Shareholders’ Agreement Overview

Before you get more than one shareholder, I recommend that you speak to a lawyer about drafting a shareholders’ agreement for your company. A shareholders’ agreement is an agreement between your company’s shareholders, of how the company is to be operated. The shareholders’ agreement also imposes obligations on shareholders as well as voting rights on the many decisions that your company will need to make.

If you are already running a startup with co-founders and you don’t have a shareholders’ agreement in place, it is likely that your company will be run by the rules in you company constitution and the replaceable rules under the Corporations Act. These rules are a ‘one-size-fits-all’ solution to run companies and are not often suitable for most startups.

Below, are some important aspects of running a company that a shareholders’ agreement will govern. It will also serve as a useful list of things to consider before contacting a lawyer.

How Shares Are Dealt With

You must consider how you would like shares dealt with. If a shareholder is freely able to sell their shares, they may sell to someone the other members know – or want. Shareholders’ agreements often have clauses that force shareholders not to sell their shares without first offering them to existing shareholders. Further, a period may be stipulated in which the shares may not be sold to anyone.

Voting Rights of Shareholders & Delegation

The shareholders’ agreement must also deal with voting rights. You must decide what decisions are made by the board of directors, the (non-director) shareholders and the managers. It is impractical to take every decision to a vote. For example, the decision to buy a new printer can be delegated to a manager, rather than calling a board or shareholder meeting to vote on a decision.

It is best to have the board of directors make the decisions on important operational, business and strategic matters in which they have expertise. What about appointing a new CFO? Should that be a board decision? More than likely.

Whereas, (non-director) shareholders may vote on matters such as appointing and removing directors or take the company public.
Once you decide who makes what decisions, you must then determine the percentage of votes required to make those decisions. For example; a unanimous shareholder vote may be required to change the shareholder agreement, and a majority decision of the board is required to hire a new C-Suite executive.
It is therefore critical to speak to your lawyer about who makes what decisions in your company.

shareholders' agreement

Disputes

It is best to plan for the worst. Your shareholders’ agreement can provide a dispute resolution process. It is better for everyone to resolve disputes outside of Court. Instead, you can allow for an alternate dispute resolution (ADR) which may involve an independent third-party expert to decide on the dispute. You can also have a compulsory mediation clause, which forces those in despite to go through a mediation process before they can commence legal action through the Courts.

Litigation is a costly process that you must avoid, so be sure to consider ADR in your shareholders’ agreement.

Who Does What?

In the early stage of your startup, co-founders provide different forms of value. Some provide cash, some provide skills, while others provide industry connections. Whatever is promised to be provided, it should be included in the shareholder agreement.

In the perfect world, each co-founder should have an employment agreement that is separate from the shareholders’ agreement. However practically, many startups are not in a position to pay wages right away. So those terms must be recorded in a shareholders’ agreement. Not ideal, but if you are not at the stage of PAYG employment, then this is the best way.

You should also stipulate what occurs if a shareholder breaches the agreement and what constitutes a material (serious) breach and which are non-material breaches.

Employees and Shares

The shareholder agreement must stipulate how shares are handled for employees who are to receive shares under the employee share scheme (ESS), as part of their package.

Imagine what would happen if you found the best coder on the planet. He accepted 2% of your company in exchange to work for your company. You assigned the shares. He stretched the truth and he isn’t as good as you thought. They are his shares now. You can’t get them back – he can retire on a beach while you do all the work – unless you have dealt with these situations under the shareholders’ agreement.

Instead of outlaying the shares immediately, shares for employees need to vest. This means they are assigned incrementally over time or upon reaching a particular milestone or point in time.

Good Leaver and Bad Leaver

A good shareholder agreement will address shareholding employees who leave the company early and may deem that employees who leave your company to work for a competitor, are ‘bad leavers’. In which case, they must sell their shares back to the company at a pre-determined, nominal value.

On the other hand, if an employee has worked their heart out for 3 months, but must resign due to illness, the shareholders’ agreement may determine that shareholder to be a good leaver. In which case the employees’ shares are purchased back for market value.

There are many different ways to handle good leavers and bad leavers. A good lawyer experienced tech and startups company can talk you through this area.

shareholder agreementThe Exit

You need to consider what happens if a larger company offers to buy your startup out and half the shareholders want to sell, and the other half don’t. This can be very problematic unless the shareholders’ agreement deals with it. This is why you should consider having ‘drag-along’ and ‘tag-along’ rights in your shareholders’ agreement.

Drag-along provisions force minority shareholders to sell their shares, along with the majority shareholders. Where drag-along rights generally force minority shareholders to follow. Tag-along rights provide give minority shareholders the option to sell their shares in proportion to majority shareholders. For example, majority shareholders A, B and C vote to sell 20 per cent of their shares. The incoming shareholder must also purchase that percentage from minority shareholder D.

Finances

A good shareholders’ agreement must also contemplate financial issues, such as who decides to pay out dividends, how much to invest in marketing and advertising and how much employees get paid. There should also be terms that force the board to make financial statements available to the shareholders each month or quarter.

As you can imagine, there are many issues regarding money that need to be addressed.  Above are just some of the things that you need to be discussed before creating your shareholders’ agreement.

SCENARIO:

Three co-founders Jim, Sally and Sam, decide to build Widgitify an app that will disrupt the widget industry – which was Sally’s brilliant idea. The trio incorporates a company “WidgetCo” to make their startup dream a reality. Jim is a full-stack programmer, and Sam is a UX designer who both have been working around the clock for four months.

Sally starts slacking off and doesn’t come into the office, except for meetings. Jim and Sam get angry because they’re the ones doing all the work. Sally hasn’t done anything. Sally says “Widgetify is my idea, you guys should be thanking me!”.

Jim and Sam want to get Sally out of the company. They visit their lawyer who tells Jim and Sam that Sally owns one-third of the company. Sam has an idea of making a new company and take Widgetify to that company. His lawyer advises strongly against this because as directors, Sam and Jim have legal duties to both Widgetco and Sally that prevent such behaviour.

The only way that Jim and Sam can get Sally out is to buy her shares, but Sally doesn’t want to sell. These scenarios are common. That’s why it is essential to have a properly formed shareholder agreement.

Also, if contemplating starting a company with someone, make sure you ask them what and how they will contribute to the startup. Add it to the shareholder agreement in a section called roles and responsibilities if you are pre-revenue, and you cannot add it to your employment agreements.

Read about the deed of accession that usually accompanies a shareholders’ agreement.

Also see the Technology Law Guide.