Should You Have Founder Shareholder Agreements?

For Founders & Professionals

Once you have decided on how to split the equity and adding a vesting schedule for the founder’s stock, it is time for you to decide if you need a founder shareholder agreement or not. Founder shareholder agreements can help set the considerations and terms of the shareholders in the company. Keep reading this knowledge-based article to know more.

All About Shareholder Agreements

A shareholder’s agreement is a written agreement made with some or all of the shareholders in the company. This defines the obligations, rights, and relationships between the shareholders and the company. It also documents the agreement related to the management, operation of the company, addresses potentially contentious issues before problems arise, and the transfer of shares.

Without a shareholder’s agreement, the relationship between the company and the shareholder is governed solely by law (state or federal). But that does not cover everything the shareholders might want to cover in the way they would choose. The best bet: take control and negotiate a shareholders’ agreement.

In short, you should have a shareholder’s agreement prepared and signed before you can do anything as the founder of the company. To understand more about the agreement, you need to know all about the key practical considerations, terms of founder shareholders’ agreements and the key complementary agreements founders should consider. The next sections would help you understand them better.

Shareholders’ Agreement: Key Considerations

To begin with, here are a few key practical considerations about shareholders’ agreements for founders to keep in mind:

Timing: Making a decision on when to spend money to make a shareholder’s agreement is not easy. Paying way too early can be a waste of money, especially if the company plan isn’t in place and the founder team isn’t finalized. Nonetheless, investors usually want to see a shareholder agreement before they add capital to your company and will expect to discuss altering the agreement to give them board participation and other things.
Minority Shareholder Rights: The legal framework of the agreement is designed in such a way that it protects the minority shareholders. So, just because a shareholder owns more than 50% of its company, it does not mean that they can easily make decisions that would disregard the interests of minority shareholders.

What’s included in a founder shareholder agreement?

There are many terms and parts of the agreement that come under this. Each has been explained below in detail.

Shareholders’ Agreement: Key Terms

With the key considerations clear, it is time to understand all about the various key terms used in the shareholder’s agreement. Below are some of the key terms of a founders’ shareholder agreement that you should know:

Management & Operations: The shareholder’s agreement should be able to address all the main aspects of the operations and management of the company. This includes the following:

Appointment of Board of Directors: You need to specify the number of directors along with the shareholder rights to designate the board nominees. But keep in mind that investors usually expect to have board representation and can be disruptive to the governance of the company.
Distribution of Profits: In case the shareholder has specific expectations about any payouts including the dividends, the agreement would need to define those things.
Restriction on Director Powers: With this agreement, the director’s powers will be removed and replaced with the control of the shareholders.
Special Approvals: It is very good to get a higher level of shareholder approval for specific fundamental changes, including revising the company’s articles, winding-up the company, major capital expenditures, borrowing in excess of certain amounts, change of business, and the sale of assets outside the ordinary course of business.

Pre-Emptive Rights: Another section that has to be a part of the shareholder agreement is the pre-emptive rights. As per this right, each existing shareholder can avoid dilution of their ownership stake in the company. In case a company decides to issue new shares, the pre-emptive rights would permit the existing shareholders to purchase those newly-issued shares before anyone else does.

Additionally, the price provided to the existing shareholders cannot exceed the price the company provides in the open market. In fact, if the company wants to lower its price, they would have to offer the shares to the existing shareholders and the process would have to start all over again. Plus, the agreement needs to also put out the procedure of using pre-emptive rights.

Rights of First Refusal: The next thing that the agreement would hold is the rights of first refusal provisions (ROFRs) that protect shareholders. Just so you know, this right tends to deter third-party purchasers as the overall process is highly complex.

Under this right, the other shareholders would get the right to match the third-party offer within a certain time. If none of them do, the shareholder who received the third party offer might sell their shares to a third party instead of selling it to the other shareholder. There are two kinds of ROFR:

“Soft” ROFR: This is a right of the first offer and it allows a shareholder to sell their shares to a third party after they have offered it to other shareholders. The sale made to the third-party has to be at the same cost and terms offered to the other shareholders. The agreement also needs to have the disclosure of the terms of the third-party sale specifically mentioned.
“Hard” ROFR: This is the right of the first option. As per this right, it requires the shareholder(s) to receive a bona fide offer from a third party before they are able to offer the shares to other shareholders. In case the other shareholders refuse, then the offering shareholder can move ahead and sell the shares to the third-party with the same offer.

That is not all. The ROFR can include special rights for a minority and/or majority of the shareholders when a third-party wants to enter the mix. These rights include the following:

Drag-Along Right: In case the third-party offers to purchase the shares of the controlling shareholder (the shareholder’s agreement would define who the controlling shareholder is), the drag-along right would permit the controlling shareholder to force all other shareholders to either approve the resulting change of corporate control or sell their shares. Due to this, the drag-along offers the controlling shareholder a great power. This right effectively ensures the shareholder cannot be stopped from dispossessing its shareholdings when they receive a legitimate third party offer.
Tag-Along Rights: This allows other shareholders to “tag-along” with the shareholder selling to the third-party. Usually, the tag-along shareholder can only sell a maximum of the same percentage of shares as the first shareholder. For instance, in case the shareholder that received the original offer is selling 10% of its shares, the tag-along shareholder can only sell a maximum of 10% of its shares.

Put/Call Provisions: Another thing that the agreement sets out are the circumstances that “trigger” put or call options. This includes the circumstances in which shareholders may obtain the shares of each other. And this is normally done at the fair market value (FMV) or possibly at a discount in specific circumstances. Common triggering circumstances include a breach of the shareholders’ agreement, voluntary retirement, cessation of employment, and marriage breakdown.

Shotguns: This clause should be a part of the shareholder agreement, called the shotgun clause. Its intent is to break a standstill between the shareholders. It is used as a great means to resolve any disputes between shareholders, but can also be a very dangerous game because an unfair price can open the process to abuse shareholders. There are both multiple shareholder shotguns and single shareholder shotguns.

Each has been explained below:

Multiple Shareholder Shotgun: This right works where there are more than two shareholders involved. Basically, one shareholder gives all other shareholders concurrent offers to sell their shares and to purchase all of theirs. Each receiving shareholder has to make the decision to purchase the offering shareholder’s shares (or a portion of them if other shareholders also decide to buy) or to sell their shares. When the decisions are made, some shareholders would be selling and others will be buying the shares.
Single Shareholder Shotgun: This is applied when there are only two shareholders. In this case, one shareholder offers the other with concurrent offers, which is an offer to sell the shares of the corporation and offer to purchase the shares that the other shareholder has. The receiving shareholder chooses which offer to accept from the sale or purchase of the shares, but the decision has to be made within a fixed time. If the receiving shareholder doesn’t choose, they are deemed to accept the sale offer.

Share Valuation: It is vital for the agreement to address the share valuation. With such a clause, the shareholders can avoid valuation disputes among founders during the business life. It is important for the pre-revenue stage of the company as there’s often uncertainty, especially with tech companies, around what the company is actually worth.

To explain better, a valuation clause demands that shareholders are needed to periodically figure out the value of shares. Additionally, it also sets out how the valuation will be made. There are two main approaches to valuation as shared below:

Fixed Formula: This can be specified as the book value of the company’s assets, an established method of pre-revenue business valuation or a multiple of corporate earnings.
Business Valuation: Under this, the business is valued by an independent business valuator as per the terms of valuation set out in the agreement.

Other Provisions: Other than the part mentioned above, the shareholder agreement also holds some additional provisions that address other parts of the company. These include:

Acknowledgment the shareholder has had the opportunity to seek and obtain independent legal advice (ILA).
“Boilerplate” provisions such as entire agreement and severability clauses.
Alternative Dispute Resolution mechanisms for shareholder disputes (e.g. requiring negotiation and/or mediation before litigation).
Signing authority for banking and contracts.
Shareholder duties and compensation.
Indemnity and insurance issues.
Provision for the company’s accounting, which also includes preparation of the company’s financial statements & budgets.

In short, all the above parts are important for the shareholder agreement. And with the explanation shared above, you now know what the shareholder agreement is made of.

Shareholders’ Agreement: Key Complementary Agreements

Other than those parts mentioned above, there are some additional agreements between the company and its shareholders that are beneficial to both the shareholders and the company. They include the following:

Employee Stock Option Plan (ESOP): In case there is such a plan in the company, it is important to have it documented with a proper agreement that states all the terms and conditions.

Employment Agreement: Another thing that the company should practice is having an employee contract. The company should always have a written employment contract with the employees including the shareholders and the co-founders as well.

Proprietary Information & Inventions Agreement: This is another agreement that protects the proprietary information by ensuring the company preserves the ownership of sensitive information and intellectual property by setting out the confidentiality of the shareholder and non-disclosure obligations, along with the recourse of the company in the event of a breach.

Reverse Vesting Agreements: This is another agreement that is made between the co-founders of a “company repurchase option”. Under this, the company would agree to purchase the shares back from the co-founder at a nominal amount. In fact, there are a few considerations in the founder reverse vesting agreement, which include:

Vesting Period: Obtaining the vesting period right from the date it would begin and till how long the vesting schedule would be active. Companies normally use a 2-year or 5-year vesting period. But it is important that you pay attention to the terminations, as if a founder is terminated during the vesting period, these agreements offer that the share should be vested completely and immediately.
Cliff: You will also need to make a decision based on if a cliff is needed for the founders. If true, you need to get the cliff done right. Basically, when a founder does not reach the cliff, the company has the right to repurchase all the shares back for a nominal amount, leaving that founder with no equity. If the founders have been working with the company for a long time before they agree to put the vesting agreement in place, they might not need a cliff at all.

Wrap Up

Now, you know all about the shareholder agreement and why you need it. The next step is to understand the taxes for the shares you would own as a founder. Check out the next knowledge-based article for understanding all about the Section 83(b) election here!