Having now been involved as either a Vice President or CEO in six early stage companies, and having advised countless others over the last 12 years, I’ve come across all kinds of situations regarding Shareholders’ Agreements: from not having one, to multiple types of share structures that were so complicated that at the time of exit, the buyer decided to throw out the original Agreement, and treat everyone as if they had Common Shares!
When a start-up CEO asks me whether they should invest time and money in developing a Shareholders’ Agreement, my answer is an absolute ‘Yes’, but only after they have reviewed their entire documentation and governance strategy, including intellectual property protection.
The Shareholders’ Agreement itself must form an integral part of a comprehensive approach to creating a professional organization, even if there are only a handful of people in the company. This will not only allow the initial Angel Investors the comfort that you are an experienced leader, but will also attract additional investors that will be impressed with the level of critical thought that has taken place in such an early stage venture.
Regarding types of shares- keep it simple. The most straight forward structures I’ve seen have all Common Shares, thereby giving all shareholders equal rights, with no extra provisions for either founders or the first seed stage investors, or negative covenants if milestones are not met. While the seed investors may ask for Preferred Shares with a discounted next round of financing guaranteed, I would strongly advise against this, especially if the next round of financing may come from a strategic corporate investor. A way around this is to give the seed investors, and founders, the first right of refusal at a discounted rate, with a hard timeline by which they must invest, based on milestones. This will confer some benefit, but will not tie the company up in a situation where other investors cannot be solicited.
In my experience, the most important element in the Shareholders’ Agreement is the drag along clause. This will determine what percentage of shareholders will have to agree to a Change in Control of the company, which usually occurs if a significant investor comes on board to take a majority share, or the company is sold outright.
I’ve been in a scenario where the drag along clause stipulated that 67% of shareholders had to agree to the sale of the company, and an investor who had only invested $30,000 at the founding of the company, and stood to gain over $1 million in less than two years, wanted to have a share of SRED tax credits paid back to him, essentially making his initial investment worth $20,000! While the entire management team and Board was against this, since without his shares we would fall below the 67% required to allow the transaction to proceed, we had to pay him the additional amount. While in principle we were against this, we could not allow one dissident, but significant shareholder, the power to stop the transaction from proceeding. It certainly did cause a lot of acrimony though! Subsequently, all my ventures have included a drag along clause that requires a simple majority for a Change in Control to be executed, and that has worked because I’ve always held a minimum of 25% ownership in these companies, essentially ensuring that the founding team would have control of the destiny of the company.
Eventually though, the initial Shareholders’ Agreement will most likely be replaced by a more complicated one by a larger, possibly strategic investor; but these guidelines may be of value in the very early stages of company formation, and will help send the right signals to all stakeholders.
Hari is a seasoned entrepreneur with over a dozen years of experience in building and exiting businesses in Canada, US and India.