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In this article, I will cover the key areas that startup founders need to be aware of before having a lawyer prepare their shareholders’ agreement for their startup. While this article is not an exhaustive list, it identifies the essential aspects of shareholders’ agreements that startup founders must know as a starting point.

Also, this article doesn’t replace legal advice. You can consult a legal practitioner for advice about such agreements.

Why Have A Shareholders Agreement for Your Startup Company?

A shareholders’ agreement is essential for most early-stage companies for numerous reasons, including:

  1. It can clarify founders and other shareholders in the early stages when the parties establish relationships,  strategies, and expectations.
  2. It can help prevent misunderstandings and disputes by defining the roles and responsibilities of the founders.
  3. It can provide a mechanism for resolving disputes.
  4. It can help ensure the company’s ongoing success by contemplating exit strategies for shareholders, including buy-back provisions, drag-along and tag-along rights, and pre-emptive rights.
  5. It can set the rules for allocating shares to key employees, including good and bad leavers.
  6. It can establish when dividends are paid and set budgets for marketing, employment, and other operational expenses.

What About the Company’s Constitution?

Most companies will receive a constitution when incorporating their company.

A constitution is a legal document that outlines the broad framework for managing and operating a company. For example, a constitution broadly stipulates the governance rules of a company, including the operation of board meetings and appointing and removing directors. In addition, constitutions can incorporate some replaceable rules under the Corporations Act.

Difference between a Constitution and a Shareholders’ Agreement

Often, due to some overlap, the differences between a shareholders’ agreement and a constitution need clarification. For example, the constitution is a legal document that provides the company’s governance rules. In contrast, a shareholders’ agreement is a private agreement that sets out their rights and obligations, including dispute resolution procedures, share sale and valuation processes.

Contributions to the Startup

Frequently, startup co-founders each provide value in different forms. Typically, one founder provides programming skills, another provides sales and marketing skills, and another provides capital.

While capital is the easiest to value, skills, on the other hand, are more challenging to value, particularly when you must value the programmer’s skills, time input, and deliverable output (sweat equity) against the salesperson’s sweat equity and sales conversions. Then, could you allocate shares according to that value?

Therefore, before drafting your shareholders’ agreement, startup founders should discuss exactly how and when they will provide their value and how they propose that their ‘sweat equity’ is valued.

For example, the shareholders’ agreement may require the programmer (who is a shareholder) to write the software specs and build the prototype and commit to 20 hours per week to do so in exchange for 500 shares of capital. At the same time, the sales and marketing founder may commit to making 200 calls a week and have a KPI of 30 sales per month for her 500 shares.

Employee Shareholders

At some point, startups will want to hire top talent. Startups often use an Employee Share Scheme to entice key staff, such as programmers, to work for lower wages and supplement the lower wage with ownership of shares in the startup.

Founders ensure that your shareholders’ agreement contemplates the Employee Share Schemes, including the decision-making process of issuing those shares to employees.

Share Sales

There are various impacts of selling shares in a company. However, if you fail to address some of the matters below in your shareholders’ agreement, significant problems can arise.

Pre-Emptive rights

Pre-emptive rights are provisions in a shareholders’ agreement that require shareholders to offer their shares to the existing shareholders before they sell them to a third party. Pre-emptive rights help prevent shareholders from selling their shares to others whom the existing shareholders do not know or want (to be a shareholder).

Drag Along Rights

Drag-along rights are provisions in a shareholders’ agreement that allow majority shareholders (usually founders and investors) to effectively ‘drag along’ the minority shareholders in the sale of the shares of the entire company. Additionally, drag-along rights compel the minority shareholders to accept the same terms as the majority shareholders when their startup is acquired.

Tag Along Rights

Suppose a majority shareholder sells their shares to a third party. In that case, tag-along rights allow the minority shareholders to join in the sale by selling their shares on the same terms and conditions as the majority shareholder.

Tag-along rights can help protect the interests of minority shareholders, as they give minority shareholders the option to sell their shares on the same terms and conditions as a majority shareholder.

Good Leaver & Bad Leaver Provisions

It is common for companies to offer equity to key employees, including founders, to incentivise them to stay with the company and work harder toward its success.

However, before allocating capital, company directors must address situations where key employees are forced to leave before the end of the agreed term and when key employees leave on bad terms.

Without good leaver and bad leaver clauses, exiting key employees retain ownership of the shares, which will be a problem if they leave earlier than agreed.

What is a Good Leaver Clause?

‘Good leaver’ provisions reward key employees forced to leave the company by allowing them to sell their shares to the company or another shareholder.

Good Leaver Examples

Common good leaver scenarios include where key employees leave due to illness, redundancy, and retirement.

What is a Bad Leaver Clause?

Bad leaver clauses operate to discourage key employees from leaving earlier than their agreed term. Bad leaver provisions also operate where key employees are forced to leave the company due to their impropriety.

Bad Leaver Examples

Common bad leaver scenarios include where key employees are fired for defrauding the company, underperforming, and leaving before an agreed term.

Compulsory Transfers

A compulsory transfer operates like an automatic trigger that allows the company to buy back the shares at the rate set in the shareholders’ agreement.

For example, a good leaver may get fair market value for the shares. At the same time, a bad leaver may only receive 5% of fair market value.

Compulsory transfers also prevent key employees from retaining shares in a company after leaving to work with a competitor.

Shareholder Decision Making

Defining how the startup makes decisions is crucial. We discuss some of the critical aspects below.

Shareholder Decisions vs. Board of Directors Decision?

Directors must consider which decisions are to be made by shareholders and which are to be made by the board of directors.

The board usually has decision-making authority concerning employment, general business operations, budget and forecasting, the business plan and dividends.

In contrast, shareholders often can vote on appointing and removing directors. Once you decide 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 the voting rights of shareholders who are also directors. Specifically, the shareholders’ agreement terms don’t give unintended additional voting power because they are both directors and shareholders.

Additionally, it would help if you decided whether to count votes in proportion to the number of shares held or whether to allow one vote per shareholder. For example, if Joe owns 50% of the shares and Nancy owns 10%, and the shareholders are voting, does that give Joe five times the voting power of Nancy, or do they each have one vote?

Deadlock Provisions

Deadlocks can occur where the votes on a decision are effectively at a stalemate – and neither side of the voting has a majority decision. Include proper provisions in your shareholders’ agreement to overcome potential deadlocks. For example, these may be provided by the CEO or a third party. There are several options when preparing deadlock provisions; discuss these with your lawyer.

Shareholders’ Agreement Resolutions

Resolutions are effectively decisions that the board or shareholders or, sometimes, both the board and shareholders. Therefore, when drafting a shareholders’ agreement, it is essential to understand how many votes are required to pass resolutions.

There are three primary types of resolutions. Companies would use different resolutions depending on the importance and impact of the decisions.

Ordinary Resolution

An Ordinary Resolution requires a majority vote of directors/shareholders over 50% to pass the resolution.

Special resolution

A Special Resolution usually requires 75% or more votes of directors/shareholders to pass this resolution.

Unanimous Resolution

As the name suggests, to pass a Unanimous Resolution, all directors/shareholders must agree to pass the resolution.

Share Ownership

The startup’s shareholders’ agreement should stipulate the names and owners of the shares and compel the directors to update the company share register and ASIC when new shareholders come on board.

Particular attention should be given to the classes of share owned. For example, most minority shareholders will usually own ordinary shares, while investors will almost always negotiate for preference shares.

The preference shareholders have additional rights over and above ordinary shareholders, such as those concerning dividends.

A startup company may need additional capital for expansion, to fund a company merger or acquisition, to prepare for an initial public offering (IPO), or because they have run out of cash.

Investors prefer preference shares over ordinary shares due to their additional rights, such as priority on dividends and the ability to convert them into ordinary shares.

However, when considering the issuance of preference shares, companies should be aware of the potential impact on remaining ordinary shareholders. In particular, preference shares can dilute the ownership of existing shareholders, including ordinary shareholders, which can reduce their overall control and voting power within the company. Therefore, it’s essential for companies to carefully consider the balance between issuing preference shares to raise additional capital and maintaining the interests of existing shareholders, including ordinary shareholders.

Related article: Preference shares.

Dispute Resolution

Avoiding litigation must be part of your company’s risk management policy. Therefore, your shareholders’ agreement should contain robust dispute resolution provisions to help mitigate the risk of shareholder litigation by shareholders.

I often implement a 3-step approach to dispute resolution clauses to put several alternative dispute resolution steps in place to help avoid Court action, except injunctive relief.

  1. Meet to discuss the dispute and negotiate in good faith.
  2. If good faith negotiations fail, arrange mediation.
  3. If mediation fails, arrange for arbitration.

Read the article on alternative dispute resolution.

Shareholders’ Agreement FAQ

What is the difference between a constitution and a shareholders’ agreement?

A company’s constitution contains rules about 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. At the same time, a shareholders’ agreement governs the relationships between the shareholders, including board members. Essentially, it sets out good 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 that allows employees to own part of the company while claiming a reduced wage. For example, an 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, you should speak to your lawyer about drafting a shareholder agreement to your startup company’s requirements regarding the rights and obligations of directors and shareholders.