Founders relations – do you need a shareholders agreement and what should it cover?
Learn more about founders’ relations thanks to Katarína Martišová from Sparring!
The links will lead you to a dictionary which is part of Sparring’s Playbook where you can find more information about legalities that can help you win the startup game.
Your startup idea may have begun over a beer with your childhood friend, or you might have searched for a co-founder in your professional network. Regardless of how your relationship has started, to make sure it continues successfully, it is best to set some standards.
How to create some rules
When you incorporate your startup and establish the legal entity, you will dive deeper into the topic of founders’ position by drafting your obligatory founding documents (Memorandum of Association, Certificate of Incorporation, etc. depending on your jurisdiction).
Some questions such as division of shares, basic rights of the shareholders or powers of managing directors are often governed by the founding documents. Remember that these documents are hard to update, and any change will require some official administrative process (such as notary acts) so it makes sense to keep the founding documents light-weight. Moreover, you should know that the founding documents are usually also public.
On the other hand, shareholders (founders, and later on the investors) have also the option to enter into a shareholders agreement (the SHA, aka founders agreement), which is simply a bi- or multilateral agreement that isn’t public and can be changed “just” by agreement of all parties. The SHA is usually drafted and always updated as part of an investment round.
How does SHA work
While the founding documents usually contain only mandatory corporate data, a SHA regulates the rights and obligations in more detail, with an emphasis on relations between shareholders. The parties of the SHA are always the founders and later on the investors (usually after an equity round). Small shareholders, such as the team members having shares through ESOP, usually don’t sign the SHA.
After the investment round, the company itself can also be a party to the SHA. This can be helpful especially if you want the company to be bound by certain obligations such as fulfilling KPIs. Such an obligation is often a condition for further investment tranches from a new investor. A SHA also contains sanction mechanisms for breaking its terms, such as founders having to sell the share(s) at a reduced value to other shareholders, or the obligation of the company to return the investment amount to the investor.
What should SHA cover
You should check what areas are already covered by your founding documents depending on your jurisdiction. In CR/SR, these usually are the right of first refusal, voting rights, or third-party share transfer restrictions. If your founding documents don’t include these, make sure they are mentioned in your SHA.
The SHA should cover these topics:
- Bad leaver/good leaver clauses that define what happens if the founder leaves on good terms (voluntarily), or bad terms (e.g., in case of underperformance). Bad leaver situation is usually connected with the obligations to sell the shares with discount/for nominal price to other shareholders.
- Tag-along clause that protects the minority shareholders, allowing them to sell their share(s) together with other shareholders who want to leave the company. Keep in mind, however, that this leads to reduced liquidity of shares.
- Drag-along clause that enables the majority shareholders to force minority shareholders (investors and team members) to sell their shares in the company’s overall exit. It increases the ability of founders to dispose of the company.
- Non-compete obligation of the founders that prevents the disclosure of know-how to competitors or the creation of new competition by the founders themselves. It is time-limited to their time in the company and usually 12 to 24 months after the termination of the founder’s participation in it.
- ESOP (Equity share option plan) provisions will state a percentage of the shares that will be reserved for the team members.
- Founders vesting clauses will usually set forth that if the founder leaves the company sooner than after 4 – 5 years, he/she will have to sell back a portion of his/her shares.
- Anti-dilution provisions may create mechanisms against disproportionate dilution of existing investors’ shares (broad-based weighted average, which is standard or full ratchet, that should be avoided if possible)
SHAs are useful tools to create rules and avoid conflicts with co-founders and investors. Therefore, SHAs significantly increase a chance of your startup’s survival. The founders can benefit from it even before an investment round and it most likely can’t be avoided after the equity investment round (although some investors insist on it even if they invest in the form of convertible loan). Therefore, it is never too soon to get yourself oriented in the basic terms and clauses that the SHA may include.