shareholders’ agreement templates are available for startups (e.g., in Finland, you can use SeriesSeed documents, and in Estonia, Startup Estonia model documents). Ensure you use a template applicable to your jurisdiction, as different jurisdictions may have other requirements and best practices for the shareholders’ agreements.
Key Shareholders’ Agreement Clauses and Their Purpose
Parties of the Shareholders’ Agreement
The parties of the shareholders’ agreement contain the shareholders of the company. In addition, holders of convertible notes, options, and similar securities that can be converted into shares in the company are also requested to enter into the agreement.
The company is also often a party in the agreement, as this adds some security that the agreement is followed (E.g., it is possible that the company’s board members are not parties to the shareholders’ agreement and are, thus, not bound by the agreement. But as the agreement binds the company, the board must also follow it.)
Legal Proceedings
If the company is a party in the shareholders’ agreement, it has the right to take legal action to enforce the agreement. But if the company is not a party in the agreement, someone else, i.e., some shareholder, must take legal action.
The parties are typically divided into groups based on their role in the company, such as founders, investors, management shareholders, etc. This allows for assigning different rights (usually to the founders and investors) and other responsibilities (usually to the founders and management shareholders) to various groups.
Governance of the Company
Nomination of Board
One of the most critical elements of the shareholders’ agreement is to set up the framework for the company’s governance. As the key decisions in a company are made by the board of directors, the right to nominate board members is addressed in the shareholders’ agreement.
Typically, the founders and the investors have the right to nominate one board member, with the other members to be nominated jointly. Some investors may also be entitled to appoint a board observer, i.e., a non-voting person participating in the board meetings.
Majority Decisions
The investors are typically minority shareholders in the company, yet they are responsible for funding it. Thus, to protect the investor minority, some decisions usually require a predetermined qualified majority.
The qualified majority can be, e.g., over 50% of the founders’ votes and over 50% of the investors’ votes in the company. This is meant to ensure that the decision is in the best interest of both the investors and the founders. Involving all shareholders in the decision-making is burdensome and should only be applied in significant decisions. Typically, qualified majority decisions are limited to situations like exiting the company, appointing a new CEO, entering into a joint venture, substantial investments, and so on. It should be emphasized that under no circumstances actions under the ordinary course of business should be subject to qualified majority requirements.
As the company sought funding from the investors, it sought funding for a particular business idea and a business plan. While the plans naturally may change during the life of a startup, the investors want to have some confidence that the founders are using the funds to execute the plans presented to the investors during the funding round. The requirement for majority decisions should be viewed in this light: The purpose of these requirements is to ensure that in case a material change to the business or the company is proposed, making that kind of change requires sufficient support from all shareholders. In other words, qualified majority decision requirements act as minority protection clauses for the investors.
As the majority decision clauses should only act as minority protection clauses, one should be careful that the clauses will not have unwanted harmful implications. One of the most common implications is that the decision-making clauses disturb the decision-making process in everyday business decisions. Another potential issue is that someone (ab)uses the decision-making rules to obtain unjustified benefits at the expense of the other shareholders. Thus, all majority decision-making requirements should be drafted, considering the company’s business and ownership of the company.
Poison Pills
Poorly considered decision-making rules may cause issues. For example, if a shareholder has a veto right on exit, the shareholder may require extra compensation to approve the exit. These kinds of shares with veto rights are also called poison pills.
Information Rights
It is common (and also recommendable) to agree in the shareholders’ agreement on the information the company provides to its investors. This can be, e.g., monthly or quarterly reporting. The minimum context of said reporting can also be specified in the shareholders’ agreement.
Good news is no news
Bad news is good news
No news is bad news
We highly recommend agreeing on investor reporting in the shareholders’ agreement and building a sound reporting practice. However, it should be noted that the reporting should be relatively light and not create an unnecessary burden for the company. A good starting point is to report the same KPIs that the founders are using to drive the business.
Future Financing
Existing Shareholders Participation
The rights and obligations of the existing investors to participate in future funding rounds may be specified in the shareholders’ agreement. This can be, e.g., that the investors have the right but no obligation to participate in future funding rounds. The commitment to provide financing usually applies only when the investment is drawn down in tranches. However, this is typically agreed upon in the investment agreement rather than the shareholders’ agreement.
Third-Party Financing
If the company is seeking further financing in the future, it may be stated in the shareholders’ agreement that the parties agree to use their best efforts to close the new investments. As this financing may require entering into new contracts, etc., the parties may agree to enter into all customary agreements as may reasonably be required.
Transfer of Shares
Having the right shareholders, or not having the wrong ones, is critical for a startup; the transfer of shares is typically minimal compared to other limited liability companies. As a starting point, it is usually stated in the shareholders’ agreement that a transfer of shares is forbidden unless expressly approved in certain situations. These can include, e.g., transfer by investors subject to a right of first refusal, drag-along sale rights, and tag-along rights.
Right of First Refusal
The opportunity to sell the share before the actual exit makes the investment more liquid for the investor and, thus, the startup more attractive as an investment target. However, controlling who its shareholders are is in the startup’s interest.
Foreing Agent
If an investor would transfer the shares to a competitor, this competitor could access the startup’s decision-making through the board’s selection and access the information given to the shareholders.
To exercise this control, the company may have limited the transfer by the investors with a right of first refusal. This means that before transferring the shares, the shares should be offered with the same terms for purchase to the other shareholders and/or redemption to the company.
Drag-Along
Drag-along sale clauses are meant to ensure effective exits. Drag-along means that if there is a purchase offer for all the company shares and a sufficient majority has approved the offer, the rest of the shareholders must accept the offer on the same terms. Thus, these shareholders are “dragged” into the deal.
Tag-Along
Tag-along is sort of the opposite of drag-along. If some shareholders sell shares that amount to ownership specified in the shareholders’ agreement, the other shareholders have a right to sell their shares in the same transaction. I.e., they have the right to “tag” into the original transaction. The purpose of a tag-along clause is to ensure that if a significant part of the ownership in a company is sold, all of the shareholders have an opportunity to participate in the sale.
Liquidation Preference
Investors may require liquidation preference, especially in the later rounds. Liquidation preference means that in case of an exit or liquidation of the company, the party having the liquidation preference has some benefit on the proceeds over the other investors. For example, the investor can take back their original investment or distribute the funds pro rata with the ownership (so-called non-participating 1x liquidation preference).
An important thing to note is the multiple of preference. While 1x (i.e., a return of the original investment) is quite common, liquidation preference of higher multiples (e.g., preference for four times the initial investment) can significantly negatively impact the value of the other investors’ shares.
Sometimes, liquidation preference is defined as the original investment amount plus a certain percentage per year (e.g., original investment + 8% p.a.). If the business does not go according to plans, and it rarely does, investors holding these shares may accumulate so much preference over the actual value of the shares that the company becomes non-investable.
Leaver Events
Founders and key employees are the most crucial parts of the startup. However, it is a fact of life that things do not always go according to plans, and people leave the company. As the founders are the key shareholders in a startup, it is important to agree on what happens to their ownership in case they leave the startup (a so-called leaver event).
Bad and Good Leavers
A bad leaver is a leaver who is fired from the startup for reasons relating to the leaver’s performance or who resigns from the company without agreeing on the resignation beforehand. On the other hand, a Good Leaver is a leaver who resigns in cooperation with the startup or has to be let go due to the company’s financial situation.
Vesting and Redemption of Shares
Leaver events are linked to vesting. When investors invest in the company, they expect the founders to continue pushing it forward. To ensure this, the investors typically require some sort of vesting period. During this period, the shares become vested.
How vested and unvested shares are handled in a leaver event depends on what has been agreed, but in any case, in a bad leaver event, the leaver is generally in a worse position than in a good leaver event. For example, the shareholders’ agreement may state that the Good leaver is entitled to keep all vested shares, and the unvested shares can be redeemed at fair value. In contrast, a bad leaver’s vested and unvested shares may be subject to redemption at fair value and nominal value, respectably.
A Bad Apple
It usually makes sense to have the option to redeem all of the shares of a bad leaver, even if vested shares would be acquired at fair value. Having a bad leaver as a shareholder, or even worse as a significant shareholder, can significantly negatively impact the performance of other founders.
Authorization in Certain Situations
While the shareholders’ agreement governs decision-making in key situations, some actions require more from the shareholders than just the decision. For example, in case of an exit, the shareholders must execute other documents after the exit decision, e.g., signing the share purchase agreement. If some shareholder refuses to perform these activities or remains passive and does not perform the required actions, the exit could get terminated.
To avoid these kinds of issues, it may make sense to include a clause authorizing, e.g., the board to act on behalf of shareholders not performing their duties under the shareholders’ agreement in certain key transactions. Of course, as this kind of clause means a significant transfer of control away from the shareholders, one should be extremely diligent when applying the clause.
Intellectual Property Rights
Most startups are founded to commercialize some intellectual property rights developed by the founders. For clarity and the investors’ protection, the shareholders’ agreement typically states that all of these intellectual property rights have been or will be transferred to the company.
Market Hedging
In one case, a founder had assigned only European intellectual property rights to the company while keeping the rights for North America with the founder. The founder’s reasoning was to hedge his position in case the European business would not fly; the founder could still try to monetize the rights in North America. This was problematic from the investors’ point of view for a couple of reasons: For one, growing the European business would also boost the value of the North American assets, but the investor would not receive any compensation. Second, there is the risk that if the North American business becomes more lucrative for the founder, the founder may abandon the European company the investor would have invested in. Not so surprisingly, the investment did not happen.
Non-competition and Non-solicitation
The founders and key employees are the critical assets of a startup. So, not so surprisingly, typically, the shareholders’ agreement forbids founders and management shareholders from competing with the firm or soliciting employees or customers for the period of the ownership and a certain period after the shareholder has disposed of the shares.
It should be noted that a non-competition clause in a shareholders’ agreement is typically more rash than a competition clause allowed in an employment agreement. The former is governed under contract law as a breach of the contract, whereas the latter is governed under employment law. Thus, both of these can become applicable at the same time.
Competition
One of the most common legal disputes between startups arises from hiring between competitors, followed by the claims that the hiring company is illegally infringing the intellectual assets of the previous employees.
Adhering to the shareholders’ agreement
If the company seeks new funding or gives shares or options to the employees in the future, the company will get new shareholders. Thus, the shareholders’ agreement should contain clauses on the requirement of the new shareholders to adhere to the shareholders’ agreement and how the adherence is made.
Typically, approval for the transfer of the shares is tied to the adherence to the shareholders’ agreement by the party receiving the shares. The approval of the new shareholders’ adhering to the shareholders’ agreement is often delegated to the company’s board of directors, provided that the conditions for adherence are met.
Breach of Agreement
Every good agreement contains clear clauses on what happens in case of a breach of the agreement. (And a great agreement contains such clear rules on everything that no one ever reads it.) Typically, there are clauses on notification of a breach, cease of breaching activity, liquidated damages, and dispute resolution. Hopefully, one never needs it, but once it is in the agreement, the consequences of a breach are more apparent, and the likelihood of a breach is lower.
Conclusion
The shareholders’ agreement is typically the most complex of the investment documents. While it might be feasible for both the investors and founders to use legal help with the shareholders’ agreement, we see that it is of utmost importance that both the founders and the investors understand their rights and responsibilities under the agreement.
This blog post is a part of our series about investment documents. See the previous post about term sheets, and stay tuned for the next post about investment agreements.