All shareholders – whether in a startup, a small or large business or a family-owned business – can benefit from a shareholders’ agreement. A shareholders’ agreement is a written agreement among some or all of the company’s shareholders. It defines the relationship, rights and obligations between the shareholders and the company, and documents their agreement on matters related to the company’s management and operation, financing, organization and the transfer of shares – and addresses potentially contentious issues before problems arise. Without one, the relationship is governed by the applicable legislation (provincial or federal), but that doesn’t cover everything the shareholders might want to cover, or do so in the way they would choose. The best bet: take control and negotiate a shareholders’ agreement. Here are the key practical considerations and terms of founders shareholders’ agreements and the key complementary agreements founders should consider.

KEY CONSIDERATIONS

Here are a few key practical considerations about shareholders’ agreements for founders to keep in mind.

Timing. Deciding when to spend the money to put a shareholders’ agreement in place isn’t easy. Paying for one too early could be a waste of money if the business plan isn’t fleshed out or the co-founders aren’t yet decided. However, investors will likely want to see one in place before they consider financing the company. And expect investors, especially active ones, to want to discuss modifying the agreement to give them board participation and other things.

Minority Shareholder Rights. The legal framework is designed to protect minority shareholders. So just because a shareholder owns more than 50% of its company doesn’t mean it can make decisions that disregard the interests of minority shareholders.

Independent Legal Advice. Shareholders’ agreements have long-term ramifications. Each co-founder must understand the terms of the agreement and obtain independent legal advice to make sure they do.

KEY TERMS

Here are some of the key terms of a founders’ shareholder agreement.

Management & Operations. The shareholders agreement should address the key aspects of the company’s management and operations.

• Appointment of Board of Directors. Specify the number of directors and the right of shareholders to designate board nominees. Bear in mind, however, that investors typically expect to have board representation, and could be disruptive to the company’s governance.
• Restriction on Director Powers. These agreements will generally remove director powers and place in the control of shareholders.
• Distribution of Profits. If shareholders have certain expectations about dividends or other payouts, the agreement should set them out.
• Meeting Procedures. Deal with the procedure at shareholder meetings, in particular for meeting quorums. Requiring two levels of quorum avoids letting a shareholder effectively veto decisions by refusing to attend – and thus defeat the quorum; for example, a quorum for the first meeting requires 2/3 of the shareholders, and the next meeting after a failure to meet quorum sets a lower level (e.g. 50%) for a quorum.
• Special Approvals. It’s also helpful to require a higher level of shareholder approval (higher than a majority, such as three-quarters, two-thirds, or unanimous) for certain fundamental changes such as: the sale of assets outside the ordinary course of business, change of business, borrowing in excess of certain amounts, major capital expenditures, amalgamations, winding-up and revising the company’s articles.

Pre-Emptive Rights. This right allows each existing shareholder to avoid dilution of her ownership stake in the company. If a company decides to issue new shares, a pre-emptive right allows the existing shareholders (or those who hold a minimum portion of them) to buy those newly-issued shares before anyone else does. Importantly, the price offered to the existing shareholders can’t exceed the price for which the company offers the shares on the open market; if the company wants to lower its price, it must first offer the shares to the existing shareholders and the process starts over again. The agreement also typically sets out the procedure to use a pre-emptive right.

Rights of First Refusal. Rights of first refusal provisions (ROFRs) protect shareholders – but tend to deter third party purchasers, because the process is complicated. Generally, a ROFR requires a shareholder who receives an offer from a third party purchaser to give notice of the offer to the other shareholders. The other shareholders then have the right to match the third party offer within a certain time; if none do, the shareholder who received the third party offer may sell her shares to the third party. There are two variations of an ROFR.

• “Hard” ROFR. This is a right of first option: it requires a shareholder(s) to receive a bona fide offer from a third party before offering the shares to other shareholders on the same price and terms. If other shareholders refuse, then the offering shareholder can proceed with sale of her shares to the third party in accordance with the offer terms.
• “Soft” ROFR. This is really a right of first offer: it permits a shareholder to sell her shares to a third party after offering them to the other shareholders. The sale to the third party must be on the same price and terms offered to the other shareholders and generally requires disclosure of the terms of the third party sale.

A right of first refusal may include special rights for majority and/or minority shareholders when a third party wants to enter the mix.

• Tag-Along Rights. This allows other shareholders to “tag-along” with the shareholder that’s selling to the third party. Generally, the tag-along shareholder(s) can only sell a maximum of the same percentage of shares as the first shareholder; for example, if 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.
• Drag-Along Right. If a third party offers to buy the controlling shareholder’s shares (however the agreement defines the controlling shareholder), the drag-along right allows the controlling shareholder to force all other shareholders to either: sell their shares; or approve the resulting change of corporate control. As a result, a drag-along gives the controlling shareholder great power: it effectively ensures it can’t be stopped from divesting its shareholdings when it receives a legitimate third party offer.

Put/Call Provisions. The agreement usually sets out circumstances that “trigger” put or call options: circumstances in which shareholders may acquire each other’s shares, usually at fair market value or possibly at a discount in certain circumstances. Common triggering circumstances are: breach of the shareholders’ agreement, cessation of employment, voluntary retirement and marriage breakdown.

Shotguns. A shotgun clause is intended to break a deadlock between shareholders. It can be an effective means of resolving shareholder disputes – but can be a dangerous game, since an unfair price can open the process to abuse by affluent shareholders. There are both single shareholder shotguns and multiple shareholder shotguns.

• Single Shareholder Shotgun. This shotgun applies when there are only two shareholders. One shareholder gives the other shareholder concurrent offers: an offer to sell shares of the corporation (or of a corporate shareholder) and an offer to buy the other shareholder’s shares of the corporation (or their corporate shareholder). The receiving shareholder chooses which to accept – the sale offer or the purchase offer – within a fixed time period. If the receiving shareholder doesn’t choose, she’s deemed to accept the sale offer.
• Multiple Shareholder Shotgun. This shotgun applies when there are more than two shareholders. One shareholder gives all other shareholders concurrent offers to sell her shares and to purchase all of theirs. Each receiving shareholder must decide to buy the offering shareholder’s shares (or a portion of them if other shareholders also decide to buy) or to sell their shares. The result may be some shareholders selling and others buying. If, however, any shareholder decides to buy then the offering shareholder must sell her shares.

Share Valuation. It’s important the agreement addresses share valuation. Such clauses can help avoid valuation disputes among founders down the road, and are particularly important in a company’s pre-revenue stage because there’s often uncertainty, especially with tech companies, around what the company is actually worth. A valuation clause provides that shareholders are required to periodically (e.g. annually or bi-annually) determine value of shares, and sets out how the valuation will be made. There are two main approaches to valuation.

• Business Valuation. The company is valued by an independent business valuator according to the terms of valuation set out in the agreement.
• Fixed Formula. This could be specified as a multiple of corporate earnings, the book value of the company’s assets, or another established method of pre-revenue business valuation.

Other Provisions. Shareholder agreements typically also include additional provisions that address other key aspects of the business.

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

KEY COMPLEMENTARY AGREEMENTS

Here are additional agreements between the company and its shareholders beneficial to both a startup company and its shareholders.

Reverse Vesting Agreements. This agreement between co-founders is, in effect, a “company repurchase option” under which the company agrees to buy back a co-founder’s shares for a nominal amount. There are particular considerations in the case of Founder Reverse Vesting Agreements:

• Cliff. Decide whether a cliff is needed for founders, and if so, get it right. If a co-founder doesn’t reach the cliff, the company can re-purchase all that co-founder’s shares for a nominal amount leaving that co-founder with no equity. If the co-founders have been working with the company for a significant time before putting a vesting agreement in place, they might not need a cliff at all.
• Vesting Period. Getting the vesting period right: from what date does it run, and for how long. Companies will typically use a two to four year vesting period. Be particularly careful with terminations: if any co-founder is terminated during the vesting period without cause, these typically agreements provide that the shares immediately vest in full.

Proprietary Information and Inventions Agreement. This agreement protects the company’s proprietary information by ensuring the company retains ownership of sensitive information and intellectual property (including inventions) by setting out the shareholder’s confidentiality and non-disclosure obligations along with the company’s recourse in the event of a breach.

Employment Agreement. It’s wise practice for the company to enter into a written employment contract with each employee – including the co-founders and any other shareholders who are employees.

Employee Stock Option Plan (ESOP). If there is such a plan, it’s critical to document it and enter into an agreement setting out its terms and conditions. There are several forms of equity compensation plans; the one that’s the best fit for a particular corporation will depend on its unique circumstances and on what it hopes to achieve. Stock option plans are commonly used by startups that often lack the cash to entice and keep top talent (like employees, directors, consultants and advisors) to help the corporation grow, and is one of the considerations founders should think about when incorporating their startup.

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Please contact your McInnes Cooper lawyer or any member of the Startup Team @ McInnes Cooper to discuss this topic or any other legal issue.