10 of the Most Important Clauses to Put in Your Shareholder Agreement

10 of the Most Important Clauses to Put in Your Shareholder Agreement

Starting a new business has many risks, including failure to achieve a viable business model with product/market fit, excessive competition, economic downturns, lack of cashflow/runway, hiring risks, delays in delivery and technical risks. However, one of the largest risks and most common cause for business failure is due to disputes between shareholders. This article will discuss 10 of the most important clauses to put in your shareholder agreement.

1. Sweat Equity

Because of the limited funds available to pay salaries, many start-up companies offer shares to co-founders and key staff who provide “sweat equity” instead of capital. When properly used, offering shares can provide a strong incentive to commit and grow the business. If the business is eventually sold or listed on a stock exchange, these shares can make initial founders and staff very rich.[1] In addition, allocating shares at an early stage usually provides significant tax advantages as any increase in the value of the shares is taxed at a lower rate or sometimes not at all.

Despite the benefits of providing equity to founders and staff, problems arise if relationships with shareholders break down and people are terminated from the company. Without a valid legal agreement in place to deal with this event, such “bad leavers” will keep their shares and the remaining shareholders are stuck with minority shareholders who are now “free riding” on the efforts of the actively involved shareholders. While there are some legal “tricks” which can be used to solve this problem, such as issuing additional shares to dilute shareholders or selling the business assets to a new entity,[2] these can create grounds for a lawsuit, and ultimately, the company may have problems raising further funds and incentivising the remaining founders and staff to stay involved with the company.

2. Share Vesting 

A smart way to solve the above problem is with the use of so-called “vesting” clauses, which are usually incorporated into a shareholder agreement. Under such clauses, a shareholder does not obtain the benefit of the shares until certain conditions have been satisfied, such as remaining with the business for a minimum period of time or achieving a specific milestone (e.g. obtaining a certain revenue target or number of users). After those conditions are satisfied, the shares or a certain pre-determined percentage of the shares will “vest” in the shareholder. Otherwise, the company may have an automatic right to repurchase the shares.

For example, a “vesting schedule” may provide that shares will vest over a period of 4 years on a monthly basis. Typically, there is an initial “cliff”, whereby a shareholder must remain with the company for a minimum period of time (say, 1 year), otherwise they will lose rights to all of the shares. Therefore, assuming a standard 4-year vesting period, after the first year, 25% of the shares will automatically vest, with the remaining shares vesting over the next 3 years, in monthly parcels of 1/46 of total shares.[3]

Another issue is if the company is acquired or a change of control occurs before all shares have vested. In that case, a “trigger” clause may be included to accelerate the vesting of the shares upon such change. A “double trigger” clause may provide that the shares only automatically vest if the shareholder is subsequently fired, in order to ensure that they have an incentive to stay with the business after acquisition.

3. Good and Bad Leavers

“Good Leaver” and “Bad Leaver” clauses deal with the problem of what to do when shareholders leave the company under different circumstances, some less blameworthy than others. For example, Bad Leaver clauses provide that if a shareholder is terminated due to a material breach of his or her contract, misconduct, or before reaching a critical milestone, they will have to transfer their shares back to the company at either the price they paid for them or market value (whichever is lower). By contrast, Good Leaver clauses may provide that where a shareholder is terminated or leaves the company through no fault of their own and/or after achievement of specific milestones, they may be required to sell their shares to the company or the other shareholders at market value, or they may be permitted to retain the shares.

4. Pre-emptive rights and Anti-dilution

As noted above, one method to remove the influence of unwanted shareholders is to issue more shares to everyone else. Pre-emptive rights clauses reduce the efficacy of such methods by requiring the company to first offer any newly issued shares to existing shareholders proportional to their existing shareholdings. This will ensure that existing shareholders have the chance to participate in new share issues without being diluted. This can also be an effective method for the company to raise money, as it incentivises shareholders to invest more money into the business in order to prevent them from being diluted. Anti-dilution clauses are similar to pre-emptive rights, but enable a shareholder to be issued new shares automatically without paying for them. This can result in founders losing control of their company if shares are subsequently issued at a significantly lower price. Obviously, anti-dilution rights are powerful, and might only be granted to investors when a company or its founders are in a relatively weaker negotiating position.

5. Restrictions on Transfer of Shares

Another protective clause for shareholders involves restrictions on transfer of shares. This ensures that shares cannot be sold to an undesirable third party without first either allowing the company to find a purchaser or offering them to the other existing shareholders at the same price offered to that third party. If there is a dispute over the price of the shares, it is possible to provide for an independent valuation or a formula to determine the fair value. If the price is lower than what was offered, the shareholder may withdraw their notice to transfer the shares. Notably, restrictions on transfers of shares do not usually apply if shares are transferred to a shareholder’s family members or a trust.

6. Drag-Along and Tag-Along Rights

Disputes between shareholders can often occur when one group wishes to sell the business and the other group does not. Drag-Along and Tag-Along clauses can help resolve this issue and ensure that a deal can proceed. Firstly, Drag-Along clauses ensure that if a minimum percentage of shareholders (e.g. 75% or more) wish to sell their shares to a third party, they can force the remaining minority shareholders to sell under the same terms, in order to ensure that the third party can receive 100% of the shares. Conversely, Tag-Along rights require a shareholder selling their shares to include other minority shareholders under the same terms. This ensures such minority shareholders are not “cut out of the deal”.

7. Rights to Appoint Directors and Restrict Activities

Usually, a majority of shareholders (i.e. 51%) is required to appoint and remove directors from the board, which allows effective control of the company. However, this means that a minority shareholder will not have the right to representation on the board, despite the fact they may hold up to 49% of the shares. In that case, a shareholder agreement may allow a minority shareholder the right to appoint a director if they hold a minimum percentage of shares (e.g. 25%). A “restricted activities” clause in a shareholder agreement may also require a “super-majority” of shareholders (e.g. 75% or more) before making certain decisions, such as entering into a major transaction, hiring key staff, paying dividends, or issuing more shares. This can ensure that minority shareholders still have some control over the governance of the company.

8. Liquidation Preferences

Of all the tricks that are used by venture capitalists, liquidation preferences are one of the most notorious. Shares are often issued to investors on the basis that if the company is sold or liquidated they will be the first in line to recover their investment before the other shareholders. In some cases, however, investors may negotiate a 2x or 3x liquidation preference, meaning that the investor will recover twice or three times their investment before the remaining assets are distributed, which can result in the other shareholders receiving a much smaller amount upon an exit. Liquidation preferences for investors are reasonable, but if they exceed 1x this should be a red flag unless the founders want to risk getting nothing when the business is sold.

9. Debt and Equity Capital

Instead of receiving shares, a founder or investor may also make a loan to the company, which could convert into shares at a later date – this is referred to as a convertible note. A loan must be repaid in advance of other shareholders (including any applicable interest) and can effectively provide him or her with the power to take over control of the company on order to repay the loan, and perhaps even sell the assets of the company to another company related to that shareholder. This can be contrasted with equity capital, which occurs where shares are received in exchange for cash. Many companies have a mixture of debt and equity capital, and it is sometimes better for founders to ensure any funds contributed are provided as a loan rather than equity capital in order to maximise their control and increase their leverage with other investors and creditors.

10. Fundamental Disputes

Sometimes, disputes between shareholders boil over to such an extent that a deadlock occurs which is incapable of resolution, and has the potential to cause serious injury to the business as a going concern. This could include a dispute over additional funding for the company, an increase or reduction or shares, payment of dividends, or disagreement regarding the sale of the business. In this case, a “fundamental dispute” clause can be used to provide an exit strategy by including a mechanism for one or more shareholders to buy out the others. There could be an independent valuation or pre-determined formula, as discussed above with regard to restrictions on transfer of shares. If an agreement cannot be reached, a “shotgun” clause is also an interesting (but somewhat dangerous) valuation method, whereby if one shareholder makes an offer to purchase the shares at a certain price, the other shareholder can either sell their shares or purchase the offeror’s shares at that stated price. This ensures that the offeror does not make an offer below the perceived market value of the shares unless they wish to risk losing their own shares at below market value. Although a fundamental disputes clause is a last resort, it is preferable to a deadlock, which may result in the company losing all the value it has built up over many years.

Conclusion

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 pre-determining 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 a shareholder agreement, and can end up with toxic shareholders, lost opportunities, and many years of wasted effort. A legal battle between shareholders is costly and dangerous, but with the right legal clauses in place, getting a good result need not be an entirely Pyrrhic victory.

[1] http://www.dailymail.co.uk/news/article-2072204/Facebook-IPO-create-1-000-millionaires-companys-rank-file.html; http://www.theguardian.com/business/2014/mar/09/bt-workers-share-1bn-windfall-employee-scheme; http://pando.com/2014/02/24/whatsapp-bought-for-19-billion-what-do-its-employees-get/

[2] See, for example, Mark Zuckerberg’s dilution of Eduardo Saverin’s stake in Facebook: http://www.businessinsider.com.au/how-mark-zuckerberg-booted-his-co-founder-out-of-the-company-2012-5.

[3] http://www.businessinsider.com.au/everything-you-need-to-know-about-cliff-vesting-2011-5.

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