In this article, we will discuss the key areas that startup founders need to be aware of when drafting a shareholders’ agreement for their startup. This will also serve as a guide for things to discuss with your co-founders before having the document properly drafted.
Please bear in mind, this is not intended to be an exhaustive list by any means. Rather some it identifies some of the most important factors that startup founders regularly do not address.
Additionally, this is not a replacement for legal advice. Consult a suitably qualified legal practitioner for information or advice regarding such work.
Before You Commence Drafting a Shareholders’ Agreement
If you have co-founders
It is vital for cofounders to agree on how their startup company is run. Failure to have this mutually agreed ‘buy-in’ at the start of the company can leave some shareholders to believe they have got a bad deal. I have seen this manifest into a complete breakdown of the relationships and companies.
I advise that all cofounders know exactly what they are getting into, and get independent advice if necessary.
If you are a solo founder
On the other hand, if you are the sole founder of a company, and you are intending to bring other shareholders (employees, investors, or another cofounder) then I advise you get the shareholders’ agreement prepared on how you want the company to run. Once the first shareholder comes on board, you can provide them with the shareholder agreement to review and accept.
Naturally, the incoming shareholder will have the ability to negotiate the shareholders’ agreement with you. A startup founders’ willingness to negotiate will obviously depend heavily on what the incoming shareholder is bringing to the table. For example, an investor may have more negotiating power than an employee.
Why Have A Shareholders Agreement for Your Startup Company?
To help you understand why you may need a shareholders’ agreement, it will help to discuss what will happen if you don’t have one. Upon registration of a company, you’ll be provided with a “one size fits all” constitution. Without a properly drafted shareholders’ agreement, will mean that your company will likely be governed by that constitution as well as the replaceable rules contained in the Corporations Act 2001 (Cth).
Operating a startup company with the company constitution and replaceable rules doesn’t often facilitate how most startup founders want their company to be governed.
Meanwhile, a Shareholders Agreement usually sets out more specific, detailed rules around the relationship between shareholders and directors, and how the capital in the company can be held and transferred.
Contributions to the Startup
Before you get started, the most important aspect to define is what each party is contributing to the company. This is most relevant to startups that are about to start. In technology, software and startup companies each founding member will usually provide value in different forms. While one founder may provide value in skills such as programming, sales and marketing, another will provide capital.
It goes without saying that capital is the easiest to assign value to, as money is easily measurable. Skills, on the other hand, are not as easy to value. Therefore, before drafting your shareholders’ agreement, I recommend you discuss with the founding members exactly how, and when they will provide their value. For example, the shareholders’ agreement may require the programmer (who is a shareholder) to write the software specs and build the prototype and can commit to 20 hours per week to do so, in exchange for 500 shares of capital. While the sales and marketing founder may commit to making 200 calls a week and have a KPI of 30 sales per month.
Once you define the value of the skills being provided, include it in the employment agreements. The shareholders’ agreement should therefore refer to each working shareholders’ employment agreement and require that it is adequately performed, as promised. Also, remember to consult your lawyer as to whether it is appropriate in your company’s circumstances to treat the party who breaches their employment agreement to be a bad leaver. This can allow the company to buy back the shares of the breaching shareholder at a nominal value. It may sound drastic. But that’s business.
At some point, startups will want to hire top talent. Especially programmers and management with connections. However, since many startups are often cash strapped, what better way to incentivize A-grade employees than with shares in the company?
Employee shareholders are becoming very common – owning a part of the company and the prospect of sharing in the next unicorn can be very enticing. You must be sure that any employee share schemes that your startup company offers are covered in your shareholders’ agreement.
Unless this is done properly, there can be several pitfalls. For example, the decision making power on how to issue shares to employees must be addressed in the shareholders’ agreement – along with the mechanism to allow new shareholders come on board without requiring a unanimous resolution to amend the agreement. The document that facilitates this is called a deed of accession.
Startups often use an Employee Share Scheme (ESS) as a mechanism to employ staff while offering shares. This allows startups to pay minimum wage to talent and supplement the lower wage with ownership of shares in the startup.
Cofounders must also get advice from their accountants on when they, themselves will become employees of the company. This will depend heavily on the cash flow of the company.
Before hiring, the startup must have employment agreements also.
There are various impacts of selling shares in a company. If you fail to address some of the matters below in your shareholders’ agreement there can be significant problems.
Pre-emptive rights allow existing shareholders to have rights to purchase shares from those shareholders who are intending to sell their parcel of shares. The shareholder wishing to sell is usually required under the shareholders’ agreement to notify the other shareholders of their intention to sell their shares, while also offering their shares to the existing shareholders.
Pre-emptive rights help avoid shareholders selling their shares to others, who the existing shareholders do not know (or perhaps want).
Drag Along Rights
Drag along rights are provisions in a shareholders’ agreement that are helpful for majority shareholders (usually founders and investors) to have if they want to have the option to make a better exit. Specifically, drag along rights allow the majority shareholders to effectively ‘drag along’ the minority shareholders in a sale of the shares if the company is being acquired.
It is important to note that the minority shareholders get less for their shares than the majority shareholders, in a properly drafted shareholders’ agreement.
Tag Along Rights
Unlike the drag along rights mentioned above, tag along rights allow minority shareholders to ‘join in’ on the share sale. Depending on how the shareholders’ agreement is drafted, this usually allows the minority shareholder the right to sell their shares to the buyer in the same proportion as the selling majority shareholder.
For example, where a majority shareholder is selling 5% of their shares, it will enable the minority shareholder to sell 5% of their shares to the buyer.
Shareholder Decision Making
Defining who and how decisions are made in the shareholders’ agreement is important.
Shareholder Decisions vs Board of Directors Decision?
What decisions are to be made by shareholders and which are to be made by the board of directors?
Once you decide who has the right to vote on certain decisions, you need to ensure how many votes are required to make the decision. Usually, the board has decision-making authority with regards to employment, general business operation, budget and forecasting as well as deciding on the business plan and issuing dividends.
Shareholders will have the right to vote at appointing and removing directors, dilution of capital, general management of the business. Once you decide on who is responsible for making which decisions you must decide how many votes are required to pass a resolution or special resolution as the case may be.
Shareholder Voting Power
Special attention also needs to be given to voting rights of shareholders who are also directors. Specifically, the terms of the shareholders’ agreement don’t give additional voting power, that was not intended, due to them being both a director and shareholder.
Additionally, you must decide whether votes are counted in proportion to the number of shares held, or 1 vote per shareholder? For example, if Joe owns 50% of shares and Nancy owns 10% and the shareholders are voting, does that give Joe 5x the voting power of Nancy? or do they each have 1 vote?
Deadlocks can occur where the votes on a decision that needs to be made are effectively at a stalemate – and neither side of the voting has a majority decision. For example, if the shareholders’ agreement requires shareholders to vote to appoint a new director, on an ordinary resolution, which requires over 50% of the shareholders to reach a decision.
To overcome potential deadlocks, be sure to include proper deadlock provisions in your shareholders’ agreement. These may provide the chairman of the board the deciding vote or even a vote from a third-party. There are several options when preparing deadlock provisions, be sure to discuss these with your lawyer.
Shareholders’ Agreement Resolutions
Resolutions are effectively decisions that are approved by the board or shareholders, as the case may be. When drafting the shareholders’ agreement it is important to understand how many votes are required to pass the resolution.
There are three primary types of resolutions. The exact percentages are those generally stipulated in most shareholder agreements, constitutions and in the Corporations Act, however, these may vary, depending on the composition of the board and the number of shareholders – and of course, what is in your shareholders’ agreement.
An Ordinary Resolution is where the shareholders or the board are required to reach a majority vote of over 50%, to pass the resolution.
A Special Resolution requires 75% or more of the votes to pass this type of resolution.
As the name suggests, to pass a Unanimous Resolution all parties to the decision, whether that be the board or shareholders, must agree to pass the resolution.
The startup’s shareholders’ agreement should stipulate the names and owners of the shares and compel the directors to update the company share register – as well as ASIC, when there are new shareholders that come on board.
Special attention should be given to the classes of share owned. For example, most minority shareholders will own ordinary shares, while investors will almost always negotiate for preference shares.
Those shareholders with preference shares will have additional rights over and above ordinary shareholders. For example, preference shareholders will have rights to be paid first from remaining funds, in the event of a liquidation.
When getting legal advice on your shareholders’ agreement consider the different classes of shares and who you want to have them.
Shareholders should be aware of their rights concerning issuing new shares in the company. This is known as dilution, as it reduces ownership rights in the company. A startup company may need to issue new shares to get further capital for expansion, a company merger or even to prepare for an initial public offering (IPO) where the shareholders wish to make the company public.
Dilution is not always bad though – it can sometimes be necessary and beneficial. While dilution can reduce the value of the shareholders’ shares, it is not always the case.
For example, GlobalEG Pty Ltd is a company valued at $1,000 and is comprised of 10 shares and has two equal shareholders, Tom and Jane. Each share is valued at $100. Therefore, Tom and Jane each have $500 of equity in their respective (5) shares.
Tom’s friend Susan wishes to buy shares in the company for $500. However, Tom and Jane realise that you can’t equally split 10 shares 3 ways. The pair agree to issue 5 new shares to Jane in exchange for her $500 investment.
While the proportion of share ownership of Jane and Tom’s shares have been reduced (diluted) to smaller percentage ownership in GlobalEG (from one half to one third) the value of the company has increased with Susan’s investment to $1,500. This means Tom and Jane’s shares, whilst diluted, remain valued at $500.
Although shareholders need to address for dilution events in shareholders’ agreements, they must be equally aware who authorises share issues. Is it a board or shareholder decision and what type of resolution is required to issue the shares to incoming shareholders?
With the above in mind, ensure that there is a proper mechanism to value the shares, in your shareholders’ agreement. Shareholders should also be aware that share issues can create complexity around control and voting power. Therefore, ensure that these things are considered when drafting your shareholders’ agreement.
Avoiding litigation must be part of your company’s risk assessment and treatment plan. Your shareholders’ agreement should therefore contain robust dispute resolution provisions to help mitigate the risk of litigation
I often implement a 3-step approach to dispute resolution clauses. As you will see, the aim is to put several alternative dispute resolution (ADR) steps in place to help avoid Court action, with the exception of injunctive relief.
The 3-step dispute resolution clause requires the parties to first notify the other party of the dispute, together with the suggested means which the disputing party recommends to resolve the dispute. The parties must then negotiate in good faith.
If the parties are unable to negotiate between themselves to resolve the dispute, the shareholders’ agreement will compel them to.
Failing that the parties then agree to go to mediation and failing that, the parties agree to arbitration.
Mediation and arbitration are known as alternative dispute resolution (ADR). Read the article on alternative dispute resolution.
Shareholders’ Agreement FAQ
What is the difference between a constitution vs shareholders' agreement?
A company’s constitution contains rules about more of the administrative side of running a business, such as when meetings are held and how they are called, voting rights and duties of directors and officeholders. Whereas, a shareholders’ agreement governs the relationships between the shareholders, including board members. Essentially, it sets out good leaver and bad leaver provisions, hiring, exit strategies, pre-emptive rights, payment of dividends, dealing with shares and dispute resolution clauses.
What is an Employee Share Scheme (ESS)?
An employee share scheme (ESS) is a scheme which allows employees to own part of the company, while claiming a reduced wage. The ATO’s employee share scheme, allows employees to receive shares in a startup, without attracting capital gains tax when they are issued.
Do I Need a Shareholders' Agreement?
If you have more than one shareholder, it is advisable to speak to your lawyer about having one drafted that is specific to your startup company’s requirements. A shareholders’ agreement will set out the rights and obligations of directors and shareholders to ensure the company is run properly and any disputes can be resolved more efficiently.