Crafting Shareholder's Agreements to Steer Your Startup's Success

Introduction

A shareholder agreement is a legally binding contract between a company's shareholders that stipulates the rights and obligations between them. For startups and investors, shareholder agreements are a crucial document that establishes the governance rules for the company and sets expectations between founders, investors, and shareholders.

Shareholder agreements help align interests and incentives, prevent future conflicts or disputes, and provide protection to both founders and investors. They outline the structure and policies around company ownership, decision making, information rights, voting procedures, and more. This enables smooth functioning and reduces ambiguity in how the company should operate.

Having a well-crafted shareholder agreement is essential when bringing on external investors. It ensures the founder maintains adequate control while investors get the protections they require before putting in capital. The agreement allows both parties to negotiate terms favorable to them upfront rather than later when conflicts arise. Overall, shareholder agreements create a foundation of trust and transparency from which the startup can grow.

Parties Involved

The key parties in a shareholder agreement for a startup are typically the founders, investors, and employees with equity.

a. Founders

The founders are the individuals who started the company and own a significant portion of equity. They are responsible for the initial business idea, product development, hiring, strategic decisions, and day-to-day operations. Founder shares are often subject to vesting schedules to ensure their commitment over time. Founders typically want to maintain control of the company and ensure their equity stake is protected.

b.Investors

Investors provide financing to the company in exchange for equity ownership. This often occurs in rounds of preferred stock financing (seed, Series A, Series B, etc). Investors want to protect their investment with rights and provisions in the agreement. They seek liquidation preferences, pro-rata rights, anti-dilution protection, board seats, and veto rights on key decisions. Their goal is to maximize financial returns.

c. Employees

Key employees are often granted stock options or restricted stock units (RSUs) as an incentive and retention tool. Typical employees become shareholders if they exercise their options. Their vesting schedules also help ensure retention over time. Employees want potential upside through stock appreciation and the ability to share in an exit or IPO. They have an interest in the company's growth and success.

Key Provisions

Shareholder agreements contain several key provisions that are important for both founders and investors. These help align incentives and protect the interests of both parties. Some of the most critical provisions are:

a. Voting Rights

Voting rights determine the level of control that founders and investors have over important decisions. Typically, voting rights are proportional to share ownership. However, investors often negotiate for additional voting rights to protect their investment. Common provisions include investor veto rights over certain major decisions like selling the company.

b. Board Seats

The board of directors is responsible for overseeing the company's strategy and operations. Shareholder agreements specify the number of board seats allocated to founders and investors. Investors want sufficient board representation to monitor their investment. Founders want to maintain control over the board.

c. Liquidation Preferences

Liquidation preferences determine how proceeds get distributed if the company is sold or goes bankrupt. Investors typically get a liquidation preference that guarantees they recoup their investment first. Any remaining proceeds then go to founders and employees.

d. Anti-Dilution Protections

Anti-dilution provisions prevent investors' stake from getting diluted in future fundraising rounds. Full ratchet anti-dilution lets investors purchase more shares at a discounted rate to maintain their ownership percentage if a down round occurs. Weighted average anti-dilution moderately increases investors' shares to account for valuation drops.

e. Vesting Schedules

Vesting schedules limit founders' and employees' ownership until it vests over time. This ensures they have incentives to perform well and remain with the company. Investors require long vesting periods like 4 years with a 1 year cliff.

Founder Control

Founders typically want to maintain control of their startup even after taking investment. There are several key provisions in a shareholders agreement that help founders retain control:

i. Vesting

Founder shares are usually subject to vesting over 3-4 years to ensure long-term commitment. Unvested shares can be repurchased by the company at cost if the founder leaves. Vesting gives founders incentives to grow the company over time.

ii. Voting Rights

Dual-class stock with supervoting rights allows founders to control a majority of voting power with a minority equity stake. For example, founders may hold Class B shares with 10 votes per share compared to 1 vote per share for investor Class A shares.

iii. Board Seats

Founders will negotiate for board seats to ensure control over major decisions like hiring/firing the CEO, approving budgets, and equity issuances. Common splits are 2 seats for founders, 1 for investors on a 3-person board or 3 for founders, 2 for investors on a 5-person board.

iv. Protective Provisions

Even minority founders can maintain control over key decisions by negotiating for protective provisions that require their approval for certain actions like raising more financing, M&A, IP transfers, etc. This prevents investors forcing decisions founder's oppose.

Investor Protections

Investors want to protect their investment in a startup's shares. Key investor protections in a shareholders' agreement include:

i. Liquidation Preferences

Liquidation preferences define the order and amount each shareholder gets back if the company is liquidated. Investors typically get their investment returned before founders and employees.

Common liquidation preferences include:

• 1x preference - Investors get their investment back first
• 2-3x preference - Investors get 2-3x their investment back before others get proceeds

ii. Anti-Dilution Provisions

Anti-dilution provisions prevent an investor's stake from being diluted too much if the company issues more shares. Common anti-dilution provisions include:

• Full ratchet - Investor gets issued more shares to maintain their ownership percentage if new shares are issued below their purchase price
• Weighted average - Investor gets issued some additional shares to partially offset dilution

iii. Negative Covenants

Negative covenants restrict certain company actions without investor approval, like:

• Incurring new debt over a limit
• Making an acquisition
• Entering a new line of business
• Issuing more shares

iv. Information Rights

Investors get access to company information, financials, budgets, board meetings, and facilities. This allows investors to monitor their investment.

Transfer of Shares

This is a critical section of a shareholders agreement that governs how and when shareholders can transfer their shares to a third party. Some key provisions relating to transfer of shares include:

a. Right of First Refusal (ROFR)

• Gives existing shareholders the right to purchase shares from a selling shareholder before they can be sold to an outside party.
• Typically provides a time period (30-60 days) for shareholders to exercise the ROFR after receiving notice of intent to sell from the selling shareholder.
• Prevents outside parties from acquiring shares without approval from existing shareholders.
• Allows founders and investors to maintain control over shareholder composition.

b. Co-Sale Rights

• Gives shareholders the right to participate in sales by other shareholders.
• If a founder wants to sell their shares to a third party, investors can exercise their co-sale rights and sell a proportional number of shares to that same third party.
• Prevents founders from benefiting from an exit while leaving investors behind.

c. Restrictions on Share Transfers

• The agreement will specify any restrictions, rights of consent or prohibitions on the transfer of shares.
• Often used to prevent transfer of shares to competitors.
• Gives company and shareholders more control over who can acquire shares.

d. Permitted Share Transfers

• The agreement may outline certain exceptions where shares can be transferred without restrictions, such as transfers to affiliates or family members.

Proper provisions around the transfer of shares help balance control between founders and investors while restricting unwanted transfers of shares. This brings stability to the shareholder group and protects shareholder interests.

Dispute Resolution

One of the most important clauses in a shareholders' agreement is how disputes between shareholders will be resolved. Litigation in courts can be extremely costly and time-consuming for startups, so alternative dispute resolution methods like arbitration are usually preferred.

The arbitration clause will specify how arbitrators are selected, the rules that govern the arbitration, and the seat or location of the arbitration. Often, arbitration will take place in a major metro area like Mumbai or Delhi under rules like those of the Singapore International Arbitration Centre (SIAC).

Specifying an arbitration seat is critical because it determines which country's arbitration law will apply. Parties may also choose to exclude certain remedies like injunctions and specify confidentiality obligations on the arbitrator and parties. Overall, clearly laying out the arbitration process creates predictability.

In addition to arbitration, shareholders' agreements also specify which courts have jurisdiction over the parties. This is important because arbitration awards can only be challenged in court in certain jurisdictions. Specifying a single court prevents multiple lawsuits in different courts.

By including robust arbitration and jurisdiction clauses, startups can avoid risky, public lawsuits between investors and founders. Arbitration preserves confidentiality and allows startups to resolve disputes quickly so they can focus on business growth.

Termination Rights

Shareholder agreements typically contain provisions outlining when and how investors can terminate their investment in the company or force a sale of the company. This gives investors an "exit" if things go poorly.

Grounds for investors to terminate or force a sale often include:

• Failure to meet performance milestones - If the company fails to achieve certain revenue, profitability, or other goals by a specified date, investors may have the right to terminate their investment. This protects investors if the company underperforms.
• Fraud or material misrepresentation - If the founders commit fraud or the company's financials are materially misrepresented, investors can terminate and withdraw their investment. This protects investors from misconduct.
• Failure to raise additional funding - If the company fails to secure additional funding rounds by a certain date, investors may have the right to terminate and get their money back. This gives investors confidence the company can continue raising funds.
• Bankruptcy/insolvency - If the company declares bankruptcy or becomes insolvent, investors typically have the right to terminate their investment and settle debts ahead of founders/employees.
• Change in control - If founders sell a controlling stake to another party without investor approval, investors may have the right to terminate and cash out their shares.
• Bad leaver provision - If a founder leaves voluntarily or is terminated for cause, investors may be able to force a sale of that founder's shares. This avoids a non-contributing founder retaining equity.

Properly structuring investor termination and exit rights is crucial for attracting investment and keeping investors satisfied with their ability to exit a struggling startup.

Confidentiality

Confidentiality is a critical issue for startups and investors. The shareholder agreement should have clear terms about what constitutes confidential information and how it will be protected.

Confidential information usually includes things like:

• Business plans, financial models, product designs, prototypes
• Customer lists, pricing strategies, marketing plans
• Technical specifications, source code, algorithms
• Any unpublished financial or performance data

The startup founders will want to ensure that sensitive information about their innovative products, services, and business strategies are not disclosed by investors to competitors or to the general public.

At the same time, investors will want assurances that the founders won't misuse confidential data about the company's finances, operations, and performance.

The shareholder agreement should clearly define what is considered confidential information. It should also specify:

• Who has access to confidential data and under what conditions
• How confidential data will be labeled and stored securely
• Limitations on copying, transmitting, or sharing confidential information
• Protocols for reporting any breaches or unauthorized disclosures
• Consequences for failing to protect confidentiality, such as financial penalties

Having robust confidentiality provisions can help build trust between founders and investors. It shows all parties are committed to protecting the company's sensitive information and intellectual property.

Conclusion

Shareholder agreements are critical documents for startups with external investors. They help align interests between founders and investors, provide governance guidelines for the company, and address key issues like founder control, investor rights, share transfers, and more.

Though there are some standard provisions, each agreement should be customized for a company's specific context and needs. The terms will evolve over funding rounds as the startup grows and new investors come on board.

Having clear shareholder agreements in place becomes even more important for startups in India, as the ecosystem continues to mature. With increasing investments, competition and complexity, founders need to set things up properly from the beginning.

Globally, shareholder agreements are commonplace in venture-backed startups. As Indian startups gain exposure to foreign investors and expand overseas, adopting these best practices will help them succeed.

In conclusion, shareholder agreements create alignment, provide protection and pave the way for long-term growth. For any startup founder, learning about these agreements, involving good legal counsel, and putting in place a solid foundation is a crucial step. These agreements may seem tedious at first, but will prevent a world of trouble down the road.

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