Explained: Shareholder Agreements

  • Election of the board: Shareholders agreements often provide specific shareholders or groups of shareholders with the right to elect directors of the start-up corporation. This ensures that the key founders have adequate representation on the board.
  • Special shareholder approvals: Shareholder agreements also usually provide certain groups of shareholders with specific approvals over certain fundamental corporate changes (such as creating new classes of shares or approving the sale of the company).
  • Share transfer restrictions: Generally, founders don’t want the shares of their company ending up in the wrong hands. As a result, shareholder agreements restrict the transfer of shares other than in certain limited circumstances.
  • Pre-emptive rights: Shareholders agreements often provide investors with a right to acquire their proportional share of any new offering of securities or shares of the company. These rights are called “pre-emptive rights”, and they are typical of most venture-backed and seed financing transactions.
  • Drag-along rights: Founders sometimes want the right to require minority shareholders to sell their shares or vote in favour of an acquisition transaction. These are called “drag-along rights”, and again are typical of most venture-backed transactions.
  • Reverse vesting provisions: These are important for founders who want their co-founders to “earn” their shares based on the achievement of certain milestones or their continued engagement or employment by the company. If they fail to do so, the shareholder agreement often gives the company or other shareholders the right to repurchase any unearned or unvested shares from defaulting founders, usually for nominal or no cost.

What must founders cover in legal agreements?

Co-founders should keep their initial legal agreements pretty simple, bearing in mind two key numbers:

  • 50.1%—the voting threshold for legally controlling the board
  • 66.67%—the voting threshold for making any other change to the corporate structure

If founders trust each other, and they collectively hold shares sufficient to satisfy these basic thresholds, they can probably limit their shareholders agreement to a few key elements.
What do founders not need to cover in legal agreements?

Founders generally need not worry about any long-term or estate-planning matters in agreements. Avoid the seventy-page, “everything-but-the-kitchen-sink”-type of agreement and go with something in line with the agreement’s expected lifespan (for most companies, this lifespan lasts until the next round of financing or other significant transaction).

Andrew Brown, Partner in the Commercial Disputes team at Capital Law LLP adds: “When two or more people enter into a business venture together, it is easy – and, unfortunately, all too common – for them to get wrapped up in the excitement of building that new business and forget what are often perceived as the more mundane aspects of the legal framework for that business.

“It is well worth taking legal and accountancy advice from the outset on the various trading vehicles that are available because there are a number of legal and financial implications if you get it wrong.  A legal partnership can exist, for example, merely as a consequence of ‘persons carrying on a business in common with a view to profit’, but the parties (or some of them) might not have intended to be bound by the legal and taxation implications arising from that arrangement.  The parties might, for example, have preferred to limit their potential liability to third parties by forming a limited liability partnership or limited liability company instead.   Condensing such arrangements to writing helps to crystallise the parties’ intentions and reduce the likelihood of hassles in the future.

“Before entering into business, it is also worth doing some homework on your partner’s character and cash!  Do they have the qualifications they say they have? Do they have a criminal record? Do they have any money – or have they put all their assets into their domestic partner’s name?

“You also need to look forward and cover what will happen if another party wishes to join and put equity into the business.  It is also vital to consider the exit provisions – which will determine, for example, how a leaver’s ‘share’ in the business should be treated and what non-compete restrictions should be imposed to safeguard your legitimate business interests.

“Some people compare going into business with entering into a marriage.  Only time can tell whether a particular business arrangement, like a marriage, is ‘made in heaven’ or whether Cupid’s arrow had a poisoned tip!  It is difficult for some people to consider the implications of a break-up when they’re still in the ‘honeymoon period’, but legal advice should be obtained early on to avoid headaches in the long-term.”






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