Why You Really Need a Shareholders’ Agreement for Your Start-Up
Most often than not, life does not give us the chance to determine how certain things would end up, if or when those things eventually happen down the road. This is largely because we either don’t see those things coming or we are just a little reckless about the consequences. But when given the chance to be able to control or have some level of control over how things would turn upon certain eventualities-especially in our personal and business relationships-we are often happy to jump at such chances. So why do many founders and business partners today often neglect, fail, or refuse to jump at the chance of arranging their business affairs or relationships in a way that helps them have some level of control over issues upon any reasonably foreseeable eventualities? A shareholders’ agreement is one of the most vital legal documents that founders or business partners should have, but it is often overlooked until it becomes a little too late. This shouldn’t be so in your business. Your startup or business badly needs a shareholders’ agreement.
A business idea is not enough
Three tech guys had a business idea. Their goal was clear-solve the international remittance problem in Africa by developing a blockchain-powered solution for cross-border money transfers. So these three guys founded a FinTech startup in Nigeria. For a start, they bootstrapped the idea, pooling their personal resources together to develop the solution. This was the first step as conceptualized in their business roadmap. Fast forward; the three musketeers successfully completed the Minimum Viable Product (MVP), but they badly needed more funds to be able to take the MVP to the target market. They needed other people’s money and all they got in exchange for capital was shares in the startup. This is where a shareholders’ agreement comes in.
You need a shareholders’ agreement
A shareholders’ agreement is an agreement entered into between all or some of the shareholders in a company (or by the company itself) which regulates the relationship between the shareholders, the management of the company, ownership of the shares, and the protection of the shareholders. The shareholders’ agreement may be executed before or during the life of a startup or business.
Sometimes, entrepreneurs set up companies with friends and relatives and do not consider protecting their interests in the company until it is often too late. While it’s legitimate to trust friends and family in business, it is not advisable to leave your startup unprotected. Although the articles of association (bylaws of the company) and the Founders’ Agreement no doubt provide certain safeguards for your startup, a shareholders’ agreement uniquely addresses certain risks that are most adequately covered by a shareholders’ agreement. Such risks involve the rights and liabilities of the shareholders, including their shares, dividends, preemptive rights, share-transfer rights, voting rights, and other vital issues that can make or break a startup.
Ordinarily a shareholders’ agreement is a pre-incorporation contract. But this is only ideal. The reality today is that a shareholders’ agreement is used at any time. Where this is the case, it is the drafter’s duty to ensure that the provisions of the shareholders’ agreement do not conflict with the company’s articles of association. This is because the articles of association is supreme.
In your best interest, you need more than trust and articles of association
While trust is important in business, you don’t want to leave your startup unprotected, believing that your friends, family, or partners will keep to their own side of the bargain. You also don’t want your startup to evolve into a hub for unhealthy rivalry and rancor among team members. Each member, rightly or wrongly, may believe that he or she has invested so much time or money, or both into the business and as such is entitled to certain returns on investment.
So a shareholders’ agreement does not only offer better protection to shareholders but also gives a startup adequate room to address certain considerations more specifically and in more detail. For example, considerations such as a deadlock may prove very difficult to deal with through the articles of association. Even where the articles are made to protect shareholders, they can be amended by a larger percentage of majority shareholders. The implication of this is that protection for minority shareholders can be taken away by passing a special resolution. As a startup, you don’t want to leave any loopholes that may end up working against your business interest, now or in the future.
7 practical considerations and clauses when preparing a shareholder’s agreement for your startup
There are a number of vital concerns and clauses that should be considered when preparing a shareholders’ agreement, such as the dividends policy, voting rights, right to appoint board members, right to access financial reports, etc. Below are seven of them:
- Valuation: When you wish to allot shares in your startup, it must be that you expect an exchange of value. But to be able to determine what amount of shares is allotted to a shareholder, isn’t it logical that you have a good or fair idea of what your startup is worth? Ask yourself what each share is worth, and whether what you are getting in return for the shares are commensurate. If you consider the values commensurate, does the shareholder agree with your valuation? This is why you need to have a valuation formula. Keep the valuation reasonable. And be realistic. Valuation is vital, especially when you consider that various events in a business could trigger a buy-out of the shares. It could be bankruptcy, death, permanent disability, bankruptcy, or simply an exit strategy. A shareholder agreement should include a valuation clause. This will determine what the buyout price will be-whether fair market value, net book value, or nominal value.
- Payment or other consideration: What is the shareholder bringing into the company in exchange for shares or stock in the company? This is usually money. Apart from money, it may be other considerations, such as the contribution of the business idea, the work done or expected to be done (known as sweat equity), or even for advisory services to the startup or business. Whatever the consideration is, the vital thing is ensuring that it is specific, measurable, acceptable, realistic, and time-bound. Think SMART.
- Vesting: If a startup or business fails to insert a vesting clause in a shareholder agreement, the unintended consequence is that upon allotment of shares to the shareholder, transfer becomes absolute, subject to no conditions. This is highly risky. Without share vesting, the benefits of retention as well as postponing dividend payout are lost. Including a vesting clause ensures that no one owns anything in the company until certain conditions are fulfilled. These conditions are stipulated in what is called the terms of vesting. A term of vesting may, typically, require a shareholder to stay with the startup or business for a specified minimum period or until certain specified milestones are achieved. Startups commonly have a 4-year vesting schedule on a monthly basis subject to a cliff period. (i.e. a minimum period of time has to pass before the allotment of shares).
- Preemptive rights: Do existing shareholders exercise any right over new shares issued by the company or shares offered by other existing shareholders of the company? In other words, do shareholders have a right of first refusal with respect to any shares sold by any of the existing shareholders? Shareholders want to be sure that they have some level of control over ownership of the company. A preemptive-rights clause enables existing shareholders to maintain the percentage of shares they own by enabling them exercise the right to purchase any new securities issued or offered in the company. This prevents shareholders’ ownership of the company from being diluted when new shares are issued. Hence, it is referred to as “anti-dilution provisions”. Where it is a private company, existing shareholders are entitled to first purchase shares from a shareholder who wishes to dispose of its shares. Section 22(2) of Companies & Allied Matters Act provides that a private company may by its Articles restrict the transfer of shares of its members. Where there is such restriction, the Articles may provide for preemptive right upon transfer of shares. A shareholders’ agreement that fails to safeguard preemptive rights would end up making existing shareholders-usually those shareholders who started early with the startup-have their shares largely diluted. A startup or business that fails to protect the interest of existing shareholders will most likely not protect those of potential or future shareholders as well.
- Drag-along and Tag-along Right: No law anywhere obligates all of the shareholders to sell their shares; this means that a single shareholder can hinder the sale of shares by other shareholders. This seems rather unfair, so that’s where ‘drag along’ and ‘tag along’ clauses can play their part in a Shareholder Agreement.Drag-along and tag-along rights are very important clauses for startups or businesses potentiating a big future ahead of them. Both rights help to secure the interests of both majority and minority shareholders in a company. On the first hand, a drag-along right allows majority shareholders in a company to force the minority shareholders to join in on a sale of their shares. In other words, regardless of minority shareholder’s choice, they will be dragged along by majority shareholders whenever these majority shareholders consider a company sale or venture-capital deal favourable to them as majority shareholders. A drag-along clause therefore prevents a minority shareholder from frustrating the sale of the company where supported by the majority shareholders. A drag-along clause confers on minority shareholders the same price, terms, conditions as any other seller. On the other hand, a tag-along right allows a minority shareholder to ‘tag along’ with majority shareholders if they find a buyer of their shares. This means that it allows minority shareholders to join in on the sale thereby providing them with greater liquidity and protection if one or more shareholders are selling their shares. Also called a ‘co-sale right’, it affords minority shareholders some liquidity since majority shareholders must take them along whenever there is a company sale or venture-capital deal. Without a tag-along clause in a shareholder agreement, majority shareholders could simply negotiate the sale of majority shares only, leaving the minority shareholders behind.
- Noncompete Clauses: Without this clause in a shareholder agreement, existing and former shareholders may take undue advantage of access to proprietary and confidential information to hurt the competitiveness of the startup or business. A noncompete clause therefore essentially regulates the affairs of existing shareholders and former shareholders in relation to the intellectual property and confidential information of the startup or business. Since former shareholders or partners would, at the time of departure, have known so much about the intellectual property and confidential information of the startup or business, it is important to protect the company and other shareholders from any unauthorized use of such information. But noncompete clauses must be prepared cautiously. The restrictions introduced by a noncompete clause must be specifically for the purpose of protecting intellectual property and confidential information. An umbrella or broad restriction should be avoided otherwise the noncompete clause may become unenforceable in an arbitral tribunal or court of law. So it’s vital to always keep it reasonable, especially concerning the period, industry, and geographical market. Unfortunately, this clause happens to be one of those mostly infringed upon out there. Notwithstanding, there is remedy available at law.
- Deadlock & Disputes: a deadlock and dispute resolution clause resolves a situation where there is a major disagreement between shareholders, but no side has the majority vote. There are numerous procedures that can be employed to resolve a deadlock depending on the nature of the deadlock. The more reason no two deadlock clauses are the same.
Why your startup badly needs a shareholders’ agreement
From the 7 considerations and clauses highlighted above, you can already see why your startup badly needs a shareholders’ agreement. Below are 4 things a shareholders’ agreement will help you achieve:
- Uniquely address specific concerns regarding shares and related issues: As we have seen, the articles of association can’t address certain issues the way a well-considered shareholder agreement would do. As can be gleaned from above, some of these issues include but not limited to the financing of the company, the management of the company, the dividend policy, vesting, and valuation. A shareholders’ agreement will also include provisions on dilution of shares, transfer of shares, removal of a shareholder, etc.
- Clarity: In a shareholders’ agreement, the rights, duties, and liabilities of shareholders are clearly spelt out. It also delineates the extent of rights and powers the directors are able to exercise in the company by providing a framework on how decisions are to be made and reached.
- Minority rights and majority shareholders’ protection: A shareholders’ agreement secures the rights of minority shareholders or those with equal shareholdings cum investment value of the shareholding. Accordingly, a shareholder agreement can be used by majority shareholders to cut some powers of directors where shareholders do not have a majority representation at board level, or take an active part in the running of the business.
- Increased chances of investment: a shareholders’ agreement increases the likelihood of attracting funds and investment opportunities for your startup. It demonstrates a sense of stability in your business and depicts a level of professionalism.
You realize the need to have a shareholders’ agreement for your startup and that it comes in before or immediately your startup is founded. (It may also come in at anytime as you leverage equity for capital.) You want to ensure that the rights, duties, and liabilities of minority shareholders and majority shareholders are drawn out, and those holding equal shares are protected accordingly. You want to be able to take care of who gets what, when, and how. It’s a company you want not a hub for brewing bad blood.
Since the lack of a (well-prepared) shareholders’ agreement in your startup could make or break your startup or business, wouldn’t you rather fix it today before it becomes too late?
‘Why you badly need a shareholders’ agreement for your startup’ is part of Infusion Lawyers’ ‘What Startups Badly Need Series’. Subscribe to our blog so you never miss a post in this series.
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Culled from Mondaq