October 21, 2016
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.
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.
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.
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.
A right of first refusal may include special rights for majority and/or minority shareholders when a third party wants to enter the mix.
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.
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.
Other Provisions. Shareholder agreements typically also include additional provisions that address other key aspects of the business.
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:
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.
Please contact your McInnes Cooper lawyer or any member of the Startup Team @ McInnes Cooper to discuss this topic or any other legal issue.
McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.
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