Shareholders Agreement 101

agreementIn the exciting early days in life of a startup, when the founders team is being setup or the external investors were just landed, one of the most important legal documents that defines the rules of the game, the Shareholders Agreement, is often treated lightly or its power underestimated by the first-time founders. Having been through this experience recently with one of the local startups, here is one of the most direct and readable summary of the issues that should be thought through and addressed very seriously as the consequences will haunt you throughout the lifetime of your company.

NOTE from Paul: The post below is written by Mike Volker and originally appeared on his site. It is the best I could find on this topic and is re-blogged here by permission.

Why Bother?

A company is owned by its shareholders. The shareholders appoint the directors who then appoint the management. The directors are the “soul” and conscience of the company. They are liable for its actions. Shareholders are not liable for company actions. Management may or may not be liable for company actions. Often these roles are assumed by the same individuals but as a company grows and becomes larger, this may not be the case. When a company is created, its founding shareholders determine how a company will be owned and managed. This takes the form of a “shareholders agreement”. As new shareholders enter the picture, for example angel investors, they will want to become part of the agreement and they will most likely add additional complexity. For example, they may want to impose vesting terms and also mechanisms to ensure that they ultimately can exit and get a return on their investment. Not having such an agreement can lead to serious problems and disputes and can result in corporate failure. It’s a bit like a prenuptial agreement.

Companies must comply with the law. Companies are incorporated in a particular jurisdiction (e.g. State, Province or Country) and must adhere to the applicable legislation, e.g. the Canada Business Corporations Act, or the B.C. Corporations Act. This legislation lays out the ground rules for corporate governance – what you can and cannot do, e.g. who can be a director? can a company issue shares? how can you buy or sell shares? etc. When a company is formed, it files a Memorandum and Articles of Incorporation (depending on jurisdiction) which are public documents filed with the Registrar of Companies. A shareholders agreement is confidential and its contents need not be filed or made public.

When a company is formed, its shareholders may decide on a set of ground rules over and above the basic legislation that will govern their behavior. For example, how do you handle a shareholder who wants “out” (and sell her shares)? Should it be possible to “force” (i.e. buyout) a shareholder? How are disagreements handled? Who gets to sit on the Board? What authority is given to whom for various decision-making activities? Can a shareholder (i.e. company founder) be fired? And so on…

A company which is wholly owned by one person need not have such an agreement. However, as soon as there is more than one owner, such an agreement is essential. The spirit of such an agreement will depend on what type of company is contemplated. For example, a three-owner retail shop may adopt a totally different approach to that of a high tech venture which may have many owners. When a company has hundreds of shareholders or becomes a “public” company, the need for such an agreement disappears and the applicable Act and securities regulations then take over.

Corporate Governance

There is no substitute for good corporate governance. Even small companies with few shareholders are better served by good governance practices. Instead of trying to anticipate every possible future event or trying to be overly prescriptive, a structure that ensures the installation of an experienced board of directors is arguably the best approach. Why? Because directors are responsible to the company – NOTto the shareholders as is commonly thought. If directors add diligently with this mandate, many problems that arise can be solved.

First Steps

Before jumping into a shareholders’ agreement, some very careful thought must be given to the share ownership. Who owns how many shares (and for what contribution – cash? time? intellectual property, etc)? And, how are these shares held? This is the time to talk to tax experts about some serious personal tax planning. Too many entrepreneurs ignore this important facet of owning shares only to find that when they “cash in”, they have a major tax headache. One should consider the merits of using Family trusts or issuing shares to one’s spouse and children. How is share ownership (and subsequent selling) treated by the tax authorities? Is there a disadvantage to granting stock options to employees versus giving shares (with possible vesting provisions) to them instead? Please refer to related articles on “structuring” and “dividing the pie“. A “Cap Table” (ie Capitalization Table) is essential.

What to Include

Some of the main points (ie. a checklist) to include in a shareholders agreement are:

  • what is the “structure” of the company? (and how is equity divided among shareholders?)
  • should the agreement be unanimous and involve all (or just some) of the shareholders?
  • who owns (or will own) shares (i.e. the parties to the agreement), i.e. a “capitalization table” often called a “cap table”.
  • are there vesting provisions? (i.e. shares may be subject to cancellation is a shareholder/manager quits)
  • are shareholders allowed to pledge or hypothecate their shares?
  • who is on the Board? What about outside board members?
  • who are the officers and managers?
  • what constitutes a quorum for meetings?
  • what are the restrictions on new equity issues, e.g. anti-dilution aspects, pre-emptive rights and tag-along provisions
  • how are ownership buyouts to be handled? (e.g. shotgun clause approach versus voluntary sale approach)
  • how are disputes to be resolved among shareholders? (arbitration clause?)
  • how are share sales handled? e.g. first right of refusal
  • what are a shareholders’ obligations and commitment? (conflict of interest or commitment? Full-time or ??)
  • what are shareholders’ rights? (what information, financial statements, reports, etc.can shareholders access?)
  • what happens in the event of death/incapacity?
  • how is a share valuation determined (e.g. to buy out an estate in the event of death)
  • is life insurance required? e.g. funding for purchase of shares from estate or for key person insurance
  • what are the operating guidelines or restrictions (budget approvals, spending limits banking, etc)
  • what types of decisions require unanimous board and/or unanimous shareholder approval?
  • compensation issues – remuneration of officers & directors, dividend policies
  • are other agreements required as well, e.g. management contracts, confidentiality agreements, patent rights, etc?
  • should there be any restrictions on shareholders with respect to competing interests?
  • what could trigger the dissolution of the business?
  • what is the liability exposure and is there any corporate indemnification (and insurance)?
  • who are the company’s professional advisors (legal, audit, etc.)?
  • are there any financial obligations by shareholders (bank guarantees, shareholder loans, etc)?

Some Do’s & Don’ts:

  • don’t confuse shareholder issues with management issues
  • don’t confuse return on capital with return on labor (i.e. cash investment vs founders’ time commitment)
  • don’t assume that everyone will always be agreeable (greedy? who-me?)
  • don’t get bogged down in legalese – decide what you want, then have your lawyer put it in proper form
  • do make sure everyone’s objectives and visions are compatible (this can be a major problem area)
  • do separate the roles of shareholders, directors, and managers (these roles often get confused in these agreements)
  • do talk to others who have gone through this process
  • do ask yourself what the downside is,  i.e. what’s the worst that can happen to you under the agreement?
  • do get some tax advice. It is very important that some tax planning be done early to avoid a headache later when you’ve made millions. e.g. you want to make sure that you are not compensated by being given shares, you want to make sure you own shares early so that you can use the small business lifetime capital gains exemption, maybe a family trust or holding company should own your shares.

Questions to Ask

After drafting an agreement, it is a good idea to ask a few key questions to ensure that the agreement will in fact be useful. Ask yourself the following:

1.Am I happy with my ownership stake? (If I’m the key founder, am I treating others fairly?)
2.Can I get out of this deal if I need to? i.e. can I sell the shares?
3.Can I buy more shares (ie more control) if I’d like to?
4.Am I committing to something I cannot live up to?
5.Will I be able to exert sufficient influence to protect my investment?
6.What is my total financial exposure and legal liability (present and future) on this deal?

Other Points to Consider

Preparing and discussing such an agreement will give you valuable insights into other parties’ styles, objectives, etc. It should force a close and honest evaluation of who will do what and who is committed to doing what. Most importantly, are the founders’ personal goals, objectives and propensities to take risk compatible? If one founder envisages a small, closely-held company as way to be self-employed and another envisages a dynamic, go-for-it enterprise, this marriage won’t work!  Even if you’re not sure about certain things and no matter how thorough you are, you will overlook something. Do it, then fix it if necessary, i.e. revise an agreement later rather than defer having one in the first instance.


Sample Agreement

Feel free to look at a sample agreement, albeit unprofessionally drafted, for some specific dertails. It will at least get you started. DON’T rely solely on your lawyer’s advice. Lawyers do have their biases and may steer you in a direction that is not in your best interest. (Note – are they acting for you personally or for the company or for other shareholders?)  Talk to other entrepreneurs who have gone through this exercise. Their experience may be worth many legal lunches!


Mike Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Past-Chairman of the Vancouver Enterprise Forum, President of WUTIF Capital and a technology entrepreneur. 

 

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