Introduction to shareholder agreements

Forewarned is forearmed. Although alarming, the expression states the advantage of being prepared, when equipped with knowledge in advance. A shareholder agreement forearms your Startup.

What is a shareholder agreement?

A shareholder agreement is a private contract agreed and signed voluntarily by all shareholders of a business. A shareholder agreement…

…describes the organisation and its management

…covers the distribution of shares amongst shareholders

…regulates shareholders’ rights, obligations, and relationships

…provides for common understanding between founders and investors

…regulates daily operations and management

…formalizes processes for an investor exit or buy-in

Why is a shareholder agreement important?

With a shareholder agreement, you are mitigating the problems of an uncertainty in the future with legal resolution. It provides for the following:

  • controls share-transfers
  • prevents shareholder’s disputes with the company
  • assists in raising capital
  • demonstrate the business’ stability to prospects – investors and partners

When can a shareholder agreement be relevant?

Modify your shareholder agreement according to your start up’s stage in the maturity cycle. If you are making a shareholder agreement, consider the stage of your start up’s growth from the following:

  • Seed Stage: You can lead the drafting  of a seed stage agreement
  • Early Stage: An early stage agreement is a pre-existing shareholder agreement that is modified for a new investor or founder. It could be a new agreement, in the absence of one, to control relationships between parties and financial rules for investors
  • Growth stage: Since they are investing at this stage, VCs will probably be as involved as you in drafting a new or modifying a pre-existing agreement

Which are the common clauses of a shareholder agreement?

    • Board of directors: You state the board’s composition and an election mechanism for appointment and removal. You could also include rights to the shareholders in the election process.
  • Employee equity: You should document and manage the process of issuing shares to employees and shareholders.
    • Share vesting: You can use the clause to control the equity structure and incentivise talent to remain with your start up. You specify the certain milestones for an employee/founder to obtain the benefit of your start up’s equity
  • Pre-emptive rights: Before the general public, you provide the existing shareholders’ the opportunity to buy more shares in future equity issues. It allows them to maintain their ownership (equity) stake in the start up.
  • Anti-dilution: You protect an investor from equity dilution resulting from following issues of stock at a lower price than the investor originally paid.
  • Restrictions on share transfers: You can restrict your shareholders’ ability to use their equity as a collateral to secure debt for themselves or for later sale/transfer.
  • Drag-Along/Tag-Along rights: You allow/oblige a majority shareholder the right to influence minority shareholders to collectively sell all the shares.
  • Voting Rights: You grant your shareholders’ the right to vote on matters of corporate policy, such as – issuing securities, corporate actions, and substantial changes in the operations.
  • Deadlock Provisions: Through a deadlock provision, you create a conflict resolution mechanism for shareholders. It entails transfer of shares, casting vote, or liquidation
  • Share Valuation: You define the share valuation method for buy-outs to protect the cash flow and reserves.

You need a shareholder agreement as a cover for protection against financial and emotional distress. Especially, against issues not within the purview of the Articles of Association.